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Israel: land of opportunity?

With increasingly sensationalist headlines and pictures, news coverage has to make people sit up if it is to make an impact today. That is not to say that terrible events and incidents do not happen somewhere in the world every day or that too many of these go unreported. But an unrelenting focus on the worst presents an unbalanced picture of countries and their economies. Avi Hasson, a partner at Gemini Israel Funds, takes a look at investors’ attitudes towards Israel.

As those who have lived through troubles in places like Northern Ireland and parts of Asia know, life and work in areas of political instability goes on. It is the same in Israel. Work has to continue as one of the most important bases of a society’s survival is its ability to generate income. The fact is that companies in Israel generate all their income from markets far from their borders and are therefore less affected by the politics on their doorstep.

Many international investors who have not previously invested in Israeli venture capital funds might query how local political turmoil might affect returns. Despite this, we are not alone among Israeli VCs in seeing interest from a range of new international investors, especially in Europe. Why should Israel now become the choice for so many European investors, when the Middle East is perceived as a tumultuous place, US technology is on the rebound and the best of Europe’s smaller band of VCs are achieving successful exits?

In Europe, the alternative assets market is going through a period of reassessment, seeking long-term returns against a background of geopolitical uncertainty, of future increased demand on pension funds encouraged by demographic change and of the recent rapid growth in hedge funds, which may or may not produce a soft landing for investors. Closer to home, there are three reasons why Israel is particularly attractive to foreign investors at the moment: the successes achieved to date; the unique culture of entrepreneurship, technical skill and teamwork; and finally, the maturity of Israel’s venture industry.

Venture firms in Israel are raising fourth generation funds and all the conditions – the experience of the fund managers, the size of our venture ecosystem, the pool of serial entrepreneurs, the presence in Israel and partnerships with Israeli companies of most major global technology corporations – are in place to produce returns comparable to Silicon Valley.

An important building block of Israel’s technology industry was the Bi-national Research & Development (BIRD) Foundation, established by President Jimmy Carter in the late 1970s, through which the US and Israel jointly funded over 13 years some 500 technology start-ups. The Israeli Government’s YOZMA programme, financing the first venture capital funds, was established in 1993 and the Israeli Government has since been generous in its fiscal incentives to start-ups and to foreign investment.

Since 1995, the Israeli venture industry has raised US$10.6bn and numbers some 64 firms, including home-grown players such as Carmel, Gemini, Genesis and Pitango and international players like Apax, Benchmark and Sequoia. Over 120 Israeli companies, mostly venture-backed, are listed on NASDAQ with a combined market capitalisation exceeding US$42bn. The development of Israel’s venture capital and technology sectors have benefited from and contributed to the country’s modern, competitive marketplace, outstanding human resources and technology-intensive culture.

The results are plain to see. Many of the world’s leading companies, including BMC, CA, Cisco, Intel, Motorola, Nestle, Nortel, Sony and Volvo, have core development operations in Israel. Global technology leaders look to Israel as a major source of acquisitions of companies and R&D. The cell phone was developed by Israelis in the Israeli branch of Motorola. Most of Windows NT and XP operating systems were developed by Microsoft-Israel. Voicemail technology was developed in Israel. The Pentium MMX Chip technology was designed at Intel’s Israeli division and the Pentium microprocessor in your computer was very probably made in Israel. These are just a few examples of how far the Israeli market has come in 25 years.

A major factor in these and other successes is the culture of technical skill and team spirit. Israel has the highest ratio of university degrees per head of population and the highest number, again per capita, of scientists and engineers in the world. Our 4,000 technology companies are second in number only to California. IT accounts for nearly 60% of our total exports.

This is in part due to the system whereby, during three years of compulsory military service from 18 years old, the military identifies and fast tracks the brightest men and women, providing them with scientific training and giving them management responsibilities at an age undreamed of in other countries. The young men and women who work together in this hothouse environment form strong bonds that serve them well in later commercial life. In addition, Israel has benefited from the immigration, especially from the former Soviet Union, of a highly educated and talented pool of scientists and engineers.

Israelis have a can-do mentality that pervades its economy, makes people want to innovate, encourages those that fail first time around to have another go and makes successful entrepreneurs want to start all over again. Culturally, Israelis have an advantage when it comes to starting and building technology businesses. Some 30% of Israeli entrepreneurs have previously built and successfully sold or floated a business.

Much of this accounts for why the region has done well with early stage technology, but not for why investors worldwide now seem to be looking to Israel in larger numbers and with greater interest than ever before.

Until very recently, investors in venture capital and private equity had not considered Israel as part of their allocation, either because they considered early stage technology too high risk, or because they had long-standing relationships with successful US and European funds. As the venture industry worldwide has emerged from the boom and bust of the late 1990s, from which Israel was not immune, canny investors have been looking carefully at where longer-term value has really been created and seen that the returns generated over time in Israel compare well with the top quartile Silicon Valley and Route 128 firms in the US.

Two examples illustrate this: Verisity and PowerDsine. Verisity began by developing software tools to assist designers of electronic devices, most commonly integrated circuits, to verify the correctness of their designs. The company, backed by Advent International, Gemini and Sequoia established a US subsidiary and attracted its first orders from Cadence Design, Cisco and Stratus Computers . The team continually met its ambitious forecasts as repeat business from major customers rolled in and new customers, such as Alcatel, AMD, Bosch, Ericsson, Lucent, Motorola, Sony, and Samsung signed up. After an acquisition, Verisity had a 77% global market share. In Spring 2001, five years after seed investment, Verisity floated on NASDAQ, raising US$28m and valued at US$150m. The company went on to achieve a 170.7% increase on its initial offering price that year and was NASDAQ’s best performing IPO of 2001.

In 1998, PowerDsine developed its Power over Ethernet technology, which allows power to be transmitted over the same network cable as data, and attracted a prestigious group of investors including Clal, Israel’s largest holding company, Deutsche Bank, JVP, Poalim, Israel’s largest bank and Vertex. The company became a major market shaper, with customers such as 3Com, Avaya, Ericsson, Nortel and Siemens, drove the IEEE 802.3af standard and grew to dominate its market. In June this year, it floated on NASDAQ raising US$69m.

An important dimension of foreign investment in Israel is the corporate investor. For many of the world’s large technology businesses, this too is a key time to look at Israel as a source of R&D and acquisition. In the downturn, a large number of these companies downsized their own corporate venturing activities but they now need access to the type of R&D emanating from Israeli technology companies, especially in communications technologies and life sciences. Investing in venture funds or in individual portfolio companies offers access to those technologies and the opportunity for strategic partnerships.

Cisco is one of a number of global companies that have deployed this strategy for some years but with a noticeable increase in investment this year. Since 1998, Cisco has spent close to US$1bn investing in and acquiring Israeli technology start-ups like P-cube and Pentacom – three of them in the past few months. One of these was Riverhead Networks, a developer of security technology, co-founded in 2000 with investment from Gemini, Koor and Sequoia. Cisco became an early investor through a commercial partnership, but this year bought the company outright for US$39m.

Another technology giant, Intel, has a thirty-year relationship with Israel. The company employs over 5,300 Israelis at its first design and development centre outside the US. Total Intel exports from Israel are in excess of US$1.4bn per annum. The company’s investment arm, Intel Capital, has invested over US$100m in Israeli start-ups including a recent investment in Silverback Systems, a company providing semiconductor and on-chip software solutions for networked storage and data centres.

The Israeli economy is in better shape today than it has been for many years, with a balance of trade deficit steadily reducing, an annualised inflation rate of 0.5% and foreign investment in the first eight months of 2004 of US$4.1bn. Tech exports leapt to over US$6bn in the first half of this year alone and the TelTech 15 Index is up 48% on 2003. On the venture side, Q3 of 2004 has seen the highest level of investment in three years, with 113 technology companies attracting US$438m from local and international venture funds, a 55% increase on Q3 2003. Four Israeli companies have had Wall Street IPOs this year with a few more in the pipeline.

Evidence of confidence in the Israeli economy comes from other sources. Earlier this year, the European Tech Tour, a collection of some 40 international companies and investors including Galileo, Infineon, Logitech, Nokia and Siemens , made their first tour outside Europe to see Israel’s venture capitalists and portfolio companies. Also this year, a group of Silicon Valley venture investors toured Israel’s high-tech centres for the first time in five years, looking for potential investment opportunities. And delegations from a number of other countries, including India, have recently visited to scout for opportunities.

With a mature VC industry that has many successes under its belt and a pool of seasoned managers to help build and run Israeli businesses, Israel has truly arrived on the global VC scene. Large institutions worldwide are again investing in technology and are setting up operations in Israel to tap into the region’s skill base and innovation. Israel has established a reputation for developing businesses that set standards and high barriers for entry in their niches. Israelis are good at commercialising technologies because they have always had to look outside Israel to meet the needs of customers. Political instability notwithstanding, Israel has become a major force in global venture capital, and Europe is beginning to take notice.