“European technology is in terminal meltdown, and everyone is in denial.” These are the cheery words of Ken Olisa. At the end of 2004, the general consensus about venture investing in tech was that 2005 was supposed to be when the industry truly began its march back to the big time. In truth, this wasn’t really much of a prediction as the market only had one place to go, up, but it seems, if Olisa is to be believed, that it can’t even manage this.
It can be tricky sometimes to discern exactly what is going on with the market when talking to VCs. They will invariably spin a yarn, full of (guarded) optimism, backed up by a few examples of some good exits or a few large funding rounds. Realism is important. It doesn’t help anyone by being overly optimistic. LPs are only too aware of the consistently poor returns offered by technology investing in Europe, as shown by the difficulty most firms are having fund raising. Compared to the US, European tech is in a rather sorry state.
The shakeout has begun
“It’s been an OK year for Europe,” says Ernie Richardson, CEO of MTI, “particularly for exits, but fund raising is still questionable. The 2004 fund raising statistics for the US were mind-boggling. They were around four times the amount raised in Europe.” MTI has felt the force of the indifference among LPs towards European technology, and has officially put the raising of MTI5 on hold. The troubles of the firm are perhaps surprising given the firm’s long history (it’s been around since 1983), but considering the firm operates in a particularly challenging area, mainly early stage UK technology, and usually quite difficult technology, it is possibly not so surprising given that even some of the equally well-established and balanced tech funds are also finding it tough.
Advent Venture Partners managed to raise £128m in December, but with a reported hurdle rate attached (which means they can’t take a share of the profits made on exits unless the sale generates a minimum of 8%). It’s hoping to close on £200m before the end of this year, lower than its previous fund, which raised £300m in 2001.
Another firm that found the fund raising trail far from smooth was German VC Wellington, whose Wellington Partners III Technology Fund closed in August on €150m. While this was €30m more than it planned, it started its pre-marketing in 2003 before officially launching in the summer of 2004.
Other firms have found the going slightly easier. Benchmark closed its second European fund in September 2004 on €308m despite realising none of the investments from its first fund, but it no doubt helps that the firm is a US one. Index Ventures III closed on €300m in March, and Sofinnova managed to get €385m in February. This shows that, for the right firm with a good track record and a consistent management team, there is money out there.
There are fewer VCs operating in the IT space than before the dot.com days. The great predicted shakeout is happening, but slowly, and for the most part, off the radar. One high profile casualty has been Abbey Road Ventures, described by one investor as the “Spice Girls” of venture capital. The firm had in place a highly respected and experienced team. Head Paul Harvey was the ex-technology head of Goldman Sachs, Brian Long was the founder and CEO of Parthus, the Irish semiconductor company which floated in 2000, Kevin Dillon, a vice-president from Microsoft in Europe, and Hitesh Mehta who came from Amadeus.
Abbey Road’s problem was its newness: new in the sense that it was literally a new firm, and new in the sense that, with the exception of Mehta, the others had no experience of venture investing. It is always difficult being a new firm, but unless you have experience of not only working in the industry but also of working together (for at least a decade one GP said), then LPs are not going to trust their money with what in their eyes, and in the eyes of their trustees/investors, is a massive gamble.
It is important to remember, though, that not all LPs are the same. Family offices and pension funds with strong leaders tend to acknowledge the long-term nature of tech investing. They are willing to recognise the fact that if they invest in enough funds over a 20 or 30-year period, they will make money. Funds-of-funds and some other institutional investors tend to be more nervous about venture.
Sébastien de Lafond, managing partner at Add Partners, says of the reluctance of LPs to commit to tech venture is going to change: “There are two different types of LPs. The first are LPs that have been exposed to the asset class and understand that these things go through cycles. The other LPs are those who invested in technology for the first time five years ago with no experience in it, and those guys got burnt. I don’t blame them for being cautious.”
There is still a question mark, though, over whether either of these two types will actually return to technology investing. One investor told of a recent chat he had with a manager at the UK’s National Association of Pension Funds who admitted he had no desire to invest in that area, but simultaneously admitted that eventually he would have to because of the need to increase returns.
In the current climate, it is exceptionally hard for any LP to justify to their trustees or investors a commitment to a European tech fund. The world of finance is just as prone to trends and fashion as the man on the street, and in the case of LPs, buyouts is where it’s at. A herd mentality has developed, and with buyout funds being raised in just a few months, it’s easy for pension, insurance or fund-of-funds managers to ignore venture and follow the river of money pouring into buyouts.
Richardson says: “Venture still has to prove it can make strong returns. It is still dealing with the aftermath of the bubble. At the moment if you are an investment manager, then it’s very difficult not to invest in buyouts because the returns have been so strong. What venture has got to do now is sell the merits of its own asset class.”
This is going to be an uphill challenge. “Technology returns have been useless in Europe,” says Olisa. “There is a very real case that needs to be made that Europe needs to adopt new models of investing. The US way is to have industry expertise rather than the European way of appointing bankers or accountants. European technology VCs need to be more opportunistic.”
Reams of pages and hours of conference and seminar talks have been spent comparing the differing investment models between the US and Europe, highlighting how the Europeans drip-feed their investments compared to the American’s tendency to give them a lot of money quickly, how Europeans are reluctant to write off failing companies and keep them artificially alive when the American’s would have killed them off much sooner, how the Europeans are more worried about managing their down-side risk than about making money etc etc.
According to de Lafond, the problem with a lot of European VC firms is they don’t know what they are: “There are a bunch of players who still have an unclear strategy. Are they local or are they global? Are they really early stage? Are they using the US venture model, ie are they being aggressive and going for the really big deals, or are they just happy to just cross the river? It doesn’t matter which one they actually are, just so long as they are what they say they are. As long as some players have not answered these questions then they are going to struggle.”
Add Partners takes the Silicon Valley approach to investing, a model often shunned as inappropriate to Europe by many European VCs. There is a movement away from this type of thinking and a recognition that perhaps European tech can benefit from a more US-style approach, based on long-term economic forecasts, which demonstrate that Europe is in a much healthier state than the US. But to take advantage of this is going to require a sea change in the thinking of how VCs approach their own industry (for more on the applicability of Silicon-Valley style investing in Europe, see EVCJ, June 2005, pp 38-39).
Where this argument ultimately leads is that the future of European technology is in the hands of the VCs themselves. There is very little more any national or supranational government can do. There are plenty of entrepreneurs out there with great ideas and, increasingly, sound business plans. The serial entrepreneur, so long an important factor in the success of US venture, is at last emerging in Europe. VCs have to look closer to home if they want the situation to improve.
Buyers are back
All this doom and gloom is not to say the European technology market is lacking opportunities. After years of pulling in their oars and restructuring, the corporates are spending on IT again. “They are now thinking,” says MTI’s Richardson, “about how they can make what they’ve already got work more efficiently. This has meant we have seen a move away from CRM application and account application software and utilities. ‘How can I make my software work better? How can I increase storage capacity? How can I improve what I have got rather than buy new technology?'”
Trade buyers have picked up on this and a number of exits over the last year have been companies that improve existing IT infrastructure rather than add something brand new. This is something Steven Clarke, director at Kleinwort Capital, has noticed: “The longer established vertical software businesses are growing and maturing and have been mopping up the smaller companies. They are looking for those companies that fill gaps and that they can easily consolidate with the technology they have already got. Rarely is it about getting new customers.”
Consolidation has been a common M&A feature over the last 12 months. James McNaught-Davis, a GP at Advent Venture Partners, says: “Parts of the IT market are maturing and there are some active consolidators like Oracle out there. In software, there are some big players who don’t think the organic growth rates that the market experienced in the past are going to come back and so they are spending their time consolidating the industry.”
Ian Lobley, a senior partner at 3i, says: “A lot of the big companies have been through their recovery phase and are now under pressure to expand. Take Openwave buying Magic4, [a UK producer of mobile messaging software.] It’s all about enhancement and broadening their platform, be it through buying technology or expanding into new territories.”
The most high profile technology sector at the moment though is wireless. Acland says: “The mid-1980s was the PC period, and the mid-1990s was the Internet period. Now we are in the wireless era. This is the most interesting theme in technology at the moment.” By way of example, Cambridge Silicon Radio, which floated in March last year at the top of its price range at 200p per share with a market cap of £240m, has at the time of writing a share price of 636p, and a market cap of £792m, which will no doubt please VC backers 3i, Amadeus, Gilde, Intel Capital, Mustang Ventures and Razorfish. The UK Bluetooth company, now known as CSR, is regularly held up as a shining example of European technology.
A recent investment highlight was the fourth round financing of DiBcom, apparently the largest venture-backed financing for a French IT company so far this year. In a €24.5m round led by Partech International, new investors Intel Capital, 3i, WI Harper and UMC joined existing backers Infineon Ventures, Convergent Capital, Credit Lyonnais, Motorola Ventures, SGAM Private Equity and Vertex Management Israel.
DiBcom is a fabless semiconductor company specialising in chipsets for mobile TV, be this TV on cellphones or notebook PCs. Lobley says: “We think the mobile TV market is set for take-off, and there are some stand-out opportunities out there for truly outstanding teams. Because of our global spread, we have the benefit of being able to take a global view, and we try and use that in order to benchmark companies and investments in them. We can then use our position as a global venture investor and grow the business out.”
McNaught-Davis says: “When it comes to software, Europe is at something of a disadvantage to the US and Asia, but not in the case of chip technology. The UK may actually have something of an advantage, especially with wireless companies like CSR. There are some good returns to be made from larger electronic chip companies buying wireless companies from VCs.”
Another big sector is the Internet. Once the golden child of the VC world, if not the world economy, dot.coms went from hero to zero in the space of about 18 months. But now they’re back. Michael Elias, managing director of Kennet Venture Partners, says: “This time it is not about selling products but enabling sales, like online advertising. We are seeing the Internet living up to what everyone said it was going to be five years ago, it’s just taken longer than we’d anticipated.”
“E-commerce is exploding,” says de Lafond. “All the dreams of five or six years ago are now coming true. We see the power of the Internet taking some of the start-ups by storm. This is an area that is coming back with a vengeance. Mistakes were made in the past, but we got it wrong with the timing, not so much the finances. Timing is of the essence, and we have had to be patient.”
A recent, and very high profile example of the power of the Internet is the US$2.6bn (€2.1bn) sale of Skype. The three-year old voice over the Internet company backed by Index Ventures among others, received wide press coverage and will no doubt give some heart to technology VCs and provide them with some ammunition in their meetings with potential investors.
Some in the industry have questioned eBay’s thinking in paying such a hefty price for what is principally a telecoms service business. One technology GP said: “I don’t know how to second guess the likes of Yahoo, or Google, or eBay. It is probably worth VCs getting to know what these companies want so they know what to buy and hopefully sell to them later on.”
Subhead] Thin on the ground
Competition now barely exists in the VC tech world. It’s more of a challenge getting a syndicate together, especially for the early stage deals as most firms in the space have moved to the later rounds, strangely enough at the same time as the London Stock Exchange’s (LSE) Alternative Investment Market (AIM) is providing some stiff competition for them here.
Richardson says: “AIM has emerged as a replacement of later stage financing. Many business and VCs see going on AIM not as an exit transaction but as a funding one. It’s being seen as an alternative form of development capital.”
“AIM and venture funding are just a small part of the financial continuum,” says 3i’s Lobley. “It depends on what sort of investor a company wants. Do they want transparency with lots of different shareholders or do they want a hands-on VC trying to create value?”
Quester’s Acland is sceptical as to whether such a development is a positive one. He says: “We have seen some businesses which try to raise money in the venture market, failing to, and then appearing on AIM, and this is slightly worrying because if they fail the VC test they should fail the public market test.”
While AIM is not without its critics, the main criticism being its lack of liquidity, there is some hope, and some genuine belief, that AIM can become the NASDAQ of Europe. If the LSE is bought by a non-UK business, as seems increasing likely, then it will become an almost de facto European exchange, and the amount of foreign companies already listing, and preparing to list, can only build up the momentum.
More and more firms have moved away from tech, especially early stage, despite many of them claiming they have not. There are reckoned to be between six and eight firms doing early stage tech in the UK and about the same figure in Continental Europe. “The fact that there are fewer of us around is a good thing in a way,” explains McNaught-Davis, “because you are left with the independent thinking, adding value VCs, but it also means there is less capital around, leading to a situation where you can’t build up a company with later stage investors and so are forced to sell early, thereby missing out on potentially higher returns.”
Syndication at early stage is not merely common anymore but almost a requirement. As Richardson says: “You know these deals are going to cost money and you don’t really want to be the only source of that money.”
“We are syndicating more than ever,” says McNaught-Davis, “and this is a positive development in way; it’s how Silicon Valley developed. We have a very good relationship with a number of other VCs which promotes an exchanging of ideas and notes on certain companies and the technology industry as a whole.”
Subhead] The challenge
The task ahead for European technology VCs is to prove they can make money. At the moment, European venture is not exactly the asset class of choice. One VC says: “They look at the industry’s returns track record, and they don’t begin to compare to US returns. That maybe true but things are improving. Everyone agrees that there are some very interesting pockets of technology in Europe, and some increasingly mature management teams that are going around the block more than once. We don’t have the same depth and quality of management teams in Europe compared to the US but there are enough of them for the fewer number of VCs here.
“We have got a case to make to the LP community that the European venture capital market has not yet produced knock-out returns, but if they give us a chance over the next several years, we will try and show we can make decent venture returns. We now have a chance to demonstrate that we can make attractive returns, and the fact that there are only a handful of European VCs around now means that they are bound to make decent returns. It’s up to us to prove that we can make money.”