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The Lights Are Still On (Think Energy and Biotech Investments), but the Party’s Over for Many U.S. Venture Deals

Xconomy National — 

The venture-capital numbers for the U.S. are out for the third quarter of 2008, and they don’t quite reflect the turmoil in the broader financial markets—at least not yet. Total venture investment in U.S. companies in Q3 amounted to $7.1 billion in 907 deals, which is down 7 percent from the second quarter of this year, when there was $7.7 billion invested in 1033 deals. The bright spots were energy and biotech deals, while there could be real trouble brewing for certain types of Internet-startup deals and capital-intensive tech operations like telecommunications and semiconductor companies.

That’s the word from a quarterly report by the MoneyTree division of PricewaterhouseCoopers and the National Venture Capital Association, based on data from Thomson Reuters. Dow Jones VentureSource also released its Q3 venture-capital figures this weekend, and they show the same 7 percent drop and grossly similar trends. Namely, deal activity is at a three-year low. Energy is up, information technology and the Web are down, and health care, biotech, and pharmaceuticals are fairly flat.

(To see the Top 10 Deals list for the nation for Q3, read on or click here to go straight to page 2.)

Sector Shakeout?

According to the MoneyTree report, biotech was the top industry sector, with $1.35 billion invested in 114 deals, a 20 percent increase over Q2 of this year. This just barely edged out the software sector, which remained strong with $1.34 billion invested in 214 companies. The fast-rising cleantech sector (defined as alternative energy, pollution and recycling, power supplies, and conservation) saw $1 billion go into 73 deals, up 13 percent over last quarter.

Potential trouble spots include “Internet-specific” companies, which received $1.1 billion in 194 deals —still a large number, but a 36 percent drop over Q2. The telecom industry saw only $323 million go into 45 deals, its lowest investment level since Q3 of 1997. And the semiconductor industry saw $396 million invested in 50 deals—fairly slow, but a 7 percent increase over the previous quarter. More broadly, in terms of overall deal stages, there were 259 first-time deals, which was down 12 percent from Q2, possibly reflecting a future trend towards fewer early-stage deals, as exit markets are all but closed.

Regional Mixed Bag

No surprise to anyone, Silicon Valley topped the deal list, with $2.77 billion put into 292 investments, down 11 percent from Q2. Investments in the New England region stayed reasonably strong in the third quarter as well, as the area saw $834.1 million poured into 117 deals. That was down only 2.3 percent from the second quarter, in which $853.8 million was invested in 123 deals. Similarly, third-place Los Angeles/Orange County rang up $572.5 million in 54 venture deals, down only slightly from the $593.8 million from the previous period.

It got worse both north and south of LA. Venture investments in San Diego in the third quarter fell to just $178.4 million (22 deals), a 52 percent tanking from Q2 and the lowest quarterly tally for the region since the first quarter of 2005. The picture in the Northwest was also fairly bleak, as venture investment sank to $294.9 million, down some 16 percent from $349.3 million in Q2.

On the international front, U.S.-based venture capitalists invested $526 million into 51 Q3 deals in China, down slightly from Q2 ($574 million in 52 deals). Meanwhile, investment into India by U.S. venture firms fell 43 percent to $271 million in 28 deals (compared to $473 million in 40 deals in Q2). On the flip side, investors in Europe and Asia have been playing a greater role in financings of U.S. companies, says venture capitalist Jim Healy of Sofinnova Ventures.

Outcome Uncertain (but the Trend Is Certainly Down)

The question on everyone’s mind is, where is this heading? “While overall venture investing hasn’t yet been impacted by the turmoil in the financial markets, as evidenced by the $7 billion plus invested in Q3, we do expect to see a dip in investing over the next several quarters,” said Tracy Lefteroff, global managing partner of the venture capital practice at PricewaterhouseCoopers, in a statement. “We also do not expect venture funding to dry up. Venture capitalists have slugged through difficult economic times before and this one should be no different.”

In a conference call on Friday, Mark Heesen, president of the National Venture Capital Association (NVCA), ventured his thoughts about the impact of the financial crisis. “We’ve been through this before, and hopefully we’ve learned some lessons from the bursting of the bubble,” he said. “You see concern out there, there’s no question about it…more on the IT side than life sciences. We see companies that should be out of the nest by now being worked on by VCs still.” Another big concern, Heesen says, is “less time and less money going to new ideas, new entrepreneurs, and new companies. The long-term issue is, we want to see entrepreneurs out there. That has very serious implications for the venture capital industry. There are clouds on the horizon.”

While some might consider that an understatement, venture capitalists seem to be standing tall, while employing extra caution in their deal selection when it comes to size and time horizons. “It’s one of the best times to build new companies,” says Faysal Sohail of San Francisco-based CMEA Ventures, which manages $1.3 billion in funds (about half in energy and materials, and the rest in information technology and life sciences). Speaking for his own firm, he says, “Deal flow is incredible…the phone is ringing off the hook. We’re making sure new deals are capital efficient, and we’ll only go in on deals with partners who are able to be at the table with us for three years.”

In the conference call, Sohail emphasized that the venture industry is still thriving. “The strong will survive. This is not a time to panic, there’s lots of opportunity,” he says, pointing particularly to the energy sector. But given the amount of capital and time needed to build cleantech companies, he says, “We’re making sure we have a lot of reserves for those companies. We’re working closely with strategic partners…some of them end customers, allocating our portfolios to those.”

That cautious optimism is echoed by VCs in the life sciences sector, but they acknowledge the inevitable impact of the failing economy. “Current financial markets will have a domino effect on our industry,” said Sofinnova’s Healy in the call. It will be much more difficult for unproven, first-time, or average venture firms to raise new funds.”

So, while the future is cloaked in apprehension, here are the top 10 venture deals of Q3 2008 (according to the MoneyTree and NVCA report):

1. SolarReserve (Santa Monica, CA) $140M
2. AVA Solar (Fort Collins, CO) $104M
3. Pacific Biosciences of California (formerly Nanofluidics) (Menlo Park CA) $100M
4. CVRx (Minneapolis MN) $84M
5. Proteolix (South San Francisco, CA) $79M
6. Recurrent Energy (San Francisco, CA) $75M
7. Trion World Network (Redwood City, CA) $70M
8. Proto Labs (Maple Plain, MN) $67M
9. Fisker Automotive (Irvine, CA) $65M
10. Portola Pharmaceuticals (South San Francisco CA) $60M

It wasn’t immediately clear why neither Seattle-based Big Fish Games’ $83 million venture financing, announced last month, nor San Diego’s The Active Network ($80 million) didn’t make the list. Matthew Toole of Thomson Reuters is supposed to get back to me about it. We’ll also be bringing you regional breakdowns for the individual Xconomy sites soon, so watch this space…

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