Toward a 'Third Coast'; Michigan venture capital starts to show up on national radar

BYLINE: Tom Henderson

When Lindsay Aspegren and Hugo Braun decided to name their fledgling Ann Arbor-based venture-capital firm North Coast Technology Partners L.P. in 1999, it might have seemed wishful thinking to venture capitalists on the East and West coasts, where a majority of the business operated.

Silicon Valley dominated the West Coast; Route 128 in Massachusetts was the hub of action in the east. A third coast of venture-capital activity in Michigan seemed like an impossible fantasy.

Today, though, there is reason to think that what were once unconnected dots of activity - a deal here, a small venture-capital fund there, a few university spin-offs - is starting to gather critical mass. And if Michigan has a way to go before it becomes the ``third coast,'' it is now on the national venture-capital radar. (See box, Page 7).

The state has long been a leader in manufacturing, and is home to some of the nation's best health systems and universities. But what's been missing is money. That, investors say, is changing.

``You can't just throw money at things, but of all the elements we've needed, the No. 1 was money,'' said David Brophy, an associate professor of finance at the University of Michigan who founded the Michigan Growth Capital Symposium in 1979.

``Now, there's money available and a process by which you can go after it.''

``We're inching forward to where we can be a center for knowledge-based businesses.''

The amount of venture capital under management in the state is expected to grow from $438 million in 2005 to more than $1.5 billion by 2010. That includes two state-supported funds totaling $204 million that began making investments in January and matching funds by out-of-state venture-capital companies. Those companies get money from the state-backed funds and at least five others that have been announced or are in the planning stages by state venture- capital firms.

``There are a number of things about Michigan that really stand out,'' said Kelly Williams, a managing director of Credit Suisse and co-head of its Customized Fund Investment Group. Credit Suisse manages the two Michigan investment funds, the 21st Century Investment Fund and the $95 million Venture Michigan Fund, and similar programs in Ohio, Indiana and Oregon.

``In Michigan we see a motivated venture-capital community, we see good technology coming out of the universities and private industry, and we see a commitment by the state,'' she said. ``We view our role as not just putting money out the door, but connecting the dots of the various entities in the state.''

Charles Rothstein, senior managing director at Farmington Hills-based Beringea L.L.C., one of the state's oldest VC firms and its largest, with $270 million under management, said the two state-supported funds ``will help restore the entrepreneurial heritage we had here.''

Rothstein is on the board of the Michigan Strategic Fund, which oversees the 21st Century Jobs Fund, which in turn includes the 21st Century Investment Fund. He is also on the board of the Venture Michigan Fund. To avoid a conflict of interest, Beringea has not applied for money from either fund.

Rodrigo Prudencio is a partner in San Francisco-based Nth Power, a venture-capital firm that invests in energy-related technologies, and an example of the types of companies the state funds are targeting. It received an undisclosed investment in January from the Venture Michigan Fund and in March the 21st Century Investment Fund agreed to invest up to $7.5 million.

The company has formed a partnership with Detroit-based NextEnergy to help find investments in local alternative-energy companies. NextEnergy will receive an equity share of the investments as well as be paid on a retainer basis. ``We're committed to being there 10 or 12 times a year, but they'll be our local eyes and ears,'' he said.

Prudencio said the money from Michigan will go into Nth Power's fourth fund, which is still being raised. He said SEC regulations prohibit him from disclosing details about the fund's size until it closes but said the company has $350 million under management in its first three funds. It has two local portfolio companies, Ann Arbor-based STM Corp. Inc., a maker of energy-efficient engines for industrial use, and Novi-based Microposite Inc., a manufacturer of siding for buildings.

Prudencio said it is Michigan's traditional manufacturing strengths that make it so attractive. ``There is a tremendous amount of manufacturing know-how. And it's manufacturing at large scale and low cost. Those industries are going through tremendous change and disruption, but in that disruption, we believe we'll find opportunities.''

John Neis, a managing director with Venture Investors, said his Madison, Wis.-based firm's traditional focus on backing companies spun out from the University of Wisconsin made Michigan a natural choice for expanding geographically.

``How do you keep making that model work? The answer was obvious,'' said Neis, pointing out that both the University of Wisconsin and the University of Michigan annually rank in the top five in the amount of research money spent at U.S. institutions. ``Research universities in the Midwest are an untapped source that have tremendous potential. You look at the East Coast and the West Coast, and those areas are both well mined. That's not the case here.''

The state's recent investments in Venture Investors put the current fund it is raising, its fifth, at more than $100 million, said Neis. Venture Investors focuses on health care and IT. It has taken one company public, Madison-based Third Wave Technologies Inc., and has registrations filed for two more IPOs.

Venture Investors has partnered with Ann Arbor-based EDF Ventures on several deals, including a very successful investment in IntraLase Corp., a UM spin-off that moved to California in 1998 and went public in 2004.

``If you were to think long-term and look back at the last five years, progress has been excellent. We've had major successes with companies like Esperion and Arbortext,'' said Aspegren. Ann Arbor-based Esperion Therapeutics Inc. was bought by Pfizer Inc. for $1.2 billion in 2004, and Ann Arbor-based Arbortext Inc. was bought for $190 million by Needham, Mass.-based Parametric Technology Corp. in 2005.

``But you're still stuck with the question, is it enough? Is it significant enough to change the economic future of the state?'' Aspegren said.

Funding startups is a positive step, but getting ``nascent companies to become major drivers of the state economy,'' will take time, he said.

And, the state lacks entrepreneurs and a business culture to support them, said Michael Staebler, an attorney in the Detroit office of Pepper Hamilton L.L.P. who co-chairs the firm's national investment funds practice.

``I always hear, `But these are companies that are only creating seven to 10 jobs,' '' said Tom Kinnear, professor of marketing at UM and executive director of the business school's Zell Lurie Institute. He is also managing director of the Wolverine Venture Fund, the school's student-run VC fund, and chairman and president of the state's Venture Michigan Fund.

``I had breakfast today with an entrepreneur whose company had 21 jobs. Last year it was 10. Maybe next year it will be 50. And these are people with skills, who are highly paid,'' he said.

``Our economy reminds me of an old joke in Ireland,'' he said. ``A guy goes up to a farmer and says, `How do I get to Dublin from here?' And the farmer says, `If I was going to Dublin, I wouldn't start here.' You wouldn't want to start here, but we're here.''

And being here is getting to be a better thing.

``Our activity level there (inMichigan) has never been higher,'' said Koleman Karleski, managing director of Kentucky-based Chrysalis L.L.C. ``We have a number of things in the early stages of review. We're seeing deal flow, and that's encouraging,'' he said.

Chrysalis invested in Detroit-based Asterand plc before it went public on the London Stock Exchange in 2006.

Ken Nisbet, executive director of UM's Office of Technology Transfer, said having hands-on management by Credit Suisse and an influx of national firms.

``The good news is: there are now big boys investing,'' he said.

Tom Henderson: (313) 446-0337, thenderson@crain.com

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$438 million: Venture capital under management in Michigan in 2005

$1.5 billion: Expected amount under management in Michigan in 2010

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Where they get it, how they spend it

Two state-backed funds that invest in venture-capital and private-equity funds to spur the growth of technology-based companies began making investments this year. Here's a breakdown of how each is funded and how they work:

The $109 million 21st Century Investment Fund is part of the 21st Century Jobs Fund and is bankrolled with tobacco-settlement money.

The $95 million Venture Michigan Fund is funded by a loan of $200 million from Germany-based Deutsche Bank. The majority of the money is set aside to repay the loan. Originally, the loan was to have been guaranteed by revenue from the single-business tax, but with its demise, the program was delayed while legislation was rewritten to allow withholding tax to cover shortfalls.

Both funds invest in in-state and out-of-state funds that in turn invest in individual companies. Both are meant to generate profits that could result in a 21st Century Investment Fund II and a Venture Michigan Fund II.

The 21st Century Investment Fund requires out-of-state firms to either open an office here or form a partnership with an existing entity. Madison, Wis.-based Venture Investors L.L.C., which was awarded up to $10 million in March, opened an office in Ann Arbor; San Francisco-based Nth Power, which was awarded up to $10 million January, formed a partnership with Detroit-based NextEnergy, which will help it find energy-related companies to invest in and will share in profits.

The Venture Michigan Fund has no such requirement.

The 21st Century Investment Fund mandates that if its investment makes up 10 percent of a fund, for example, then 10 percent of that fund must be invested in Michigan. The Venture Michigan Fund requires only that firms make a best effort to invest here, according to Ned Staebler, director of capital markets for the Michigan Economic Development Corp.

While the funds were intended to have some overlap - so far they have invested in the same venture-capital funds - Venture Michigan was meant to be more seed and early-stage and the 21st Century fund more later-stage, including investments in private-equity firms, according to Staebler.

- Tom Henderson

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Thoughts differ on state funds

Koleman Karleski, managing director of Kentucky-based Chrysalis L.L.C., thinks the state's hiring of Credit Suisse as its funds manager was a smart move.

``That's another reason we're excited about Michigan,'' said Karleski, who has applied for an investment from Michigan's investment funds but has yet to get one.

``They're getting capital into the hands of the best managers. They're doing a great job there with what will likely be one of the best state programs in the country.''

But others in the investment community are less certain.

Frank Hennessey, chairman and CEO of Huntington Woods-based Hennessey Capital L.L.C. and a longtime angel investor in state companies, thinks that venture capital should be left to the private sector and not be a function of government. ``The people who set up the state investment funds are well-intentioned but misguided,'' he said.

Sam Valenti III, chairman and CEO of Bloomfield Hills-based private investment firm Valenti Capital,, founder of the Michigan Venture Capital Association and former head of the state's pension fund, said out-of-state money on a large scale will flow into Michigan not based on state funding but based on big successes for original investors when young companies are bought or go public.

``Show me five times the (original) money, show me seven times the money, show me 10 times the money, and money will come from the moon. We haven't had enough show-mes,'' he said.

- Tom Henderson

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