Funding European venture capital

Fund raising for European venture capital has long been a thankless task for all but a select few. Underperformance in the face of US venture and European buyouts has made it an uphill struggle.

Despite this, venture capital fund raising performed relatively well in 2008 according to the preliminary statistics published by EVCA.

Forty-seven funds closed last year, up by 10 from 2007, with an average fund size of €84.7m. Early stage funds saw a rise in number from 15 to 21, with the growth capital segment seeing 10 vehicles raise almost €3bn compared to nine raising €2bn the previous year.

Pension funds remained the largest contributor to private equity overall, accounting for 23% of all money raised, contributing €15.2bn to the total, up from €13.9bn in 2007 (a 17% share).

The situation in the opening months of 2009 is looking decidedly worse. Turning to the UK specifically for the moment, in a BVCA/Populus survey published in February, 67% of respondents to the question of whether the fund raising environment for VC was easier or harder over the last 12 months, 67% said it was more difficult, and 98% said the credit crisis will have a negative impact on the ability of firms to raise money from investors.

News from NESTA is no more sunny. Using a blend of Thomson Reuter’s data from VentureXpert and its own research, NESTA reveals just seven venture funds raised money in 2008 in the UK, 68% less than in 2007. The total raised was £179m, down by 72%.

Fund raising

According to VentureXpert and EVCJ’s own research, there have been two large fund raisings completed in Europe in the opening five months of 2009 – Index Ventures V, which raised €350m, and Atlas Ventures, which raised US$283m for its eighth fund.

There have been a number of first closes, notably Balderton Capital, which reached US$430m, alongside smaller funds like Target Partners, BioMedPartners, Seroba Kernel Life Sciences and NextStage. There was even a first-time fund, TIME Equity Partners, a French firm which launched with a €100m fund. In the UK, angel investors the Rickman brothers launched a €100m fund for investment in UK technology companies, and hopes to reach a €50m first closing in the summer.

There was also a fund-of-funds raised by Siemens Venture Capital (SVC), the early stage investment arm of the German engineering and electronics giant, which held a first closing of almost US$100m, with a target of US$200m aimed at venture and growth capital funds, with investors so far including German Siemens pension funds and two leading European insurers. However, most of the money is heading to the US, with one-third reserved for Europe, Israel and Asia.

Stripping out the Siemens fund and the Bookham launch, a total of just over €1.4bn has been raised by European venture funds in the first four months of the year. The figure for the same period in 2008 is around €3.5bn, meaning there has been a significant drop-off.

Taking the money

European venture capital gets its money from a range of sources, not dissimilar, at least in type, to European buyouts. EVCA stats (from Thomson Reuters and PEREP_Analytics) show that it’s the usual suspects, primarily pension funds, fund-of-funds, insurance companies and banks, although the banks’ share has dropped dramatically, according to the preliminary data.

More interesting is the location of venture backers – over a third of the money comes from the US and Canada and a little over 10% from Australia and Asia. The size of the contribution from North America indicates two things: one, that US investors are far more willing, and able, to invest in venture capital than their European counterparts (it must be remembered many of them are restricted by law as to the amount they can invest in alternative assets to a greater extent than in North America); and, secondly, it shows the importance of the US links certain European funds enjoy.

Of the top 10 investors in private equity, fund-of-funds dominate, as can be seen from the table below. Collectively, they have invested a total of US$292bn in the industry, and 571 venture funds received backing. Of this, a total of just 93 headed towards Europe – that’s only 16.3%. According to this chart, the most enthusiastic investors are European – half of all AlpInvest Partners’ venture funds are in Europe, just under half of AXA Private Equity’s are, and all bar one of Capital Dynamics’. However, even in Europe, Pantheon still only backed 23 funds, which despite being the highest number, only represents 15% of the total number of VC vehicles it has backed.

Strip out the fund-of-funds and the picture is even worse. The largest investor in private equity as a whole is now Credit Suisse, which has committed a total of US$52.9bn to the asset class over the years, and invested in just eight venture funds, only two of which are European based, the last one of which has a 2007 vintage. The most prolific investor is the California Public Employees’ Retirement System (CalPERS), which has invested in a total of 295 venture funds, 14 of which are European (representing 4.7%). But 2007 is as far as those investors go, with other high-profile private equity backers like the California State Teachers’ Retirement System not investing anything since 2005.

The American connection

For Balderton and Accel – which raised US$525 for Accel London III late last year – US investors play a large role. One such investor is Montagu Newhall Associates, an American venture fund-of-funds, which has backed both Accel London (as well as the US parent firm) and Balderton.

The American link is important for both firms – shortly after Benchmark Europe became Balderton Capital, Barry Maloney said they would recommend portfolio companies to approach Benchmark when looking to raise money in the US, and the American heritage no doubt helps sell the firm to LPs.

A number of the biggest European venture funds also invest in the US, which again helps attract investors from there. Index, for example, regularly backs US companies, and has 19 such businesses currently residing in its portfolio. Life sciences VC Abingworth, which raised the largest European fund in the sector in 2008, prides itself on being a trans-Atlantic firm, and has more offices in the US than in Europe.

Not that having US links is necessarily a golden ticket – Atlas Venture, which has offices in Boston and London and has 57 US investments in its portfolio, came in well under target for it latest fund, raising US$283m for its eighth fund despite a target of US$500m.

Nor does not investing in the US mean you can’t raise a large fund – Sofinnova Partners, raised €385m in 2005, making it Europe’s 10th largest VC fund in history, although it will be pushed out when Balderton closes. Again however, Sofinnova has US links. It has co-invested with its sister firm, Sofinnova Ventures, on a number of deals.

Vicious circle

Talking to VCs, the most important factor they mention in attracting money is track record, and Balderton, Accel, Abingworth and Sofinnova have all produced good returns for their investors – but VCs can only produce good returns if they have enough money to invest.

The capital constraint of European VC is a serious problem and is part of a vicious circle whereby small funds try to build global companies, find they don’t have enough money to finance this growth, which leaves the door open for US VCs to swoop in and generate the big returns at the expense of the European VC, which means LP cash pours into US funds (or at least used to) rather than the European ones, constricting fund sizes, and so the cycle continues.

One solution, other than LPs deciding to loosen the purse strings and commit more money to European venture capital themselves, is to get governments to encourage them. One only needs to look to the US and the Small Business Investment Company (SBIC) programme for a successful example – under the programme, government provides two-thirds of the capital as a loan and just takes a government interest rate and 10% of the fund’s profits, with the private LPs collecting the rest.

Closer to home is the case of Israel’s Yozma programme, which invested in local funds back in the early 1990s. The Government invested 40% of the total size of the fund which could then be repurchased by the fund manager within five years at cost plus a nominal interest rate. A number of the leading lights of Israeli venture capital were founded as a result of Yozma, including Gemini and Vertex.

There are equivalents in Europe – the UK has Enterprise Capital Funds (ECFs), which are based on SBIC, and a number of countries participate in funds targeting seed and early stage investments. A number of European governments also support seed and early stage funds to encourage entrepreneurship and SME growth – the Italian Government launched such a fund in April, committing €80m to a €160m fund focused on the south of the country. On a pan-European level there is the European Investment Fund (EIF), which has invested in a total of 266 VC funds and manages a portfolio of over US$4.4bn.

Low ambition

The problem with most of the national schemes is they are focused on small funds building small businesses to serve the local community or surrounding areas. They are not concerned with building global players and so generally make small returns. Investors aren’t interested. The EIF may as well be just another LP as far as fund raising is concerned – they don’t offer encouragement to potential investors in the same way the US Government does through SBIC or the Israeli Government did through Yozma.

What the EIF does well is supporting first-time managers – it is prepared to take on the risks that other investors aren’t, and its very presence in a fund can often attract other investors. Without EIF support, there’s no question many European venture funds wouldn’t not exist.

Despite this, the programmes aren’t enough. European governments, and the EU need to show more ambition, be braver with their decisions rather than just setting up small publicly-assisted funds which are only a drop in the ocean. The UK Government’s new £750m Strategic Investment Fund to support high growth technology businesses received mixed reviews, with NESTA’s CEO, Jonathan Kestenbaum calling it a “vital step”, but his BVCA counterpart Simon Walker “deeply disappointed” by what he saw as a “return to the public sector seeking to ‘pick winners’ (but ultimately subsidising losers)”.

The main bone of contention is the lack of role for people who know what they are doing, i.e. venture capitalists. Walker would have preferred “a highly targeted UK Innovation Fund for venture capital in which the private sector would have played a pivotal role.” Gary Robins, chief executive of Hotbed, the UK private investor syndicator, is similarly sceptical: “Past experience shows that these projects are often slow to get off the ground and frequently fail to achieve a return for the public purse.”

Without a well thought-out and targeted plan by European government, home grown venture capital funds, barring the odd exception, will continue to struggle to raise the funds necessary to create the global titans of tomorrow. Without easing the allocation rules governing institutional investors and educating them as to the benefits of venture capital, fund raising will continue to be an uphill battle.