Kevin Delbridge, senior managing partner at HarbourVest, has a mile-high view when it comes to the economic downturn and its effect on venture capital firms. Managing a $30 billion “fund of funds” will give one such an industry perspective. Yet his industry is facing something of a perfect storm right now. Returns are threatened everywhere. Venture capital, one sector of HarbourVest’s capital deployment, is particularly troubled to deliver returns.

Add to that the potential for congressional changes to taxation of carried interest and it all looks pretty grim right now.

Red Herring recently talked with Mr. Delbridge about the industry and HarbourVest. Excerpts from that conversation follow.

Red Herring: How do you feel about the nuclear winter we’re going through?
Kevin Delbridge: Over the past 30 years we’ve experienced some slowdowns, a couple of crisis situations, governmental actions or inactions, but lately we’ve seen everything happen at the same time and rapidly. This is unique in my lifespan. But you would think that there might be some very good opportunities coming out of this. The rules of the game are changing, without a doubt.

RH: With the potential for Congress to change taxation of your industry, what are your thoughts on such government intervention?
KD: How badly will these measures hurt? Right off the bat, this is not good for the industry. It is amazing to me that Congress would want to experiment with the engine that helps to drive technology and innovation and more importantly job creation that comes through the venture industry in the U.S. It ought to be evident to lawmakers that the U.S.’s edge globally is not our ability to mass manufacture low-value goods. We are in a global competition to maintain our edge on what we do best--and that’s technological innovation in the IT area, in health care, in clean tech, and other areas. And why our government wants to change the rules of the game at any time, and especially at this time, seems to me rather to be very political, very punitive, and it’s nowhere near to being constructive.

I would think that if anything we ought to be rewarding success in venture because success means jobs. Sometimes they forget about that. This is an industry that is resilient, and we’ll figure it out. But it really means that practitioners, the venture managers and the investors, are going to be spending critical time to get above the hurdle that government is putting in the way rather than spending that time to help build companies and generate returns for investors.

RH: We’ve been looking at the sour market for IPOs, and we’re particularly interested in how you reallocate your portfolio or how you reconsider some of your investments and funds when there is no liquidity outlook for some investments.
KD: This is the most disappointing aspect of the private equity sector. Profitable exits happen, but clearly the big winners are farther and fewer in between. And yes, the big winners make a difference in this business, without a doubt. There are venture managers on top of the food chain who are generating liquidity at a lower pace than historically and than what’s desired, but our feeling is that as long as we keep backing what we think are the best 25 venture managers here in the U.S, those who can access liquidity, then we are going to continue to support the venture asset class, without a doubt, because we think that there is a venture industry here and it has to continue. But there are some venture programs that are too diversified and also too many managers, and they must be re-evaluating their perspective on the venture industry.

RH: Will we see some venture Darwinism going on here, where the best managers are going to emerge and some firms fade?
KD: There should be some Darwinism. The problem is that it’s hard for a venture firm or even a private equity firm to go out of business. It’s hard to kill a private equity management company.

Let me say this: I think there should be a couple hundred institutionally backed venture firms. Does it mean we’re gonna get down to two hundred? No. We are not going to get down near. If we are at 600, then maybe we could go to 400 or so. Again, it’s hard to kill a venture firm.

RH: Your recipe is to find the best mangers and beat averages on good firms?
KD: That’s exactly what we’re trying to do. More often than not we make the right decision, but we are not infallible and sometimes we may invest in the best managers and things don’t go as planned. What we have to do is as soon as practical say, 'Next time around we’re not going to invest with you again. We made a mistake and let’s figure out why we made a mistake and try to move forward.'
The VC industry is not going to go away--it is here to stay forever.

RH: Are you banking on certain geographic sectors to beat averages? Are you reassessing locations or sectors?
KD: When one makes a commitment to a venture fund today, that fund is generally invested over a three- or four-year period. The companies have to build their businesses and operate in an economic environment that might extend five, six, seven, or eight years of time. And the liquidity market--if IPOs ever come back and M&A--that’s going to happen in a fund from years two through 12. And there are a lot of cycles of those three factors. Today clean tech is a hot area. In two years from now it could be energy. We make sure we include every area in our portfolio, but we don’t overlook areas today because it takes time to get into these areas. We want to make sure we have a good participation and work with managers who have strengths in certain sectors. Geographically, the U.S. continues to have the best infrastructure to invest capital--hands down. It’s got the most experienced managers, the most experienced entrepreneurs. It’s the largest market for most tech, and most of the time it’s got a financial system that can provide funds to growing companies and can provide liquidity to investors. I say most of the time it has had. We will continue to support, obviously, U.S. ventures, but we know there is VC being done in Europe, in China, in India. We’re going to look at those areas as well, but we believe the hurdles to be successful on a portfolio basis are greater in those areas and therefore we would expect some premium upon return.

RH: How many GPs are you getting in? Which ones are they?
KD: Over the last year or so, there have been a number of venture partnerships that are considered very good, the top of the heap. We are in a number of those, but we are not in all of those. Some of those only take endowment money, or some of them only take individual money, and frankly they’ve been closed out to investors that fall outside of these categories. We always try to stay in contact with those folks in case things have changed, and for the first time things have changed, and again we do not mention names, but we have gotten into three groups that would be considered among the classiest within the capital industry, and it’s because their long-term sources of capitals, the endowments and private individuals, are going through difficulties and they can’t answer the bell right now and we can.

RH: So somehow you benefited from the crisis?
KD: Yes, even in this market there are a lot of opportunities.

RH: Is it a real buyer’s market?
KD: Yes, and when the seller sees the price they are shocked, and some of them, by the way, end up not selling until they realize they have to sell and then the price just goes down even more.

RH: Is the venture industry to blame for the lack of exits, of IPOs?
KD: I don’t blame the venture industry for the reduction of IPOs. Sarbanes Oxley? Did that affect IPOs? Did someone think about how it would affect small businesses before implementing that? One thing we have to keep in mind is that although there aren’t many IPOs, M&As are still happening.

In fact within the last month we had two companies within our portfolio of funds that got acquired by Medtronic at some phenomenal value. In fact, one deal is going to return more than half the entire fund. Those do happen. People shouldn’t think there is no liquidity in venture. If you’re in the right fund, there is some liquidity, and you can do very well with your companies. It is not happening with the same frequency, but deals are still out there. There is liquidity. It’s down but there is liquidity. The one thing people should keep in mind with respect to venture and private equity, unlike the public markets, you don’t have to sell. You can keep a company in a portfolio as long as the cash flow breaks even and wait for a better market, and we will have a better market.

RH: Is Washington insensitive to your industry? If so, how are you feeling about that?
KD: I can only speak for myself, not the entire industry. What the venture industry does certainly promotes technological innovation and helps us keep our lead globally and by virtue of that we certainly help create a lot of jobs. The NVCA has done a marvelous job of tracking all that, but keep in mind the venture industry creates return for its investors. We are generating money for endowments, which I think are a necessary part of the fabric of the U.S. Generating money for public pension’s funds so maybe the taxpayers in those states won’t have to put as much money into these pension funds.

When the venture industry performs well it creates returns for corporate pension funds. It’s generating returns for those funds and for those who are managing it, and why not? They are putting their lives into this. When it comes to Washington, I don’t know where their head is in this business. I would think they would do whatever they can to help the industry rather than punishing the industry.

Red Herring reporters Lalee Sadighi and Scott Martin contributed to this interview. This is the first in a 10-part series of interviews with managers of funds ranging from private equity to pension funds among others.