Editor's Corner

Dear Friends, Investors and Associates:

As the dust settles in the aftermath of the great contest, the pundits now opine that the important issues which divide the country such as the "war on terror," taxes, healthcare, Supreme Court appointments, government-sponsored medical research, social security reform, tort reform, and the environment were of secondary importance to "values" in determining the outcome.  It remains to be seen if the predominantly coastal BLUE, secular and intellectual U.S. population, so graphically depicted on our TV sets, can find common ground with the U.S. RED heartland citizens of faith who harbor more conservative views.  This drama will unfold over the next decade and beyond.

But, I expect a number of post-election near-term effects.  Although many analysts have speculated on the culprits underlying the faltering pace of economic growth during the year, I attribute it in part, to a pre-presidential election pause in the course of which millions of individual and corporate decision makers and investors postponed their decisions until after the election when the general direction of U.S. policy on many fronts would be clarified.

I think too much has been made of this economic pause and there is much cause for optimism.  The $11 trillion U.S. economy actually expanded at the respectable (and sustainable) rate of 3.75% during the third quarter of 2004.  Although it marks a decline from the 4.5% posted in the first quarter of 2004, it exceeds the 3% rate for all of 2003 and compares quite favorably to 1.9% for 2002 and 0.8% for the infamous 2001.  So my view is that we are still in the midst of a gentle and steady recovery which will accelerate.

The venture capital industry statistics mirror this positive direction measured by what I think of as the "Venture Capital Cycle."  The cycle consists of the amount of capital being raised by venture firms, in turn, the amount the venture capitalists invest in entrepreneurial enterprises and the number of investees and finally, the liquidity achieved by venture investors through mergers and acquisitions and via IPOs (Initial Public Offerings of equity securities). All along this wealth creation trail, the indications are auspicious.

In the third quarter of 2004, venture firms raised $5.5 billion and are likely to attract more than $20 billion of fresh capital for investment this year.  Although down 80% from the bubble year of 2004, $20 billion per annum is more than 4 times the historical annual norm.  Also, during Q3 2004, venture firms invested $4.3 billion in 601 companies  (That figure was below Q2 2004 of $5.9 billion, but equal to the comparable quarter of 2003).  The software industry retained its status as the favored sector for venture investment with $942 million invested in 160 companies followed closely by biotechnology.  With respect to liquidity, for the first nine months of 2004, sixty-six venture-backed companies raised an aggregate of $8 billion through IPOs.  This compares very favorably with the $2 billion raised by 29 companies in this fashion for the full 2003 year.  On the M&A front, for the first half of 2004, 164 companies realized $8.4 billion of value when acquired or merged into acquiring corporations.  Again, this comfortably exceeds the performance for the full 12 months of 2003.

However, we see some developments which concern us.  We are disconcerted that venture investors are increasingly investing in publicly listed companies and hedge fund managers are more frequently doing venture deals.  It suggests that investors can't find attractive opportunities within their core strategies and therefore are looking farther afield.  It also assumes that the skills required to invest in public equities and those that pertain to venture investing are the same and transferable.  I think this proposition is, at best, highly debatable and the case certainly has not yet been demonstrated.

Venture capital requires certain skills which were well-characterized in a recent article as Social Capital, Intellectual Capital and Interpersonal Capital.  Social Capital suggests the possession of useful relationships and the ability to harness this network in support of your investments.  Intellectual Capital is the store of knowledge that comes from investing in scores of companies through a variety of economic cycles over many years and learning from both successes and failures.  Interpersonal Capital is the ability to build relationships with entrepreneurs and mentor or coach them to realize their full potential.

This is the kind of capital, in addition to cash, that we invest in our portfolio companies.

With gratitude for your support,

Edwin A. Goodman
General Partner

MVP II Portfolio NEWS

Medidata Solutions, Inc. was ranked highest in Coherence of Suite Architecture in Forrester Research's September 29, 2004 report "Clinical Trials EDC Endgame."

Forrester assessed the EDC (Electronic Data Capture) capabilities of the products of seven vendors (including Oracle Clinical RDC and Phase Forward), scoring them on the strength of the company's current offering, and market presence.  The report ranked Medidata in the "Leaders" tier of EDC vendors.

Medidata provides software products and consulting services to pharmaceutical and biotechnology companies, to more efficiently track and manage clinical trials.

The Offshore Outsourcing Canard

Milestone invests primarily in technology-enabled service companies with an emphasis on business process outsourcing solutions in the healthcare and financial sectors.  When I use the word outsourcing in the context of our investment strategy, I mean that our portfolio companies take over business functions for their customers because they can save them time, money and produce a better end result.  For the most part, our companies do not engage in offshoring, i.e. they do not produce these services outside the U.S. with less expensive labor.  Out of the 600 employees our companies employ in aggregate, a small percentage are located outside the United States.  When they do use offshore labor, at present in India, Croatia, and Russia, the primary reason is to develop some portion of the software required to deliver their services effectively.

We regularly discuss offshoring strategy at our board meetings, and if we were presented with a sensible plan to make our companies demonstratively more competitive by moving operations abroad, we would support the plan.  Similarly, many of the companies we evaluate for new investments use offshore labor and we are often happy they do because if they didn't, they would be too capital intensive for us to consider.

We therefore conclude that it is in the economic interest of our portfolio companies to consider and, when appropriate, to utilize offshore labor.  With the question of our narrow economic interests answered, let's pose a broader political question; are we "Benedict Arnold" venture capitalists?  The answer is no.  In coming to this conclusion, I read articles and papers that discuss all sides of the issues and the statistics I cite below derive from these sources, including: "The Outsourcing Bogeyman", Daniel W. Drezner, Foreign Affairs May/June 2004; "Exploding the Myths About Offshoring", Martin Baily, Diana Farrell, McKinsey Global Institute April 2004; and "Winners and Losers; Annals of Economics", John Cassidy, The New Yorker August 2, 2004.

Most people would agree that Adam Smith had a good argument advocating the division of labor and free trade in 1776 in "The Wealth of Nations", pointing out that it was logical for the shoemaker to employ a tailor and, by extension, for England to produce clothing and Portugal to produce wine.  There are also not too many people who would argue that it was a good idea for Congress to enact during the Great Depression the Smoot Hawley Tariff Act, which prolonged our economic misery.  But the impulse to protect persists.  From March 2002 to the end of 2003, the U.S. imposed tariffs on steel, which cost steel users about 60,000 jobs, vastly more than were "saved" in the steel industry (40:1?).

When examining the facts behind the offshoring debate, the reasons for the uproar largely melt away.  Between 70% and 90% of U.S. jobs require physical proximity to customers, so they cannot be performed offshore.  The U.S. consistently runs a trade surplus in services, i.e. we export $64.8 billion in services such as legal, banking, consulting and system integration services more than we import.  In fact, we even run a trade surplus with India!  In India, the outsourcing industry generates approximately $10 billion in revenues and employs perhaps 500,000 people, so we are talking about an infinitesimal fraction of the U.S. economy.

The predictions are also worth reviewing.  Forrester estimates 3.3 million white collar jobs will be lost over 15 years, or 220,000 per year on average.  When you consider that the $11 trillion U.S. economy employs 150 million workers, 80% of which are in the service sector, the projected annual offshore job losses as a fraction of total employment is less than 0.2%.  Even when you look at the "hardest hit" sectors, such as IT, the facts are very different than the rhetoric.  Since 1999, 70,000 programming jobs have been lost, mostly due to the burst bubble, but 115,000 higher food chain software engineering jobs have been created and jobs for computer support specialists, systems analysts, and administrators grew by 83,000.  In fact domestic payrolls at Microsoft, Oracle and IBM are growing despite significant efforts to utilize offshore labor.  Lastly, the Bureau of Labor Statistics predicts IT-related jobs will grow 43% by 2010.

So why do we constantly hear about the evils of outsourcing?  The main reason, other than the election cycle, is that we have had less than robust job creation during the economic recovery.  The weak job creation could be attributable to many different forces, including a lack of confidence on the part of employers.  Charles Schultze of the Brookings Institution hypothesizes the real problem is that this economy's productivity has recently outpaced its ability to add jobs.  He points out that productivity (output per hour) growth in the non-farm business services sector rose 2.6 percent per year between 1995 and 2000, but between 2000 and 2003 productivity surged   to 4.1 percent per year.  If productivity had held constant, he reasons that the economy would have added two million more jobs, which would have offset the losses.

There is other data that supports the productivity hypothesis.  According to McKinsey, the majority of the recent jobs losses have been in manufacturing, not in services.   If outsourcing was the culprit instead of technology, manufacturing employment abroad should be increasing.  In fact, a study by Alliance Capital Management shows that while American manufacturing employment decreased 11% between 1995 and 2002, China's decreased 15% [sic], Brazil's decreased 20%, and global manufacturing employment decreased 11%.  Global manufacturing output increased 30% over the same period.  Clearly automation is driving manufacturing job losses.

Dealing with these issues rationally is a challenge because the people who are losing their jobs feel their loss acutely, while the rest of the country experiences the benefits of free trade, outsourcing, and productivity diffusely over long periods of time.  In our dynamic  economy, many of the people who lose their jobs are able to find new work, some at a higher wage, but many will be out of a job for longer than one year or will have to take a new job at a lower wage.  The answer is not protectionism.  Even John Cassidy, who wrote the piece in the New Yorker that is critical of economists who embrace the law of comparative advantage and free trade as an unqualified good, does not recommend protectionism.  He makes the case that we must increase high school graduation rates (currently 72%), and invest in science and math education and in a variety of other programs.  The McKinsey Global Institute recommends employment insurance, which it estimates would cost as little as four or five cents for every dollar saved from outsourcing.  These recommendations should be pursued vigorously…as vigorously as our politicians are pursuing protectionism.
-------Todd T. Pietri, General Partner

If you would not like to receive this newsletter in the future, please reply to this e-mail with the word "remove" in the subject line, and include the e-mail address to be removed. If you would prefer to receive a text only version, please reply to this e-mail with the word "text" in the subject line.