With European venture capital at a crucial juncture in its evolution, the German market too ends the year on a cautious high. The industry has passed its nadir, and most VCs agree that 2005 was the best year since the bubble. “This business is so cyclical,” says Rolf Mathies, managing partner at Earlybird. “The pendulum after the Neuer Markt collapse drastically swung one way and now it is coming back.”
Like VCs elsewhere, competition between funds is not an issue; rather, the challenge is finding who else to co-invest with. Wellington Partners is currently interested in buying a company but is as yet unable to find a willing investment partner. “There are only about five to 10 VCs around now, and this means there is not much capital for early stage opportunities, something which is not helped by the fact that most funds still have their fundraising ahead of them,” says Jörg Überla, a GP at Wellington.
This lack of funding has stifled young German companies at a time when the country desperately needs to be producing exciting, innovative companies to help kick-start its anaemic economy. With a fresh round of venture fundraising going on as we speak, this situation does have an end in sight. The lack of co-investors faced by Wellington is because the funds in Germany at the moment don’t have any, or much, money left. Assuming the fundraising environment is clement, this should be a temporary problem. Unfortunately there is little evidence to suggest there is much appetite from LPs for German venture capital. Wellington raised a €150m fund in August, Wellington Partners III Technology Fund, €20m over target, but Überla said “there was a very sceptical fundraising environment.”
What helped Wellington was its record of investing outside of German speaking countries: 40% of its investments fit into this category. Most of the leading VCs in Europe now are, and have to be, pan-European, and although Wellington operates mainly from Munich (there is an office in Zurich), the firm does have a Frenchman, Eric Archambeau, and a Dutchman, Bart Markus, on its team, which enables it easier access to foreign opportunities.
MVision acted as placement agent for Wellington’s recent fund closing, and Mounir Guen, CEO at the firm, admitted European venture is a hard sell, but what helped Wellington was how it had improved since its second fund. “They cleaned up their portfolio, they added value to their investments and they strengthened their team. LPs have a list of things they want to see a firm improve on, and Wellington was able to improve on 15 points,” says Guen. In particular investors were impressed with the way the firm didn’t just abandon struggling companies but successfully salvaged something from them and was able to return capital.
Another successful fundraising this year was in the life sciences sector, with TVM closing a sixth fund in this sector on €240.3m. It attracted over 20 LPs including AlpInvest, the European Investment Fund’s ERP-FIF Fund-of-funds (a cornerstone investor), KfWBankengruppe, pharmaceutical services giant Quintiles Transnational, Skandia Liv Asset Management, the Taiwanese Government’s Development Fund, Temasek Holdings, and US biotech companies Biogen Idec and Genzyme. The fund will focus on early and late stage companies specialising in drug discovery and development in Europe and the US as the firm looks to increase its presence in the biotech industry on the other side of the Atlantic.
Two investments have already been made: the first in Newron Pharmaceuticals, an Italian late stage company, and elbion, a German company that has just raised €35m. Part of TVM’s appeal to investors is its longevity. Founded in 1983 it was one of the first German venture firms, and probably the oldest.
One thing which holds European venture back is its lack of a track record. Many funds are currently finishing off their second fund and/or raising a third. This means a bad fund is going to be much more significant when an LP looks at the historical performance of a fund. Guen says: “This is in contrast to US firms which have a long track record so if they have one or two bad funds it doesn’t really matter.” Many of the larger German firms have been around for a while, and so have managed to raise more than just a couple of funds, but it is the smaller ones that are suffering.
The small funds with a more domestic focus have generally found it difficult to fundraise and many of those that appeared five years ago have fallen away. These funds lack the international edge the larger funds possess. Alexander Bruehl, a senior partner at Atlas Ventures, says: “Most of the companies that I consider to have high quality management or business models have international expansion plans quite early on. In general people understand they have to take an international approach to their business. Those VCs able to help them with this don’t have much competition.” As with most countries, it is important for many German companies, though not all, to internationalise quickly. Überla said one of the trends Wellington has observed is the need to get companies selling, and ideally have some sort of operational activity in the US, which is much more important now.
The confidence level among Germany’s VCs is high. The barren years after the collapse of the Neuer Markt appear to be over, and the primary reason is the reopening of the IPO market. According to the BVK, there have been eight venture-backed German IPOs up to October this year, the highest since 2001, which also saw eight companies go public.
Earlybird has been especially active on this front. In September online mortgage broker Interhyp listed on the Frankfurt Stock Exchange, an investment Earlybird has held since 1999, with 3i getting involved in 2000. The offer was 30x oversubscribed and at the time of writing the company has a market cap of €425m, having seen its share price climb from €42 per share to €65.
The following month saw the IPO of Tipp24, an online lottery and betting company. Tipp24, like Interhyp, floated at the top of its price range (€20.50) but has had a mixed time since then, it’s share price dropping below its initial offer, before stabilising at just over €20. Earlybird is the only VC backer.
Another recent float has been Q-Cells, a company with backing from Apax, Good Energies Investments, and Stroeher Finanzholding. A manufacturer of solar equipment, Q-Cells is one of the success stories of German venture capital in 2005. Its initial share price of €38 closed on the opening day of trading at €47.50, and although it has dipped since then, the IPO represented a 20x return for Apax, according to Christian Reitberger, who serves on the board of Q-Cells.
Despite all the talk of the popularity of the London Stock Exchange’s Alternative Investment Market (AIM) and its vision to become a pan-European stock market for technology companies, the Germans remain suspicious of the UK’s plans for continental domination. “It is not so popular with German-speaking VCs,” says Reitberger. “There’s still a prejudice against AIM because the liquidity level is still very low, so people do not regard floating on AIM as necessary when the Frankfurt Stock Exchange is here.”
Andreas Kochhäuser, head of German venture for 3i, says: “Although there have been a couple of German companies that have gone on AIM, I think it will be the exception rather than the rule. It’s not really an exit route, more of a funding round. The Frankfurt market is where you go to capitalise on your investment, and that requires that you have a company that attracts the right kind of investors. Who are the investors on the AIM market who would be interested in backing a German company?”
Trade sales have experienced a similar renaissance over the past year, with the BVK predicting around 80 will have taken place before year-end (40 had been completed in the first six months of 2005.) 3i’s success on the flotation front has been matched by sales to trade buyers, which includes June’s sale of telephone service number provider dtms AG and RedDot Solutions, a content management software company with headquarters in Germany and the US, yet another example of the importance of the US market to German VCs. Joern Pelzer, the 3i associate director who led the deal, said at the time: “RedDot made possibly the best US market entry that our German investment team have seen to date.” Nearly 50% of the company’s current revenues come from the US, and the company that acquired it, Hummingbird, is a US one.
Germany has traditionally been seen as a place with high quality technology in abundance but lacking in successful managers. But according to the German VC community, this is changing. Bruehl of Atlas says the reason 2005 has been a considerably better year than previous years is because the quality of deals has increased: “There are more experienced management teams around now. They have come back into the start-up world after the storm of the market over the last few years, which saw a lot of good people shy away from the business. But this is changing and you are seeing more top level management teams setting up and owning businesses.”
Serial entrepreneurs are growing in number, but remain quite low in total. The Global Entrepreneurship Monitor Report 2003 records that there are 8.1 per 100 people in the US considering starting up a business compared to 3.5 in Germany. To make up for this shortfall, 3i’s Kochhäuser turns to the corporates: “In Germany we do have a lot of people who have built up a lot of experience and who have worked in companies that have floated and we try and pull these people into the management teams of some of our portfolio companies.”
Of course high quality managers do not emerge overnight. “It’s a long and painful process”, says Apax’s Reitberger, “but we are seeing at last a larger number of experienced people starting companies. A number of these are people who worked in start-ups a few years ago and now feel in a position where they can come back and setup new businesses.”
The success of German venture-backed companies this year has given heart to an industry that was in danger of collapsing in on its own pessimism. The consolidation of the VC market over the last four years has not been matched by either a dramatic upturn in deal flow, funds raised or exits, until this year. Deal flow apart, anecdotal evidence suggests 2005 will be similar to 2004 in this regards, although most VCs agree the quality of investments has significantly improved.
There is a large funding gap in Germany, as there is across Europe as a whole, for early stage companies. Figures published by FHP Private Consultants and the European Venture Capital Association show that in 2003 early stage investments in relation to GDP in Germany were 0.014%, compared to the European average of 0.027% and the UK’s 0.039% and the US’s 0.16%, but the country’s actual technology output is quite competitive, according to analysis undertaken by Earlybird and the OECD in May this year. R&D spending in 2003 in Germany was 2.3% of GDP, higher than Europe’s 1.5% average and not too far off America’s 2.6%. By using an ‘innovation capacity index’ developed by academics Porter, Stern and Furman in 2000, Germany is ranked fifth in the world based on 2003 statistics (criteria include such things as the number of R&D personnel and regulations in place.) Germany has 70 triadic patent families (patents taken at the European Patent Office (EPO), the Japanese Patent Office (JPO) and the US Patent & Trademark Office (USPTO) that share one or more priorities) per million population, more than double that of Europe and 17 more than the US. But the lack of VCs in Germany means there is a massive supply and demand imbalance: the country has 8.6 such patents per VC principal. Europe has 3.2 and the US 1.6. This means Europe, and in particular Germany, has significantly lower valuations for investment opportunities than the US.
Mathies of Earlybird believes, “early stage venture capital is like buyouts were five years ago.” The next step now is to get LPs to agree with what the VCs and the stats suggest. “The majority of LPs,” says Reitberger, “still have this old perception, especially in Germany, of there being no venture market and no entrepreneurs and no management expertise. The fact is that this is a country filled up to the hilt with good technology with serial entrepreneurs. All the fundamentals are in place, and there’s a minority of educated LPs who have realised this and are keen to back German venture, but the herd of LPs are still in this buyouts mania. A lot of LPs have not yet realised how good the situation is here, and instead think that the only way you can make money from venture is in the US. This is obviously wrong.”