Elderstreet Capital Partners (Elderstreet) is a UK venture capitalist mostly investing in UK businesses. Nothing unusual in that, but what is remarkable is that the fact that only 15 per cent of its new GBP57 million ($93 million) fund for investment in software and Internet companies has come from UK institutions. Over 30 per cent of the money comes from Switzerland, with German, French and US institutions also accounting for a greater percentage than their UK counterparts.
What does this say about the appetite of UK and continental European investors? There are two ways of interpreting it, according to Elderstreet partner Paul Frew: “You could say that despite what Tony Blair would like to achieve, UK institutions aren’t backing early stage technology funds in their own geographical market, which is sad. But the other way to look at it is that European fund-of-funds are very keen to back a UK fund management team investing in the UK, which I think is very positive.”
Over 70 per cent of the fund-of-fund investors which Elderstreet presented to ended up committing to the fund – 16 of them in total. Frew is encouraged by the fact that many of them had previously invested in West Coast US funds, so they were sufficiently experienced and knowledgeable to have spotted any weaknesses in the firm’s sales pitch.
IT deal flow
The fund raising effort, which was capped at GBP57 million, was aided by what are perceived to be excellent opportunities in European early stage technology. But the environment was somewhat less promising when the firm was established in 1990. Michael Jackson, the current senior partner of the firm – who is also chairman of Sage, the largest software company in the UK – had been hired by Kleinwort Benson Development Capital (KBDC) in London to advise on the smaller company end of its portfolio, which meant transactions up to GBP1 million ($1.6 million). Jackson was seeing an increasing deal flow in the IT sector, but investments in this area were specifically ruled out by KBDC, which saw them as too risky.
Frustrated at the lack of funding for businesses in the sector, Jackson established the Elderstreet Investor Club (EIC), effectively a business angel network, on behalf of a group of high net worth individuals who were keen on exposure to venture capital, and IT in particular. While the latest fund (its first external fund) sees Elderstreet diversifying its investor base beyond the EIC, all members of the club are being contacted in the expectation that they will continue to invest in a GBP5 million ($8 million) affiliate fund to run alongside the main fund and benefit from the same investment opportunities.
As the business has grown, the KBDC agreement has continued through its backing of a non-technology team led by Chris Kay, a recruit from 3i who heads three other professionals. This part of the business has subsequently raised the Elderstreet Downing venture capital trust (VCT).
Technology investing, meanwhile, was the sole remit of Jackson until 1996, when he was joined by Frew. Frew had been the chief executive of a medium-sized software business employing around 150 people until it was sold to a US company in 1995. At that point, he contacted KBDC and informed them that he was seeking to a lead a management buy-in at a technology company. They replied that it was not their specialisation, and that he should contact Jackson.
Frew takes up the story: “I went to see Michael, told him I ran software businesses and that I was looking for a buy-in opportunity. He said no, don’t do that, come to a meeting this afternoon – I’ve got a company coming in to do a presentation and I don’t really understand what they do’. That was three years ago and I’m still here.”
Using EIC money, Frew and Jackson between them built up the firm’s IT practice, making eight investments with an average size of GBP1 million ($1.6 million). From these low-volume and tentative beginnings, the technology team is now receiving 80 to 90 business plans a month, ensuring that external fund raising was a necessity if the technology boom was to be fully exploited. It also meant the recruitment last year of a third team member in Barnaby Terry, who had spent four years at 3i, having previously worked in the data communications industry.
Frew maintains that, as the years have passed, the team’s investments have become increasingly specialised. In terms of sector, the focus is on early-stage software – it will not invest in hardware, and does very little development capital. In terms of investment stage, the firm targets companies where the product is developed, most of the required management team is in place and where a reference sale’ has been recorded, which means that at least one corporate has paid cash for the company’s product.
Adds Frew: “They will typically be loss-making businesses, burning cash, but projecting significant sales growth. The investment decision we take is whether the management team is capable of taking the product forward and driving top-line growth.” Frew considers early-stage to be a market niche where there is not a proliferation of funds available relative to the development capital through to exit stage.
The technology team focuses on three software sub-sectors. Firstly, enabling technology’, ie the development of infrastructures, such as security systems, which sit beneath end-user applications. These are businesses which can create value very quickly and which have produced Elderstreet’s best returns so far, but is a difficult area in which to distinguish potential winners from losers. The second area is applications which sit on top of the infrastructure, eg accounting and word processing packages. And thirdly, services businesses which install and integrate the technology.
Within the Internet sector, it also targets three types of businesses. Firstly, existing software companies which have a good Internet strategy. These companies are in a position to leverage the Internet effectively in order to give them wider reach and grow their scale. One example is of this is Micromuse, a company with the ability to identify problems in ever-more complex computer networks which has been successful in attracting business from Internet service providers (ISPs) and telecommunications companies. When Elderstreet first invested in the business in 1994, it was turning over GBP1 million ($1.6 million) per annum. This year it is projecting GBP60 million ($98 million) turnover, and is listed on Nasdaq with a market capitalisation in excess of GBP1 billion ($1.6 billion).
The second area is enabling technology specifically relating to the Internet. The most notable investment made by the firm in this area was in a company called Mediasurface, which has developed a software product aimed at the content management of websites. At the time it was first backed by Elderstreet 12 months ago, it had minimal turnover and one reference sale’ in the form of Reuters. Currently turning over around GBP400,000 ($652,000) per month, the business recently attracted second-round financing from a number of investors including Elderstreet, and is being lined up for a possible flotation by Goldman Sachs, its financial adviser.
The third area is e-commerce, ie website retailing, which is currently producing a highly prolific deal flow. The opportunities, says Frew, arise from those businesses that will become established consumer brands in their own right as well as those that will be mopped up as part of ongoing consolidation stimulated by US acquirors who see Europe as a greenfield site relative to the more mature e-commerce market in the US. One successful investment for Elderstreet in this area has been iMVS, a seller of CDs and videos. The business was recently merged with Swedish on-line retailer Boxman.com and is another Elderstreet investment in line for a flotation, this time orchestrated by Morgan Stanley Dean Witter.
E-commerce is an unusual segment of the early-stage technology sector in that there is a raft of available capital. In general though, Frew claims that the firm operates in a market niche: “The early-stage market is still largely collaborative rather than competitive.” Competitors include firms such as Amadeus Capital Partners, Geocapital Partners and Kennet Capital, but there are few players prepared to invest at the GBP1 million ($1.6 million) to GBP2 million ($3.3 million) level. Larger software/Internet investors which also invest in the later as well as early-stage market, such as Apax Partners and Schroder Ventures, rarely make investments below GBP5 million ($8.1 million).
The competitive environment is no more fierce in continental Europe, where Elderstreet is looking to invest for the first time following the raising of its new fund which breaks it free from the UK-focused investment restrictions of the EIC and VCT. It does not feel well acquainted enough with the markets, however, to go it alone. “When we invest on the Continent, it will be alongside a local investor – we won’t go in by ourselves because we don’t know the local legal jurisdictions well enough. What we’re trying to do at the moment is obtain local partners in each of the key European countries, and then co-invest alongside them,” says Frew.
He is especially keen to develop the firm’s contacts in Germany, where there is an indirect link to Munich-based technology investor Technologieholding through a fund investor which has an existing relationship with the firm. Frew also claims to be an admirer of Techno Venture Management (TVM), a biotech and healthcare specialist, also based in Munich.
On the whole, though – except in the Internet sector – the firm is of the opinion that there is a large window of opportunity for early-stage technology investment throughout Europe. Frew considers that a UK fund will be welcomed on the Continent by European investors that see the UK as a potential stepping stone to the US.
In addition, Elderstreet can leverage off the experience of its investors in their domestic markets. “Our investor base has a lot of experience of investing in other funds, as well as making direct investments themselves in European technology companies,” says Michael Jackson. This will provide the firm and its investee companies with inside knowledge of such things as who are the best headhunters, who are the best lawyers and where is the best place to locate.
While promising market conditions combined with a new fund naturally fill the Elderstreet team with enthusiasm, they are aware of independent commentators who feel that the Internet phenomenon is a bubble about to burst. Even the exceptional performance of Germany’s Neuer markt, for example, is unlikely to be sustainable for ever. But Jackson takes his lead from the US in justifying his optimism in the future: “Every time there is a fluctuation, the press will say this is the end of the market, we told you not to invest in technology’. But if you take the US example, these companies are becoming more and more attractive – they’re in a growing market, and they’re well funded. You’ve got to pick the right time in the cycle to invest, but this market is not going to go away.”