The year Lehman fell. The year that taught everyone in venture capital who had not lived through 2000 what cycles actually feel like. We did not lose money this year, which is in some respects the truest measure of family-fund advantage. But that is not the only thing we have to report.

On the Quarter We Stopped Sleeping

From mid-September to mid-November, we were not certain that the global financial system would survive in its existing form. We do not say this for effect. The probability we assigned to a complete cessation of inter-bank lending — and what would have followed from it — was higher than we have ever assigned to any tail event before or since. On the morning of September 16th, after AIG was nationalized in the overnight hours, we held an unscheduled partners' call in which we discussed, in plain terms, what the firm would do if commercial-paper markets remained closed for an extended period. The conversation was not abstract. We had specific portfolio companies whose payroll cycles would have failed within ninety days under the conditions we were modeling.

We were wrong to be that worried. We were also wrong to be only that worried. The crisis was less severe than we feared and more severe than the consensus in October was modeling. Both errors are humbling. The first taught us that our tail-risk modeling was structurally too pessimistic; the second taught us that the consensus modeling — including ours, in modified form — was structurally too optimistic. We are revising both directions.

The deepest lesson of the autumn is one we will carry forward more carefully than the others. It is that liquidity disappears faster than counterparty quality deteriorates. Companies whose underlying businesses were performing well lost access to capital in October not because the businesses had changed but because their funding partners had been destabilized by exposure to other companies. The contagion was structural. The framework we will use, going forward, will treat the funding partner as a separate underwriting decision from the company.

On the Companies We Recapitalized

Six companies in our portfolio came to us between October and December needing capital they had been told would be available from later-stage funds and was no longer available. We funded four of them. We did so at terms that, in 2007, would have been considered punitive; the founders accepted those terms because the alternative was worse, and we accepted them because we wanted these companies to survive.

None of the four founders has held the recapitalization terms against us. Several have thanked us in writing. We mention this not to congratulate ourselves but to record, for our own future reference, that crisis terms must serve both sides if the relationships are to survive the cycle. The terms we wrote in October required the founders to accept dilution that would have been unimaginable a year earlier; we, in return, committed reserves that would have been impossible for a decennial fund late in its lifecycle. Both concessions were necessary. Neither was permanent.

The two we did not fund will not survive 2009 as independent entities. We considered both at length. The decision not to participate was, in both cases, that the underlying businesses were not going to support the recapitalized cap tables under any plausible recovery scenario; funding them now would be funding a continuation rather than a recovery. We do not enjoy these decisions. They are part of the work.

On What Family-Fund Capital Could Do That Decennial Funds Could Not

Several of our peer firms had, this year, to mark their portfolios down without the option of supporting the companies underneath the marks. The structural reason was that they were nine years into ten-year fund commitments and had no remaining reserves. We had reserves because we always have reserves; reserves are how a family fund operates.

The advantage compounded across the year. We finish 2008 with more capital deployed into our existing positions than we held going in. The mathematics of long-tenured family capital are different from those of decennial LP funds in ways that this year has made visible: a family fund can underwrite an additional check at the bottom of a cycle that an LP fund, regardless of how good its judgment is, simply cannot. The underperformance differential between the two structures, in 2008-2009 vintages, will be substantial. We expect it to compound through the recovery.

This is the year for which our 1997 founding memo was written. We can say so now. We could not have said so in advance.

On the First Checks We Wrote Into This Storm

We wrote three first checks in the fourth quarter — into companies founded in the worst capital environment in twenty-five years, by founders who knew what that environment was when they founded them. We have written first checks in every fourth quarter since 1997 and these are, we believe, the most considered ones we have ever written.

The shape of the founders is different. None of them came to us through warm intros from prior portfolio companies; we found two of them through customer references in adjacent businesses, and the third through an ex-engineer of one of our 2003 companies who had quietly resigned to start something. The selection process was longer than usual; the diligence was more expensive; the term-sheet negotiations were almost perfunctory because the founders' alternatives were limited. The 2008 vintage of our portfolio will, we predict, be one of the strongest we ever produce. The 2008 vintage of the venture industry overall will, almost certainly, be the same.

A Closing Note

The crisis is not over. It will continue into 2009, and the companies that emerge from it will be of a kind we have not seen in a decade. We are awake. We are also more grateful, this December, for the founders who have continued to take our calls, the companies that have continued to ship product, and the operators in our portfolio who have, almost without exception, behaved with the seriousness this year required. We are aware of how rare such cohorts are. We will not waste this one.

The Partners
Winzheng Family Investment Fund · December 2008