MICHAEL HILTZIK GOLDEN STATE

Swelling of a Venture Bubble in Security

Michael Hiltzik

March 20, 2003

The ingenuity of American entrepreneurs being endless, it should come as no surprise that the newest flavor in venture capital investing is, so to speak, ripped from the headlines.

As U.S. troops march on Baghdad and the color orange becomes a national fashion statement, homeland security is building into the hot topic at investment conferences around the country.

In part, this is because the promise of homeland defense stands out amid the dismal performance of most other emergent investment categories.

"If you look at the classic venture capital investment areas like enterprise software and collaboration software, people talk about anemic growth," Frank Kline of Kline Hawkes & Co., a leading Los Angeles-based venture firm, told me. In his mind, though, things are worse than that: "I don't know what they're talking about -- there's no growth. People are not buying stuff."

Then he ticks off three companies in his firm's portfolio, all of which make communications and sensor equipment related to safety and security. "Sensor Systems, Ascendant Telecommunications, IP MobileNet Inc. -- these companies are getting traction," Kline says. "There are dollars being spent, which for a venture guy is unusual" in the current economic climate.

Homeland security already has accumulated many of the traditional accouterments of an investment segment on the rise. There's an industry trade group, the Homeland Security Leadership Alliance; a host of private equity companies and venture capital firms trolling for inviting opportunities; and a widely quoted market analysis firm, Homeland Security Research Corp.

Homeland Security Research, based in San Jose, predicts that spending at all levels of government and by private industry on safety measures will reach more than $130 billion annually within five years. That would make the sector larger than the entire airline industry is today.

There are two ways to look at this activity: as a grim attempt to turn public anxiety into a business opportunity or -- the viewpoint naturally favored by those in the industry -- as a chance to fight the good fight while upholding sound capitalist principles.

"I see it as an interesting potential-growth area, and it makes me feel good to be doing something worthwhile," says Hilary Goldstone, a former lawyer whose Los Angeles investment firm, Millennium Financial Advisory Group, brokers deals between small companies and sources of investment capital.

For all that, we may be witnessing less the birth of America's next great growth industry and more the swelling of its next venture bubble.

This one might not necessarily repeat the dot-com craze, when entrepreneurs spouting rank nonsense could attract millions of dollars in backing. But it might resemble the digital storage, biotech and telecommunications frenzies of years past, when scores of companies competed in niches that could support only three or four.

Even Kline is uneasy at that prospect. "My biggest fear is that it will turn out like telecom," he says. "If you like a space, probably 28 other venture firms like the same space. The risk is that it gets overcrowded."

Indeed, investment professionals say they have seen many companies, large and small, tout themselves as homeland security plays with varying levels of plausibility. Some fall into the category of what Goldstone calls "9/12 companies" -- that is, those that sprang into existence to take advantage of the post-

9/11 environment.

Most any executive "with any possibility of positioning their company as a homeland security company is doing that," says Sean Spence, the founder of the Homeland Security Leadership Alliance. (The alliance is based in Spence's hometown of Boise, Idaho, which gives it an appropriately hunkered-down image.)

One distinguishing mark of the homeland security business is that it will be heavily driven by federal funding. Like aerospace and defense contracting but unlike, say, semiconductor manufacturing, the key to success in this field is going to be finding an open seat at the government trough.

Some firms have lined up rainmakers with gilt-edged connections in the nation's capital. Washington-based Paladin Capital Group is hoping to raise as much as $500 million in institutional backing by November for a homeland security investment pool to be advised by former CIA Director R. James Woolsey and former National Security Agency chief Kenneth A. Minihan.

"We frankly don't see an end to it," said Paladin's managing director, Michael Steed, when asked on National Public Radio when the nation's level of anxiety might abate. "We're looking at decades."

But others are less sure. After all, it is unclear how big the federal trough will be and when it will open for feeding. Spence notes that President Bush has requested $36 billion in 2003 appropriations for the new Department of Homeland Security. That sum, however, includes the preexisting budgets of such agency members as the Coast Guard, making the incremental increase hard to gauge.

Johnathan Tal, the Israeli-born founder of Homeland Security Research, estimates federal expenditures over the next five years at up to $170 billion. But he acknowledges that this funding is subject to politics and other short-term considerations. "Government expenditures are shifting sands," he says.

Goldstone, a former counsel to the Los Angeles city attorney, says the ability of state and local governments to pay for technologies useful to "first responders" -- the police and fire departments that could be prime customers for many homeland security vendors -- also is questionable.

The $3.5 billion that Bush promised for police and fire departments in his 2003 budget "won't hit for several years," she points out. That's one reason that smart investors are looking most closely at companies whose products have civilian applications in addition to public safety uses.

"Most of the VCs I know won't invest in a company that's just for homeland security," Goldstone says. "They want something that will kill microbes in hospitals, not just post offices. They're afraid this could be a fad."

Golden State appears every Monday and Thursday. Michael Hiltzik can be reached at golden.state@latimes.com.

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