VC Review

This time last year, Europe’s venture capitalists were possibly the most optimistic they had been in several years. The sale of voice over internet protocol telephony player Skype to eBay for €2.1bn a few months earlier had provided a much-needed confidence boost. For investors Bessemer Venture Partners, Draper Fisher Jurvetson, Index Ventures and Mangrove Capital Partners, the exit meant a dramatic fillip to their fund returns; for the European venture capital community, it was proof positive that Europe could produce technology winners that international corporations wanted to buy – and pay handsomely for.

Yet 2006 proved to be rather trickier than many had hoped. “It was a disappointing year in terms of exits,” says Philippe Poggioli, managing partner at Access Capital Partners. “We take a poll of VC general partners every year in October to assess their expectations about exits for the coming year. In 2005, they were very bullish – a significant number of their portfolio companies had been developing well, revenues were reaching material levels and the GPs thought they were right for exit. Yet in 2006, we saw less than half the amount predicted reach exit both by value and volume.”

At the time of writing, there were no figures available for VC exits in 2006, but Poggioli’s sentiment is echoed by others. “There were higher expectations for exits in 2006 than actually came to pass,” says Martin McNair, general partner at Advent Venture Partners. But why? One of the reasons is that the traditional trade buyers for venture assets, US companies, were put off by unfavourable exchange rates, says Poggioli. “We haven’t seen many offers from the other side of the Atlantic over the last year,” he says. “The euro/dollar parity has really damaged the exit prospects for a lot of VC portfolio companies. They are just not able to pay the multiples firms are looking for and so they are delaying selling up.”

As for venture-backed IPOs, 2006 was a pretty good year, with over 50 completed in Europe by the end of Q3, according to various sources. Once the final tallies are calculated, the year could be the best for IPOs since the tech boom. But even here, the year was rather disappointing. “We did see a number of good IPOs,” says McNair. “But most of these were fundraisings rather than exits. Investors want VCs to remain committed and locked in to the business.”

For those focused at the later stages of the venture spectrum, exits proved a little less elusive. Kennet Partners, for example, saw three exits in the last five months of the year: application service provider Aspective, which was sold to Vodafone UK; operations support systems specialist Cramer, which went to US trade buyer Amdocs for €375m; and compliance and security software business Consul, which was acquired by IBM. “We’ve seen M&A activity increase at our end of the market,” says Michael Elias, managing director at Kennet Capital. “There’s a desire among buyers and investors for predictability in uncertain times. As a result, there’s been a high demand for companies that provide software as a service.”

Elias has noticed another trend over the last year – and it’s another that has boosted his exit prospects. “Traditionally, technology investors’ exit routes have been mainly via M&A and sometimes IPO. We’ve noticed that buyout houses are really starting to take notice of the tech industry following on from deals such as SunGard. Over the last few months, they’ve been approaching us to see if we’ve anything to sell.”

Overall fundraising for VCs was also rather harder than many had anticipated. By Q3, 27 funds had raised €1.6bn, against 39 funds raising €2.9bn for the same period in 2005, according to Dow Jones VentureOne statistics. There were a handful of successful fundraisings towards the end of the year, including Benchmark Capital’s final close for its European fund at a significant US$550m. Scottish Equity Partners was also particularly successful in its fundraising earlier in the year, notching up £160m for its third fund in an offer that was oversubscribed. Northzone Ventures was another that managed to raise assets in 2006: it attracted €175m for its fifth fund.

In general, VC funds found it difficult to convince investors to part with their cash. “There were high expectations at the beginning of the year about fundraising,” says the European Investment Fund’s Ulrich Grabenwarter. “But 2006 turned out to have mixed fortunes for funds. I think people felt that after five or six dry years there would be renewed interest among investors, that they might recognise the relative unattractiveness of the buyout sector, where there are doubts about the sustainability of returns. But that hasn’t really happened.”

Mounir Guen, CEO of placement agents MVision, agrees. “With the successful fundraisings we saw in 2006, many might come to the conclusion that European venture is back,” he says. “But the reality is that there is very little capital available and few investors.” This is despite the fact that European venture is now outperforming the US, he adds. “Many venture firms have demonstrated they can generate good performance and they have discipline, but the investors are just not there to support them,” says Guen.

Indeed, the latest available performance statistics from EVCA show venture ahead of even buyouts for one-year rolling IRRs in 2005. The figure was a very respectable 36.5% for venture capital; for buyouts it was 31.7%. The five-year horizon showed European venture outperforming its US cousin, albeit in negative territory: European VC registered a -3% five-year horizon, US a -6.7% performance.

Improved performance has resulted in some softening of limited partners’ views towards European venture capital. But that hasn’t been enough so far to make much of a difference to all but a handful of very successful funds, say many. “There has been a small shift among LPs over the last 12 to 18 months,” says Poggioli. “Some are prepared to reconsider their investment strategy, but that is a long step away from actually investing.” What we’ve seen among those prepared to invest has been a scramble for the well-known funds, leaving the rest falling way behind. “We’re seeing PPMs coming in all the time, but in general it’s the best known names that are having most success at fundraising,” says John Gripton of Capital Dynamics. “There’s a flight to quality among LPs.”

Calum Paterson, managing director at Scottish Equity Partners agrees. “The last 12 months were not an easy ride for firms seeking fresh capital – far from it,” he says. “The underlying trend has been a flight to quality and it remains a fiercely competitive market for venture capital firms raising money in Europe, with private equity houses and buyout funds in particular vying for institutional investors’ attention.” Indeed the buyout funds have taken so much attention that some even say that LPs that have previously been supportive of European VC have recently cut their allocations. “A number of LPs have reduced their exposure to VC,” says one observer. “Either their programme has finished or they have decided to invest in particular sub-sectors. They’re looking at buyouts instead – mega deals can generate cash whichever way you look, and quickly. With VC, you’re looking at an extended J-curve and you may not start seeing your cash for five to seven years.”

Yet despite the disappointments of the year, 2006 did have some bright spots. The most significant of these was an uptick in investment and in particular, an increase for early stage funding. By the end of Q3, at nearly €3bn, the amount invested by Europe’s VCs had already surpassed that for the whole of 2005, according to Dow Jones VentureOne The number of deals declined by 26% on the previous year, but the increase in value suggested an improved confidence among investors in portfolio companies and reflected efforts to help them compete in an ever-more global marketplace.

Early stage fundings saw an increase, making up 39% of venture capital deals in the first three quarters of 2006, according to Dow Jones VentureOne, with median sizes reaching record levels of €650,000 for seed deals and €2.4m for first-round deals.

The reason? Part of it had to do with the relative health of the public markets. “IPOs are getting done at an earlier stage than a few years ago,” says Gregoire Revenu of the corporate finance team at investment bank Bryan Garnier. “There’s competition between IPO and later rounds of funding where VCs aren’t looking for exit, but the company needs a further round of financing. This competition for later stage is one of the reasons why there has been an increased focus among VCs on early stage opportunities.”

But it also had to do with supply. There were more exciting – and promising – early stage opportunities than there had been for some time. The digital media and Web 2.0 space was a particular area of focus for European VCs in 2006. “We’re seeing renewed interest among entrepreneurs to establish start-ups, particularly in the internet and new media spaces,” says McNair. “That means there are a lot more early stage opportunities around at the moment. These are usually high quality companies with credible business plans and with good management teams.”

Nenad Marovac, managing partner at DN Capital saw the same trend. “Last year saw the emergence of a lot of new business models, especially in the area of digital media, such as social networking and user-generated content,” he says. “We also saw the re-emergence of e-commerce, which has been driven largely by increased broadband speeds and increased consumer confidence of buying over the internet.” VC interest in this area was sparked by some very attractive realisations. “One of the most exciting things over the last 18 months has been the serious exits of players such as Skype, You Tube and MySpace,” says Marovac. “These have happened in a short space of time. They’ve come from nothing to being extremely well used and show the viral nature of the next generation of applications.” Wellington Partners’ partial exit of business networking platform Xing (formerly known as OpenBC) through a €36m IPO towards the end of the year will only have added to the enthusiasm about Web 2.0.

In some ways this kind of talk, together with the rise in the value and proportion of early stage investments, is reminiscent of the over-exuberance we saw in early part of this century. So does this mean we’re likely to look back on 2006 as another 2000-style internet bubble? Some believe the pressure is building up. “We’ve started to see some areas of hype because of some successful exits,” says Revenu. “Digital media is one of these. We’re seeing a flow of investment into me-too types of company in this space. There is the danger of a small bubble happening here.”

But most believe it really is different this time. Gone are the days when internet-related companies raised mega sums to invest in indoor lawns and pool tables. The focus over the last year has been on using funding efficiently. “We’ve seen the emergence of capital-efficient business models,” says McNair. “In the digital media and internet sectors, for example, it’s possible to build a large business with just a small group of people. Much of the content is user-generated, it costs little to acquire customers because of the viral nature of these businesses. It’s also that the business model is understood now, as are the advertising models.”

And part of the reason the model is understood is that many of the people backed by VC firms last year had been there before. “We’re seeing repeat entrepreneurs now in the Internet space,” says McNair. “Many of these are people who were involved in the initial wave in 2000 and 2001, they’ve worked with their companies for several years and done well. They are now looking for their next venture.” In September last year, for example, Advent backed internet entrepreneur Stephan Uhrenbacher’s latest venture, Qype, a local search and recommendation site. He was previously founder of and has held senior positions at and DocMorris.

It’s this kind of opportunity that LPs like to see. Gripton is particularly enthusiastic. “We’ve always been positive about European VC, but what’s different now is that there are more repeat entrepreneurs in Europe,” he says. “One of the fund managers we work with has just done three deals with repeat entrepreneurs. With this kind of experience, there’s a greater ability to commercialise technologies than there used to be.”

So, even if 2006 hasn’t quite lived up to many people’s expectations in the European VC community, especially in the exit and fundraising arenas, it may be that in times to come the investments made and the people they backed in the year can finally prove that Europe is able to take early stage ideas to a global stage. We’ll see over the next two to three years.

…A new one just begun

If 2006 was a bit of a disappointment, what does 2007 hold in store for Europe’s VCs?

After the excitement many felt going into 2006 and then the disappointment by the beginning of the second half as exits and fundraising started faltering, few are willing to pin their hopes too much on 2007 being a cracker of a year.

In fundraising terms, it’s hardly going to break any records. Abingworth is expected to announce a final close on its latest fund imminently, with a target in the region of £300m, although observers say that fundraising in theory belongs to 2006. But otherwise, it’s likely to be a quiet 12 months. “There will be some groups out raising in 2007, but most of the well known names have already raised over the last couple of years, and we’re unlikely to see new entrants to the market being successful,” says John Gripton of Capital Dynamics. Yet we may see TVM coming to market for its latest tech fund. And a lot of the smaller funds in Europe may be due to start fundraising efforts over the coming year, says Ulrich Grabenwarter of the European Investment Fund. He points to many of the Irish VCs as an example.

For those unable to raise sufficient further funding, 2007 could well see the end of the road. “We’ve only really seen a partial shake-out so far,” says Philippe Poggioli, managing partner at Access Capital Partners. “We haven’t seen as many casualties as there should have been yet.” But, with successful fundraisings in 2000 nothing but a distant memory for some, another year without fresh capital could finally bring them to their knees. “We will see some mergers and some managers will fold altogether as their funds run out and they can’t raise new capital,” says Gripton. And there will be plenty of people vying for their portfolios, with new players entering the market to snap them up (last year saw Strathdon Investments enter the fray with a new £20m secondary direct fund and BML got in on the act by acquiring Nordic Biotech’s stakes in several life sciences companies).

Others believe that we’ve seen as much of a shake-out as we’re going to and that will lead to greater predictability and visibility in 2007. “The investment climate is now more stable and more sustainable than it has been for some time,” says Calum Paterson, managing director at Scottish Equity Partners. “Post-bubble restructuring is largely over, leaving fewer but better-resourced and more experienced venture capital firms remaining.”

Despite the lack of larger and better known names on the market, there may be more interest in European VC than we’ve seen in the years since 2000. “Optimism has been deferred to 2007,” says Grabenwarter. “US investors increasingly want exposure to European VCs now. They’re seeing that US valuations are high, they’re being cut back on US VC fund allocations and they are starting to see some good results from European VC portfolios.” The difficulty is that many of these investors are huge. “The sums that they’d be able to put into these funds are peanuts to them,” says Grabenwarter. One way around this will be for them to increase the allocations they have to funds-of-funds that invest in European VC,” he adds.

And elsewhere, the market appears to be quietly confident. “The expectations for 2006 have been displaced to 2007,” says Poggioli. “They are confident that, having had another year of development in their portfolio companies that they will be able to build larger, more valuable exits. If we saw a string of major exits – and that is not impossible – it would boost confidence among VCs and their investors. It would also help to provide a stock of role models for future generations of entrepreneurs.”

Few are counting on IPOs being a block-busting route to exit – markets are too unpredictable for that, and besides, there is little to suggest that public market investors will change their view any time soon that they want VCs to remain committed over the medium term. Instead, many think that trade could be back in a bigger way over the next year, in some sectors in particular. “The major software and hardware houses in the US are looking to make strategic investments and we’ll see more of this over the next 12 months,” says Martin McNair, general partner at Advent Venture Partners. “Their acquisitions are driven by a need for technology in the next generation of wireless and services for PDA and 3G/smart phone. They need this technology to differentiate their products.”

The fly in the ointment, though, (as with 2006) is exchange rates. Even those that did well last year are concerned for 2007. “There is continued interest among US businesses for European companies,” says Michael Elias, managing director at Kennet Capital. “But if we continue to see the dollar so low against the pound and euro, we’ll start to see some push back on price.”

Predictably, no-one’s willing to say what they think will be the big investment story for 2007. But there is optimism here, too. “This will be a very interesting year to invest,” says Nenad Marovac, managing partner at DN Capital. “Our pipeline is very full and our space is very attractive right now.” And the emphasis we saw on early stage funding looks set to endure. According to European Investment Fund’s Grabenwarter: “With a new round of fundraising for some firms and a new wave of opportunities on the market, the increased exposure to new companies looks set to continue well into this year.”