After languishing in the doldrums since the dot com crash, Europe’s venture capital market finally has something to shout about. Following a near death of realisations in 2003, the last 18 months have seen some extremely successful exits, via both sales to corporates and IPOs.
Top of Europe’s exit success list is the landmark sale by a consortium including Index Ventures of UK Voice-over IP software provider Skype to eBay for US$4.1bn in September 2005 – the most successful VoIP exit ever and Europe’s first really big home run, on a par with US VC exits. This was swiftly followed by another major triumph – the October 2005 listing of German solar energy company Q-Cells. With a market cap of about €2.5bn on IPO, Q-Cells gave investor Apax a return of 27x its €11.5m investment. Both deals were lauded as definitive proof that Europe is capable of creating world class VC companies.
Behind these headline deals are a raft of other successful realisations, including this year’s sale of Betfair, the IPO of Russian TV network operator CTC Media and, on a smaller scale, Amadeus’ €44m flotation of eye scan firm Optos on the LSE and MTI’s AIM listing of fabric enabled soft interface technology company Eleksen.
In addition to Skype and Q-Cells, 2005 also saw the exit of Munich-based online survey provider Ciao to the US’s Greenfield for US$154m, while 2004 – the year exits started to pick up again – saw Cambridge Silicon Radio IPO with a market cap of £240m – the largest fabless semi-conductor IPO globally since 2000.
Although there is still significant room for improvement in exits, VCs with quality companies and well-managed portfolios are achieving good realisations and are in substantially better shape than 18 months ago. “It’s still nothing like the buyout market, but the climate for VC exits has improved greatly since 2003, especially in the last 12 months. Exit prices are rising, with lots of interested buyers and a growing number of IPOs on AIM,” says Ernie Richardson CEO of UK venture firm MTI.
Although the market for VC IPOs has dropped off recently, in line with global stock markets volatility, one of the main developments in the last year has been the rapid evolution of AIM. The small London exchange is often still viewed as merely a financing tool, but is nevertheless providing exits for a growing number of VC-financed start-ups.
Many VC managers hope AIM is evolving into the world’s major exit route for small to mid-cap VC firms – aided by the decline in importance of the Nasdaq for firms of this size. Not only is a certain market cap required before listing on the NASDAQ, but, following the strict disclosure requirements imposed by the US Sarbanes-Oxley Act, some companies now prefer to list elsewhere. “AIM is taking the place of NASDAQ as the world leader for technology companies of all nationalities,” says MTI’s Richardson.
Fund raising success is limited to the biggest VC players, though, with Index Ventures, Sofinnova Capital, Advent, Eden Ventures, Pond Ventures, TVM, Northzone Ventures, Wellington Partners, Via Venture Partners, Scottish Equity Partners and US firms Axcel and Benchmark Capital among the very select list of firms to close a fund in the last 18 months.
Another reason for optimism is that the quality of investments is believed to be higher now than ever before, with experienced, repeat entrepreneurs coming back to the market. “We are cautiously positive about European VC. Exits are rising and there are some great investment opportunities out there, with far higher quality entrepreneurs than five years ago,” says Pantheon’s vice president Nicolas Drapeau.
So far, the focus has been firmly on portfolio management and exits meaning new deal-flow has remained flat. However, some firms say their deal pace is rising now. In particular, investment in early stage deals is slowly picking up again, an area which has been starved of cash in recent times as VCs have concentrated on later stage deals. IT continues to attract the most investment, with nearly twice as many deals as healthcare. Other popular sectors include mobile communications, broadband into the home, internet technology and security, medical device innovation, clean technology and environmentally friendly energy.
Yet despite the positive developments of the last 18 months, many experts say European VC has still not emerged from its post-bubble near-death. The ability to raise funds has so far been limited almost exclusively to the top quartile firms, with most smaller or newer VCs still encountering the desert-like conditions endured since the crash.
Many firms have not raised what they wanted to, taken longer to raise follow-on funds, or, like MTI, put their latest funds on hold to concentrate on exits. The post-bubble fall-out has slowed, but more firms have ceased operations recently, including newcomers Abbey Road and Mowbray Capital. “European VC is still going through a nuclear winter in terms of fund raising. There is now a serious danger that the entire industry could wither on the vine. How can you sustain it with no capital?” says Guy Fraser-Sampson, former managing partner of Mowbray and author of “Multi-Asset Class Investment Strategy”, which was published in June.
The disparity between the two regions is principally due to the fact that, even after several years of improving exits, Europe is still having difficulty shaking off its history of poor returns. During its, albeit brief, history, it has delivered far below its US counterpart – the top quartile of US funds peaked at a whopping 76.1% pa IRR for the 1997 vintage, against Europe’s top quartile best of 18% for the 1998 vintage, according to Private Equity Intelligence.
With many LP fund managers still making investment decisions based on aggregate, rather than fund and manager-specific, returns, many are still reverting to historic norms, investing their VC allocation purely in the US. Many LPs even prefer to support second and third tier US funds rather than top quartile European funds, even though returns for Europe’s best firms are superior.
In addition, many of the LPs that do invest in non-US VC are currently being drawn more to Asia – in particular to China, which is regarded by many as the next venture hot spot.
Compounding the problem is that, even leaving regional preferences aside, the VC industry as a whole currently has a formidable adversary in the buyouts market. The immense success that buyout funds have enjoyed in the last few years, with some incredibly lucrative exits and an unprecedented number of deals, has resulted in a veritable fund-raising bonanza of late.
With European VC languishing far behind not only buyouts but also US venture in the returns department, it is still being overlooked by many investors. “The figures suggest European VC has underperformed every other sort of private equity. And unfortunately, although Europe has some fantastic investment opportunities and great VC firms, most investors won’t look beyond these figures,” says Fraser-Sampson.
LPs are also concerned that Europe still lacks the infrastructure to adequately support VC exits, despite the rapidly maturing AIM and new exchanges such as Alternext. “Exits are rising but are still significantly held back by the capital markets. AIM is evolving gradually, but there is still no broad, deep technology market giving good valuations,” says George Anson, managing director at fund-of-funds manager HarbourVest.
In addition, the much debated, time-honoured criticisms of European VC firms – their supposed lack of global ambition, overly tentative investment strategy and dominant population by bankers not entrepreneurs – remain a cause for concern for many LPs.
For a total, sustainable recovery, many still feel a seismic shift is required among European VCs, with a change in risk-taking mentality and a move to the US model of more assured investing and entrepreneur dominated firms. Europe’s VC industry has long been censured by detractors for a tendency to drip-feed money to portfolio companies, a reluctance to grow companies outside the home market and a propensity to exit investments too soon. “To generate great returns you need global companies. More of Europe’s VCs need to have genuinely global ambitions,” says Pantheon’s Drapeau.
Such shortcomings could be one reason why Europe has only delivered a couple of big home runs to date. “Our research shows that the failure rate is the same in the US and Europe. But what Europe lacks for investors is deals that return over 2.5x your investment – the US has far more of these,” says HarbourVest’s Anson.
Given many investors’ enduring misgivings, Europe’s VC firms are currently united in trying to combat what many perceive as a retrospective, out-dated view of their market. “You should invest in European VC because it is a good asset class that produces good returns. The top five or six European firms are as good as the best US firms. But people still look at the best US firms and compare them with the European average,” says MTI’s Richardson.
Top of the agenda is to try to get investors to look beyond historical and current aggregate returns, which reflect investments made at the peak of the market, to today’s exits and future returns. “The problem is that most investors go by historical data, not forward-looking research. Aggregate returns won’t rise for about five years and the benchmarks will look awful until then, because 80% of our industry’s recent capital was raised in 2000/2001 and invested in bad or overpriced deals – just like in the US at that time. But unlike the US, Europe’s VC market is too young to have the historically high returns that the US can boast from the ‘90’s,” says Amadeus’ Glover.
Many VC firms oppose the perception that returns in Europe now are inferior to those in the US, insisting Europe’s top quartile will match their US counterparts’ returns. “The perception that US returns are higher is debatable. Returns for the 2001-2002 vintage funds are likely to be similar in the two regions. European venture capital only really got started in the late 1990s and then the dot com bubble burst, so it wasn’t around long enough to deliver the spectacular returns the US did in the late 1990s, before the crash. But future returns will be evenly matched,” says MTI’s Richardson.
Statistics back up the argument that many European firms are performing as well as their US counterparts. The huge successes of mega exits like Google have skewed the results in the favour of the US VCs, but by taking these handful of divestments out of the equation, the average returns between the US and Europe are much closer.
Europe’s VC firms also point out that Europe can offer better investment opportunities than the US, as entry prices are far lower. Although there is rivalry for quality assets in Europe, entry valuations are still lower than the fiercely competitive US market which, critics say, is over-funded and over-priced. “Unlike the US, our pond is not over-fished. The last few years have been a great time to invest – with many high quality deals at much lower prices than in the US. This won’t feed through to returns for another three years or so, but when it does, the best European firms’ returns will match the best in the US,” says Amadeus’ Glover.
Meanwhile, countering the view that Europe is still held back by a lack of capital markets support, managers point out that, with AIM maturing rapidly, Europe’s exit environment is improving while, post-Sarbanes-Oxley, in some regards the US’s can be viewed as deteriorating.
Perhaps the key message firms are trying to get across to LPs is that venture capital itself is now a truly global industry. The US no longer dominates technology and investment opportunities are no longer isolated to Silicon Valley. Start-ups are occurring across the globe, with centres of excellence scattered everywhere. This is cause for huge optimism among European firms, which are trying to persuade LPs that Europe can deliver big hitters just as easily as the US.
Just as VC companies now need to be global to be competitive, Europe’s VC managers are telling investors to follow suit and change their investment strategy. “The VC industry is globalising, but the financial markets have not yet caught on and LPs still allocate to venture capital on a regional level. But this will change – just as country-specific private equity firms started going pan-European in the mid-1990s, so LPs will start to look sectorally not regionally and the US bias will disappear,” says Amadeus’ Glover.
Managers also point out that the strategy and make-up of many European firms is now changing to more closely resemble the successful US model. Firstly, firms are investing more per portfolio company. Also, more US-style firms, such as Eden Ventures, Add Partners, Pond and Northzone, are emerging, with fewer players now populated just by investment bankers and accountants.
The challenge continues
Yet despite VC firms’ attempts to generate wider investor support, European venture remains an extremely challenging market and, most agree, this could remain the case for the next two years at least.
Indeed, some take such a dim view of the fund raising outlook that they fear there may be no market to speak of in five years’ time. “I am pessimistic about the outlook for European venture capital because I don’t see an improvement in fund raising. My big fear is that by the time sentiment improves – if it improves – there won’t be any firms left to invest in, despite the huge opportunities and great teams out there,” says Fraser-Sampson.
Without sufficient funds, not only will many firms be unable to make new investments, but others will end up having to exit existing investments earlier or bring in other investors, diluting their returns. “It is a self-perpetuating problem – just as European returns are starting to look good, firms will struggle to repeat them as they cannot raise money. And with so much more money invested in the US, the chances are stacked that the next Google will come from there again,” says MTI’s Richardson.
Others remain more upbeat, however, given the intrinsic opportunities in Europe. Not all LPs look just at benchmarks, with an enlightened cluster committed to the asset class. Many hope fund raising will receive a further boost as, with buyout returns generally expected to fall in future, LPs start to prepare alternative investment strategies. “A core group of investors, including ourselves, are investing in European VC today. We believe that it will deliver good returns,” says Pantheon’s Drapeau.
Thus, even though many LPs may sit and wait for aggregate returns to improve before investing, most believe the industry will survive – even if there is further rationalisation of players. Amadeus’ Glover says: “In three to five years’ time, people will wonder why they questioned the future of European venture capital. Many firms have quality portfolios and exits are rising, so returns will eventually deliver. But fund raising won’t increase for the next few years, a further reduction in players is possible and money will be concentrated among an even smaller group of firms. It’s just a question of hanging in there until the returns start to come through.”