Venture capital wanted

Ireland’s venture capital industry has built a critical mass over the past 10 to 15 years, with some 20 indigenous funds investing largely in the country’s dynamic technology sector. More than 80% of VC investment in Ireland goes to technology, compared with less than 20% in other European countries and this makes the Irish industry more comparable to the US.

Some of the early Irish VC funds have performed very well. According to one study, the annual IRR of Irish VC funds between 1994 and 2005 was 15.7%. This compares with returns on European VC of 9.4% a year and on European equities of about 10%. The only investment in the study that performed better was the Irish equities market, which has been through a boom period in recent years.

But the returns story is not all good. Many of the funds that went to the market in 2000, which was the last major fundraising round for many VC firms, have struggled because they raised their money at the top of the dot-com bubble.

Nevertheless, Irish funds have invested more than €1bn in local companies since 1994, international VC houses invested a further €900m, mainly at later-stage funding rounds. Some people see this as a potential problem, as many of the Irish funds are simply too small to fund their portfolio companies through later-stage financing.

Regina Breheny, director general of the Irish Venture Capital Association (IVCA), says: “One of our challenges is growing our funds so that they can be more active in later-stage funding, because what often happens is at that stage international funds come in and cherry pick the best companies.” She adds that this international interest is a vote of confidence in Irish companies, but that it would be a positive development to have local funds with more investment clout.

Funds are getting bigger, however, although still small compared to many overseas funds. Government agency Enterprise Ireland earmarked €170m last year to invest in VC funds. The idea was that Enterprise Ireland would be a cornerstone investor, taking 15% or so in a fund in order to help leverage in further investment. The agency first did this in 1994 and again in 2000.

Because Enterprise Ireland’s investments were made from last autumn onwards, most Irish VC’s are still in fundraising mode, although there are likely to be some first closings announced in the near future.

Sean Higgins, head of investment services at Enterprise Ireland, says that most of the funds that applied for investment were in the €70m to €100m or €100m to €150m range, which he says was significantly higher than the previous Enterprise Ireland funding in 2000. That previous round was criticised for giving money to too-small funds, which would not have the size needed to generate decent returns.

Higgins says: “In the current funding round we set the bar at a minimum of €30m because we know that below that a fund only needs one or two investments to go wrong for the whole fund to be in trouble. We were pleasantly surprised that most of the applications were from funds of more than €50m.”

But do Irish funds really need government support? According to Higgins, they do – at least for now. The agency commissioned a study by PricewaterhouseCoopers and Gordon Murray of Exeter University last year which reported that Irish funds were not yet able to successfully fundraise without state help but that this help should exclude very small funds.

Another challenge concerning the involvement of Enterprise Ireland is that fundraising tends to be bunched together. The IVCA’s Breheny says: “There’s a recognition by all parties that we need to try and stagger the funding more in the future because having it all take place at the same time can cause problems. At the moment, there is very little investment going on because nearly all the VCs are in fundraising mode.”

According to Maurice Roche, a partner at VC fund Delta, the smaller funds that got money from Enterprise Ireland in 2000 did not come back for further funding in the recent round. He believes that consolidation will continue: “There are fewer players now and there will be fewer in the future.”

There are probably only a handful of decent-sized Irish VC players. These include Delta, ACT, Trinity and Atlantic Bridge Ventures and, on the life sciences side, Seroba BioVentures.

For these firms there has been strong deal flow in recent years and that looks set to continue, thanks to the booming Irish economy, foreign investment in the country and government support for research and development. The country’s GDP growth this year is forecast to be 5%, more than double the Euroland prediction of 2%. There is also low unemployment and inflation.

The government’s role in creating a VC-friendly environment has also been important. According to the 2006 EVCA benchmarking study on the legal and tax environments for private equity and venture capital, Ireland was the top location in Europe.

The report highlighted Ireland’s record in fiscal research and development incentives. In 2004 the government introduced a new research and development credit, which includes fiscal incentives for business R&D spending, R&D capital expenditure and co-operation between firms and research institutes/universities.

Apart from capital gains taxation for individuals, Ireland also has a good environment for retaining talent in portfolio companies and management funds, the EVCA found. Its company tax rate of 12.5%, which applies to all trading income in Ireland, is the lowest in Europe and far below the European average of 26&, the study said.

Last year the government announced a major boost in its funding of scientific research and development, earmarking €3.8bn to be invested by 2013.

The Irish government has also been extremely proactive in encouraging inward investment, offering investors an attractive package of grants and incentives. These, together with the low corporate tax regime, and a relatively well-educated workforce have helped the country become an affluent and fast-growth economy.

As well as government support and the benign macro-economic climate, VCs in Ireland have benefited from the foreign direct investment in the country from overseas, predominantly US, companies in pharmaceutical, medical technology, services and the ICT sector.

The success of these businesses has helped create a group of entrepreneurial and ambitious young executives keen to launch their own businesses. This has meant earlier high-tech companies have generated start-ups now receiving venture capital funding. Examples are Dublin-based mobile phone software company Aldiscon, which has generated 14 spin-offs and bio-pharmaceutical company Elan, which has generated eight spin-offs.

According to John Tracey, chief executive of Trinity Venture Capital, a big advantage Ireland has is that because VC activity goes back to 1994 there are now a lot of people involved in ventures for the second or third time around. “They weren’t necessarily shareholders the first time, but were involved perhaps as senior managers in a portfolio company,” he says.

There has also been more overt encouragement of VC activity by multi-nationals. For example, in November last year IBM announced it was teaming up with the Irish government to help young technology businesses by creating a venture capital hub in County Dublin, to provide support to new software companies and advice to start-up managers.

John Tracey says Ireland’s entrepreneurial culture has much in common with other small countries like Finland, Denmark and Israel: “The people behind start-ups tend to be very entrepreneurial and ambitious and because they come from a small country they are very focused on overseas markets right from the start.”

But these entrepreneurs have found that Irish VC funds can often only take them so far. Sean Higgins of Enterprise Ireland says that even though a growing number of firms are raising funds of €150m or more, in the long term he would like to see larger funds. “We need to build bigger funds and they need to be international,” he says, adding that Enterprise Ireland wants to encourage funds to build expertise in a particular technology or sector and use that expertise to invest in overseas companies as well as Irish ones.

There is some concern, he says, that Irish start-ups nurtured by Irish VC funds, are almost invariably sold to US or other non-Irish companies. “We’re realistic and we know the Irish economy is relatively small, which means overseas companies acquiring young Irish companies is bound to happen a lot,” he says: “But it would be nice if we had larger VCs with an international perspective, who could help young Irish companies expand their presence.”

John O’Sullivan, a partner at VC firm ACT, agrees and says that his firm is already moving towards becoming larger and more international. Its previous fundraising was €170m, up from €100m the time before. “We increased the fundraising because we wanted more capital to support our companies through the various stages of development,” he says.

O’Sullivan says that there is more scope for young Irish companies to go further with their Irish VCs before exit. “Yes, it’s about building bigger companies and about exiting at the right time, but whatever strategy we adopt has to be one that is best for the shareholders.”

He cites the example of AGI Therapeutics, which was established in 2003 by a group of senior industry executives. It develops new drug therapies for gastro-intestinal diseases. In 2004 the ACT led the first-round funding of €9.5m with investment from three other Irish funds including Seroba. In early 2006 the company floated on the AIM market and Dublin’s Irish Enterprise Exchange (IEX), which had been launched in 2005 as a market for emerging firms.

The AIM and IEX markets have provided further exit options for Irish VCs. But trade sales will continue to be the dominant exit route for funds and they currently represent about 80% of all exits. “AIM and IEX give Irish companies another exit route apart from trade sales,” says Enterprise Ireland’s Higgins.

O’Sullivan says that IPOs on AIM or IEX are not strictly speaking exits, but rather the next stage of development for a particular company. What these stock markets do bring, he stresses, is another option for some of the better VC portfolio companies. “The very good companies are in a position to choose between an IPO and trade sale and they can use that tension to get a better deal from a trade buyer.”

O’Sullivan notes that better access to stock markets means young Irish companies can raise capital more easily to make their own acquisitions. “That will enable them to build scale,” he says. But he adds that the lion’s share of exits will continue to be through trade sales, not least because corporate earnings are the highest they’ve been for several years.

While the IVCA and Enterprise Ireland are calling for more involvement of domestic VC firms in later-stage funding, some firms are already responding. Trinity, for instance, has shifted its investment strategy away from early stage and towards later stage. This decision has been due to market forces, however, rather than exhortations from agencies like Enterprise Ireland.

John Tracey of Trinity says the software market, which the firm focuses on, is moving towards consolidation. “The sector is beginning to mature and this changes the nature of investment opportunities,” he says, noting that customers in the banking and telecommunications industries increasingly want a single solution from their suppliers.

He adds: “They don’t want a product or technology that needs lots of other products for it to work, but rather a single solution with support. That means the supplier needs to be a certain size, not huge but perhaps 50 employees or more.”

The consequence of this change in customer attitudes, he says, is that Trinity is now more interested in backing companies that are looking to be consolidators and not just grow by organic means but also by acquisition. “There are still some very good companies looking for early-stage funding but the investment opportunities in that market will get harder,” says Tracey. Trinity, he says, has moved from 100% early-stage financing a decade ago to 20% today.

But not everyone agrees with such a strategy. Delta Partners, for example, is still sticking with its focus on early-stage investment. “Our aim is to be the first institutional investor in the technology or business services companies we invest in,” says Maurice Roche.

Roche acknowledges that there is some truth in the claim that many corporate customers are today looking for single solution suppliers. “A lot of customers who took on technology suppliers in the 2000-01 period got burnt when those companies went out of business, so there is an issue around the credibility of suppliers and customers will probably go for the biggest or longest-established supplier if they have a choice.”

But he adds that there is still a major opportunity for a start-up with a genuinely new technology. “If a technology is providing something different, and better, from the other suppliers, then a corporate customer is probably going to take a risk on it,” says Roche.

Attracting pension funds

One of the main challenges facing Irish VC funds has been attracting investment from the country’s pension funds. This source of funds could make a significant difference to fundraising in the future, given that Irish pension funds, including the government’s National Pensions Reserve Fund (NPRF), hold assets worth close to €90bn.

IVCA director-general Regina Breheny says: “Encouraging Irish funds to invest in domestic venture capital is an uphill struggle, which is why we’ve been collating information that we hope will persuade them.”

She says that it has been hard for Irish VC firms to attract attention from pension funds, given the stellar returns made by international buyout funds in recent years.

Last November the IVCA commissioned a report looking at the issues surrounding current pension fund asset allocation and the role that venture capital could play in future investment. The report, by consultants Investment Faculty Ireland (IFI), predicted that there would be a steady rise in the allocation to alternative assets by Irish pension funds and made a case for the inclusion of Irish venture capital.

One of the main arguments made by IFI to encourage pension fund investment was the strong performance of the main Irish VC funds launched in 1994. At an IRR of 15.7% , the funds outperformed most other mainstream investments, except for the unusually high-performing Irish equities market.

Frank O’Brien, a director at IFI, says that the wider trends of increasing longevity, falling equity markets and rising bond yields have forced pension funds to look at alternative assets. “A significant shift in the asset mix is occurring and I think Irish venture capital is in a good position to take advantage of that,” says O’Brien.

Of the 1994 funds, O’Brien says the managers exploited the strong domestic economy background with investments in building and construction, consumer businesses, and media. In the latter years investment switched to the development of the domestic technology sector.

Among the successful venture capital investments in building and construction were McInerney, Geith International and Senator Windows. In consumer investments included O’Leary’s Pharmacy, Lifestyle Sports and Let’s Talk Phones. In media investments included TV3, County Media and Today FM. In ICT and pharmaceuticals successful VC investments included Aldiscon, BCO Technologies, Massana, Rogers Group, and Datalex.

He says: “The fund managers followed a diversified strategy, balancing the cyclical sectoral opportunities created by the booming domestic economy with the emerging high growth and technology driven business models that are central to Ireland’s long-term development.”

O’Brien says that IFI has been encouraging pension funds to look at venture capital, but has met a certain reluctance, partly because of the poor performance of later Irish VC funds. He says: “Those launched in 1994 have performed very well, but those that were launched around the turn of the millennium, virtually at the top of the technology bubble, have struggled.”

Those later funds still have a few years left to turn things around, says O’Brien, but their struggles have deterred many pension funds from the asset class. Things are changing, however, he argues: “There has been some Irish pension fund investment in the current round of fundraising.” He adds that the decision by the NPRF to allocate 8% of its funds, over time, to alternative assets would also encourage private pension funds to go down the same road.

John O’Sullivan, a partner at one of the larger VC firms, ACT, says: “I think we’ll see more Irish pension fund money going to venture capital, as funds broaden their investment strategy. Also, by some measures European venture capital is doing better than the US at the moment.” But he acknowledges that VC funds in Ireland and elsewhere in Europe face intense competition for funds from buyout houses.

ACT, says O’Sullivan, has been consistently expanding its investor base and now has a wide range of LPs, including pension funds and fund-of-funds from Ireland, Europe and the US.

Delta, another of the larger funds, is also attracting pension fund money in its current fundraising, which has a €120m target. Partner Maurice Roche says he expects a first closing of €80m-€100m to be announced by the end of June. “Most of our initial investors are Irish and UK pension funds and after our first close we will market the fund to mainland European investors,” he says.

It is not just Irish pension funds but other domestic investors that have been reluctant to back the country’s venture capital funds, says the IVCA’s Breheny, and a key factor in this is the country’s booming property market. She says: “As well as pension funds we would like to get more wealthy individuals investing in venture capital, as many have done extremely well out of property. But they’ve got used to making a quick buck from property and so we may need to educate them about the longer-term nature of venture capital.