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25339 Milestone Summer2012.qxp:Layout 1 Issue 49 9/5/12 9:37 PM Page 1 Milestone Matters Summer 2012 “We have met the enemy . . . and he is us.” Ewing Marion Kauffman Foundation Report on venture capital investing, May 2012. Editor’s Corner Dear Friends, Investors and Associates, The humid doldrums of summer have been exacerbated for venture capitalists by an authoritative resuscitation of the troubles buffeting the industry. This time they emanate from the prestigious Ewing Marion Kauffman Foundation which recently issued a comprehensive fifty-one page funereal report. The foundation was established in the mid-1960s with the goal of encouraging entrepreneurial activity in the U.S. and improving educational opportunities. In due course, in addition to research and grant making, it entered the investment business on its own behalf. As of February 29, 2012, the foundation had an endowment of $1.83 billion invested in a globally diversified portfolio including $249 million committed to an assortment of venture capital and growth equity funds. The portfolio includes investments in more than 100 venture funds managed by more than sixty General Partner teams and these, reportedly, include some of the “Top Tier Funds.” The foundation’s findings are of particular interest because the statistics are drawn from their own portfolio from which they receive detailed and accurate reports rather than via third party sources which rely on VC management selfreporting and therefore, the report argues, are suspect. The report is a mea culpa. The foundation’s investment portfolio has done poorly as illustrated by a few select admissions: (1) Of 100 venture fund investments, only 20 beat their respective public market equivalent benchmarks by the standard annual 3 percent or more; (2) Of 30 funds larger than $400 million, only 4 delivered returns better than a publicly traded small cap index; (3) Of funds which raised more than $500 million, none, net of fees, returned capital equal or greater than 2X the initial capitalization. The Kauffman report claims that many major sophisticated VC investors have also done poorly including the sample below which shows returns as a multiple of invested capital: Kauffman Foundation VC Portfolio 1.3X; Washington State Investment Board - 1.4X; Oregon Public Employee Retirement Fund - 1.5X; New York State Retirement Fund - 1.04X. The report closes by stating that Kauffman plans to reshape their VC investment portfolio by shrinking the number of VC partnerships in which they invest to “only five or ten,” a winnowing from the current 100. This raises the issue of risk management which is, in part, achieved through diversity, but that discussion must await another letter. Suffice it to say that Kauffman’s plan to reduce the amount of money allocated to venture funds and to severely limit the number of General Partner team relationships, is very much in line with institutional investor thinking that we encounter as we expand our conversations in an effort to raise capital for MVP IV. Now a wag might argue that the obvious conclusion is that the Kauffman investment team is not very astute. Perhaps the fault lies with their selection rather than the ills they attribute to the industry? But if one concluded the discussion with just that riposte, the opportunity to learn from the data would be lost, so it is best to assume that it is representative of the whole and therefore entertain the questions, where does the venture community go from here and what are the implications for Milestone? Let’s begin this exercise with a brief summary of the five Kauffman recommendations to their peer institutional investors: (1) Abolish VC investment mandates normally expressed as a minimum percentage of assets to be allocated to VC funds; (2) When assessing potential VC fund investments, be very skeptical that the inevitability of the “J Curve” will lead to solid VC fund returns; (3) Require transparency with respect to the economics of the General Partner and the Management Company of VC funds; (4)Abandon the standard 2% and 20% fee structure in favor of fund management budgets and 20% profits interest only to be collected after LPs have received 100% of their capital back plus a preferred return; (5) Measure VC performance against a Public Market Equivalent (PME) benchmark. In addition, Kauffman wants VC fund managers to invest at least 5% of the total in lieu of the industry standard 1%. If these recommendations are widely adopted, the VC industry will shrink. Venture funds for several years (including the 2012 pace) have raised about $20 billion per annum. This total is likely to revert to about $5 billion per year which was typical during the early 90s prior to the build-up and bubble culminating in the $100 billion raised in 2000 and the debacle immediately following. The shrinkage will occur because there will be less capital available but also because many VCs will abandon the field reasoning that the most lucrative days for General Partners are behind them. If one credits the report’s overarching findings, very large funds will cease to attract investment and smaller ones will flourish. The further implication is that large institutional investors will not be able to CONTINUED ON PAGE 2 Milestone Portfolio News In July 2012, MVP III, MVP III NY, and MVP IV invested a total of $400,000 in Grovo Learning, Inc. NYC-based Grovo is an online education and training platform that helps people find and use sites, and helps sites reach and educate users. Grovo produces free and premium business video tutorials that cover the Web's most popular and useful sites as well as essential cloud services in social media, productivity, and online marketing. Applications include Facebook Profile, Advertising, and Pages, Google Analytics and Apps, Twitter, Yelp, Basecamp, and LinkedIn. The videos are delivered through the Company’s proprietary education and training platform, which includes the lesson, pre-written notes, quizzes, and glossary terms. Grovo will use the capital raised to increase its library of video tutorials and to expand its marketing efforts. Morgan Rodd serves on the board of directors of Grovo. MVP II portfolio company Octagon Research Solutions has entered into an agreement to be acquired by Accenture Inc. (NYSE: ACN) a global management consulting, technology services and outsourcing company. Milestone originally invested in Octagon in 2002 and again in 2005 for a total of $800,000. The total exit proceeds after the transaction clears regulatory approval will equate to a 5.5x multiple of invested capital and a 32% IRR. Octagon alone returns 34% of Milestone Venture Partners II. Todd T. Pietri served on the board of directors as an observer. Pennsylvania-based Octagon is a leader in clinical and regulatory information management solutions to the life sciences industry with 380 employees. The Octagon exit further strengthens Milestone's long term successful track record in the Digital Health sector, which includes one IPO and four profitable sales to strategic acquirers. 25339 Milestone Summer2012.qxp:Layout 1 EDITOR’S LETTER CONT’D FROM PAGE 1 fruitfully invest meaningful amounts of capital and will move on to other asset classes while wealthy individuals and sophisticated family offices will reassert themselves as key funders of the industry. If this occurs, it will be a return to the venture capital ecosystem which prevailed prior to the ERISA ruling of 1974 (implemented in 1979) which enabled the huge U.S. pension fund capital base to embark on VC fund investing. As to whither Milestone? We can abide by all the Kauffman Foundation recommendations some of which are simply not relevant to our business model. We are small and have formally capped our new fund at $125 million. By far, we are the largest investors in the funds we manage. We are not fee driven. We have enjoyed strong performance relative to many criteria including PMEs. We are backed predominantly by wealthy individuals, family offices and small endowments. Frequently, we receive institutional responses along these lines, “we like your performance and strategy but you are too small for us to consider because we have to put large amounts of capital to work.” So we look forward to new conversations with nimble investors who agree with Kauffman that small is beautiful. With best wishes for the balance of the summer, 9:37 PM Page 2 Digital Healthcare Initiatives Page Two MapMyFitness, which helps consumers record and track their fitness activities such as running, cycling, walking and hiking, is also enjoying increased demand from health plans as a result of health reform. As health plans make the shift to a more consumer-focused business model, MapMyFitness, which has 11 million registered users , is an attractive advertising vehicle for health plans as they try to sell policies to members who exercise. In addition, health plans, in an effort to improve their digital offerings for consumers, are utilizing the MapMyFitness mobile and web solutions. eHGT also stands to benefit from the increase in health insurance coverage. eHGT enables a hospital to gather the disparate medical records of a newly referred patient so that it may properly diagnose and, if required, admit the patient. The more people who have health insurance, the greater the number of patients who will be channeled through the standard cycle of care (primary care doctors making referrals to specialists and hospitals) as opposed to accessing care initially through the emergency room. Halfpenny also benefits from a greater number of patients moving through the standard cycle of care. Specifically, Halfpenny helps hospitals with significant laboratory operations communicate with referring physicians. Physicians can electronically place an order for a battery of lab tests through their Electronic Health Record (EHR) system and have that order routed to one or more hospital laboratories. When the lab has completed the tests, it can send the test result data directly through Halfpenny’s hub into the referring physician’s EHR. The greater the number of doctors with EHRs, the larger the market is for Halfpenny’s services. Personally, I feel the U.S. could have improved access to care, the quality of care and the national health technology infrastructure with a smaller investment and a greater focus on consumer incentives than what was passed as law. That said, I do like the payment reform elements (paying for the quality of care rather than the volume of care) in the ACA. Payment reform is generating a new wave of innovation in care coordination, mobile health applications and big data analytics. Milestone intends to make investments in these areas and feels it is well positioned to continue to prosper from a rapidly changing U.S. healthcare industry. Digital Health companies provide software and data services to pharmaceutical companies, hospitals, doctors, health insurance companies, self-insured employers and consumers. We have invested over 40% of our capital in the digital health sector since 2001. Medidata Solutions (Nasdaq:MDSO), Octagon Research (recently acquired by Accenture), MedPage Today (acquired by Everyday Health), Premise (acquired by Allscripts), and CareGain (acquired by FiServ) have delivered high realized returns for our limited partners. Several of the Digital Health companies that remain in our portfolio, such as Vitals.com, Halfpenny Technologies, eHealth Global Technologies (eHGT), Skill Survey, Integrichain and MapMyFitness are attacking attractive markets, generating top line growth and are well-positioned to deliver superior returns. The recent Supreme Court decision which essentially upheld the Affordable Care Act (ACA) has important consequences for four of these portfolio companies: Vitals.com, MapMyFitness, eHGT, and Halfpenny. Because as many as 30 million additional people will obtain health insurance, Vitals.com will see increased demand for its offerings. Vitals.com helps consumers find and evaluate doctors. Because the supply of doctors will not grow as fast as the demand for doctors from the newly insured, consumers will need better web services to find the doctor with the right expertise, the capacity to see new patients, and the willingness to accept their insurance (Vitals knows which insurance policies doctors accept). In addition, health plans will see a big shift in their mix of business once the state-based exchanges begin to sell health insurance directly to consumers and employers choose to terminate their policies in favor of paying the proscribed fines. One large plan estimates the percentage of its revenues coming directly from consumers will increase from 6% to over 20%. As such, health plans will choose to advertise on Vitals to reach this segment, given that Vitals has a growing base of 10 million monthly visitors. In addition, plans will need to offer better data and software than they currently possess to attract and retain new retail customers. Vitals is therefore experiencing significant demand for its cost transparency solutions which help tell a health plan member what their out of pocket expenses will be for a contemplated medical procedure ---------Todd Pietri, General Partner with a given doctor. investing in early stage technology-enhanced service companies in the new york metropolitan area Milestone Venture Partners 551 Madison Avenue - 7th Floor New York, NY 10022 V: (212) 223-7400 f: (212) 223-0315 www.milestonevp.com Edwin A. Goodman General Partner 9/5/12