Israel: business as usual?

There is an imbalance of funds and deals in Israel. Attitudes are contrasting while institutional investors are cautious of committing to Israeli funds, the Israeli VC community is alive and kicking and those that have the money are actively investing. A recent example is Actimize, a developer of real time analytics software, which has secured $10 million second round financing from Carmel Ventures, Giza Venture Capital and Vertex Venture Capital.

Since there is a shortage of funds, syndication is becoming increasingly popular with a close-knit community of well-established players in the region including the aforementioned firms and those such as Concord, Genesis, Gemini, Jerusalem Venture Partners, Pitango and Sequoia Capital. Most of the major large corporates are active in corporate venturing in Israel including Ericsson, Nokia, Phillips and Siemens and international firms Accel Partners, Apax Partners and Benchmark Capital also have offices in the region.

Zeev Holtzman, chairman and CEO of Giza Venture Capital, says: “The market has become less competitive while three years ago competition was much tougher, now players will syndicate. In this climate we want partners with deep pockets. No one wants to be alone.”

He adds: “The global crisis in the high tech industry and the political situation in Israel continue to have strong influence on investment activity, resulting in the investment falloff continuing in the third quarter. Still, $1.2 billion in investments in 2002 is higher than the total investment in 1999, which was considered a successful year.”

It comes as no surprise that the number of new investments in Israel has fallen in 2002. According to the Israel Venture Capital Research Center, during the third quarter of 2002, 92 private Israeli high tech companies raised $266 million from venture investors, local and foreign. This amount is down nine per cent from the second quarter and 29 per cent from the same quarter last year.

The short-term impact of a war with Iraq on financial markets is unclear. In a conservative, but not worst-case, scenario economists forecast that its effect on the US economy is likely to be serious, but not severe. What its effects will be on the Israeli venture capital market, which has been reliant on Nasdaq as its major exit route, remains to be seen. In the past three years the Isratech index, which is comprised of the 50 most active Israeli and Israeli-related companies traded on Nasdaq, has outperformed Nasdaq.

However, the threat of war with Iraq continues to weigh down trading and no stockbroker dares predict when prices might recover. According to a report by the US-based Putnam Institute, the impact of war on the stock market has historically been mixed. In some cases such as the onset of US involvement in the two World Wars, the short- to medium-term impact was generally negative. In others, such as the Gulf War of 1991 and the end of World War II, the effect appears to have been positive. According to the Putnam Institute, many forces exert an influence on equity markets military conflict is only one of them and a war’s duration, scope and outcome has much to do with its impact on financial markets.

There has been a shift away from Nasdaq with VCs trying to convince portfolio companies that AIM is a realistic alternative. This has happened before, says Jacob Burak, founder and chairman of Evergreen Partners. “There was rush of Israeli companies to AIM in 1996 and for a while AIM was known as the alternative Israeli market.” Ivor Levene, chief executive of the British-Israel Chamber of Commerce, agrees that there is a renewed interest in AIM as a potential exit route for Israeli VCs. “The London Stock Exchange has targeted Israel and is putting in a lot of effort to drum up trade for Israeli companies that want to float,” he says.

Commenting on investors’ attitudes to the region he says the main problem is ignorance. “In spite of Israel’s reputation in high tech sectors, many people still can’t see the benefits of investing in the region because their views are clouded by what they see in the press,” he says. “The last couple of years, the way the media has portrayed what is going on has added to the doubts of investing in the region. You shouldn’t believe everything you read. More people have died in road accidents in Israel, than in all the bombings and wars. You have to put it into perspective – the odds of being affected by a terrorist incident are low.”

But players are nervous of travelling to Israel. Japanese firm Jafco is said to have prohibited employees from travelling and so is ceasing investments in Israel as the legal structure of their fund prohibits the firm from doing deals remotely. This, however, is not preventing Israelis from doing deals. For a nation that has always had an outward-facing culture commercially, travel is not an issue.

Jonathan Morris of international law firm Berwin Leighton Paisner, says: “Israel is going through difficult times, but the atmosphere is still vibrant. Some people are reluctant to travel to Israel, but the Israelis will travel and are continuing to do business.” And so international VC investing in Israel continues. Select deals in the last six months include Sequoia’s $10 million investment in HyperRoll, an $18 million round in Banter, led by FT Ventures, and Aduva’s $18 million round led by BMC, Intel, IBM and Elwin Capital.

A hotbed of technology

“Israel is a country where there is so much innovative technology partly because people go through the army and partly because of the academic excellence in the Israeli academic institutions. There is a lot of talent here,” says David Osborne, partner at Israeli law firm Yigal Arnon & Co. A prime example is Given Imaging, the first company to go public on Nasdaq after September 11. The Israeli wireless technology company secured a total of $34 million in four rounds of funding from investors including Discount Investment Corp, Elron Electronic Industries, OrbiMed Advisors, PEC and Rafael Development Corp. The innovative technology that attracted the funding is a wireless camera in the form of a pill. The Israeli company’s origins lie in military missile defence research, and the entrepreneurs developed the imaging capsule, which is about the same size as a typical multi-vitamin, to transmit diagnostic imaging of a patient’s gastrointestinal tract.

While Israeli entrepreneurs have skills in technology, what they lack is managerial talent, says Jacob Burak of Evergreen. “Israeli companies are not famous for their marketing and managerial efforts, but they are more robust on technology content and will always therefore have downside protection in the context of an acquisition.”

The reason for the ongoing success of Israeli start-ups is that from day one they are international companies. Ninety-nine per cent of these companies are targeting markets outside Israel and so have to be global from inception. In addition, a global approach and presence largely eliminates exposure to Middle East risk, says Burak.

An increasing number of Israeli companies are looking to Europe rather than the US, says Julie Kunstler, co-founder of Portview. With the current downturn, it is no longer enough only to look to the US. “One thing the downturn has done it has forced start-ups to look at all the markets [worldwide] and evaluate the opportunities elsewhere,” she says. It is for that reason that more Israeli firms such as Giza and Jerusalem Venture Partners are setting up in Europe. Portview has offices both in Israel and the US and is considering Europe for its next fund, although the firm’s current fund at $61 million is too small to justify opening another office, says Kunstler.

Israeli funds that have offices in Europe are based in London and Munich. This may be to serve their investor base, but also because there are some tech sectors where Europe is more advanced than the US particularly the wireless sector where Israel is very strong. It is a natural step for successful Israeli VCs to set up in Europe to add value to portfolio companies.

Why London? David Osborne of Yigal Arnon & Co explains: “London is a large capital market and you’re regarded as well-established if you have an office there. The instability of the Shekel is another factor the larger VCs are now seeking to balance their portfolios with European investments. It is mainly a strategy to diversify and also attract investors from Europe. Funds today want a worldwide presence.”

Attracting funding

In the current climate, valuations are favorable and it is a good time to invest. The problem is finding the funding. Money is tight and funds are very much on a drip budget, says David Osborne. “Every couple of months the board has to justify its company’s existence to the venture capital fund. In the last 12 months with the downturn in the markets and valuations, the funds have been drip-feeding the companies within their portfolios. The challenge now is attracting new funds.”

Fund raising is tough. It is a combination of three factors, says Jacob Burak of Evergreen, currently in fund raising mode for Evergreen 4, which has reached a first closing at $60 million and hopes to raise $170 million by the end of Q1 2003.

The first factor is of course a major crisis in the tech markets. Secondly the downturn in the public markets is affecting the major exit route for Israeli companies and funds have to find alternative methods of returning money to LPs. Also in the US, pension funds are over-allocated to private equity as a result of their decreasing allocations to public equity as the stock markets are down. As a result, many pension funds that previously would have committed to private equity funds are reducing their exposure to this asset class. Thirdly, says Burak, the political situation in Israel adds a layer of complexity especially to investors who don’t know Israel well. “Many institutional investors are reluctant to assume an undefined risk,” he says.

Despite recent tax reforms exempting foreign investments in Israeli funds from tax, commitments to venture capital funds fell from $3.7 billion in 2000 to $1.4 billion in 2001. This ends a ten-year period of growth in the country’s VC industry.

Of the $10 billion raised between 1992 and 2001, IVC Research Centre estimates $4.1 billion is still available for investment. However, of this amount only $1.1 billion is free for new investments while the rest is destined for follow-on rounds, management fees and other expenses.

This amount is only enough for one-year consumption, says Burak. “The mega funds of 2000 are a phenomenon which I don’t see repeating. What we are seeing in Israel is the opposite of what is happening in Europe. In Europe there is an overhang, but in Israel there is a shortage of funds for investment.”

He adds that taxation in the past was a problem for investors in Israeli funds but this is not an issue anymore. “The change was a prerequisite, but it is not enough. In addition to the zero tax you need a more stable political environment. It is going to be a challenge to raise funds but the more established funds will be able to do it,” he says.

Opportunities are rife for Evergreen’s secondaries fund. The firm has just closed its second fund of this kind at $90 million. “That fund is so busy right now,” says Burak a further indicator of uncertainty in the market with those who cashed in during the boom time, trying to find a way out. Who is selling? Both Israeli and non-Israeli portfolios, says Burak. Zeev Holtzman of Giza says: “There’s going to be a shake-out in the VC community here. Out of the 50 VC funds in the [Israeli] market today, there will soon only be around 15 to 20 left.” This may throw out some prime opportunities for Evergreen’s new fund.

Matty Karp, managing partner of Concord Ventures, which invests in software applications & Internet infrastructure and biotech and has fully invested its third $180 million fund, says for institutional investors who have not worked in Israel before it is difficult to look at the picture objectively when their judgments are clouded by what is reported by the press.

Contributing factors are a lack of understanding of the region by the advisory boards on financial institutions and investors in fund-of-funds. Concord will raise a fourth fund, but not until the market has settled. Karp is watching the market with interest. “It is time to stop moving with the herd,” he says. “Institutional investors behave like a herd in uncertain market conditions and Israeli VCs attempting to raise funds in the current climate are being impacted by this.” Karp encourages investors to look at past experience. “If you look historically, the better returns were often achieved by the contrarians. I believe those that invest in this environment will achieve better returns.”

Ivor Levene of the British-Israel Chamber of Commerce agrees: “The reality is that those [investors] that go and have a look now will be remembered. My guess is that those firms will come away with good investments.” There is optimism in the region, he says. “You can’t get away from the fact that Israel has a lot of issues at the moment, but in spite of this the people there are very bullish and very confident and business is carrying on in a normal way.”