Venture Finance in Europe

While European venture financiers have been booking business over the last few years, it is really only in the last nine months, or so, that a kind of renaissance has taken place for European venture finance with new entrants and newly raised funds ready to invest. Anthony O’Connor reports.

ETV Capital, European Venture Partners (EVP), ETV Capital and Noble Fund Management are all completing deals in the UK, Europe and Israel, funding their venture finance activity from recently raised dedicated funds. The fourth player in Europe, SVB Europe Advisors, a subsidiary of Silicon Valley Bank in the US, formally set up its London operation last September and uses the parent bank’s balance sheet to fund deals.

“It’s a cyclical business and it goes in and out of fashion. It’s probably riskier than it looks, unless you’re good at it or lucky,” says an executive at ETV Capital in London. “We take a steady and cautious approach. We do approximately E100m in Europe each year.” The company has recently set up an office in Israel.

ETV Capital and EVP have both been active through some of the recent lean years (post- 2000), but with more VC activity in the technology sector, improving economic conditions in many countries across Europe and healthier signs of stock market activity, the platform has been set for growth in venture leasing and venture loan products.

Europe vs US

In Europe, it would be a generous estimate to suggest that the comparatively fledging venture finance market would amount to as much as E200m in a good year. Although it is hard to predict the future of any developing asset class, there are now more providers of this form of finance than at any other time in the market’s seven-year history. This compares to the venture finance market in the US, which amounts to an estimated US$2bn a year and has developed consistently through a number of cycles over the last 20 years. Venture financiers Stateside generally agree that for every dollar of equity invested about 10 cents of venture finance is made available.

“We found it quite slow last year for funding, full stop,” says Mark Taylor at Noble Fund Management in London. Noble started 2004 with a five-year fund, Noble Venture Finance I, totalling £45m. “At the end of May we had £8.5m invested and we expect to have invested between £12m to £15m by the end of the calendar year 2005,” he says. The general size of the deals Noble works on approximates to between £1m and £2m.

The demand for venture finance is inextricably linked to venture capital activity and a willingness on behalf of the VCs to work with the venture financiers. Despite it being an industry dependent on another cyclical industry, there is a growing number of LPs looking to invest venture finance funds. “I think that there’s more investor appetite for venture finance funds now than there was before because people are more educated about the product, its greater resilience to downturns and the fundamentals of the returns,” says Ross Algren at EVP in London.

“Our investor base for the second fund is a mixture of European and US investors. The difference is that some US LPs have been active in the asset class for 20 years. So, you’re seeing a cross- pollination of US LPs, driving the European LP approach,” says Algren. “US investors are still a little hesitant about the European early stage/ venture capital market.”

ETV Capital’s fund raising focuses on LPs comprising private banks, pension funds and family offices. “Most of them have invested in venture funds too,” says the ETV Capital executive.

“We raised our first fund primarily through high net worth individuals at the end of 2003. So, we’re not beholden to one institution,” says Taylor. “You get institutions that can be supportive today and then quickly change their minds; banks in particular,” he says. “On the pension and life insurance side they should take a passive view on an investment of five years or so. But I don’t think they’re all there yet for the asset class.”

ETV Capital is effectively raising its fifth fund, which is expected to close in July. And Noble Fund Management would look once again to high net worth individuals if it decided to launch a second fund raising. “We could raise a second fund whenever we want,” says Taylor.

“Good diversification is a necessity for a venture debt fund by industry, geography, asset types and VC backers,” says Algren. “So, when funds are of equal size, you can expect that at a venture debt fund would do four- to -five times the number of company investments thant a venture capital fund would make.”

The venture finance market seems to have picked up rapidly in less than a year. “In general, compared to a year ago, the availability and use of venture debt have both increased,” says Andy Tsao, who together with one other colleague makes up the investment team at SVB Europe Advisors in London. “We have been calling on Europe for a number of years looking for inbound business back into the US. I’d say that the market conditions have changed fairly dramatically since we’ve moved into the market,” he says.

It is not surprising the relatively close competition in the venture finance market leaves those companies guarding the more precise details of how their fund raising works and what the precise returns look like for their investors, (and in SVB Europe Advisors’ case its parent bank.) “For a venture debt fund, the upside is “capped” compared to a pure VC fund because you don’t have such exposure to the equity. As a result, an IRR of 50% per annum may not be possible, but something in the upper teens to mid- 20s with capital protection, is very interesting in all but the frothiest markets,” explains Algren.

“We operate where banks won’t lend. It’s not an alternative to bank lending, it’s more complimentary to venture capital. If a company can get bank financing they shouldn’t be speaking to us and any good VC would advise that,” says the ETV Capital source. “We take less risk than the VCs and generate lower returns than them.”

The UK market has to date has been the source of the majority of business for venture finance companies in Europe and a number of banks have dabbled in venture lending. However, banks, including Lloyds TSB and RBS, confirm that this type of funding is not a target market, even though they have both completed deals for venture-backed tech companies in the past.

Venture finance covers a whole range of working capital facilities from asset-backed leasing facilities to loan packages, typically categorised as venture leasing or venture debt. Although much smaller deal sizes prevail in the world of venture, the asset class is often compared to the mezzanine of private equity. Venture financiers make their money in three ways. They charge fees, interest or lease rental payments, and they also take warrants as part of their funding package. “It’s not a substitution for equity but to augment it,” says Tsao at SVB Europe Advisors.

The warrants come in many shapes and sizes and the amount in any one deal will be determined by a number of factors ranging from the size of the deal, the financial health of the company and the perceived risk of the deal. “We usually receive warrants on the basis of what we lend, in the range of the high teens to 20% of the overall facility. Due to the historical expectations with exit returns and a different risk profile and maturity of the market, we have to receive more warrants from companies in Europe compared to the US venture debt market,” says Algren.

Each of the four main players in Europe has a different approach to the venture finance products they offer but what is ien vogue generally reflects the demands of venture-backed companies at their respective stage of development. Some will provide venture loans to pre-revenue equity-backed companies, while others, like SVB Europe Advisors, are initially focusing on 12- to 18-month working capital facilities.

Tsao says there is a difference in the way the fund-funded venture financiers price leasing and debt products because they have to maintain a certain rate of return to their limited partners. “Lending off the bank’s balance sheet, we have more flexibility in terms of what pricing we can offer.” He adds that working capital facilities by their nature offer also offer more pricing flexibility.

Because venture finance goes hand-in-hand with venture capital, where the latter is most active the former will follow. “What we’re doing now is not that many series A deals,” says Taylor. “What we’re seeing more of are companies that are looking to move to an exit. Previously, we were more venture-lease orientated and now we’re doing more venture- loan business.”

“I do see more series A deals starting to happen, but it’s not going to dominate our business,” he says. However, without many series A deals in the pipeline this may have an impact on the flow of series C and series D companies in times to come. “It’s a general trend facing venture capital,” he adds.

While there are few truly pan- European venture capital firms in today’s market, more and more VCs are experiencing venture finance as part of a funding tool in syndicated deals, helping to build relations and the all-important product awareness. Because of the small universe of venture financiers, they have all built up and are developing relationships with VCs across the UK, Europe and Israel.

Initially focused on the UK, which incorporates Ireland, SVB Europe Advisors has a medium- term view on the rest of Europe and Tsao says the bank will probably start doing deals from about mid- 2006. “In the deals that we have done so far they have featured syndicates of investors, so we’ve already built up experience of working with European firms,” he says.

Some US players like Lighthouse Capital have done some deals in Europe, yet the company is has still to open a European office. “We are intrigued by the potential in Europe and have done some deals there, but are still considering our options,” says Anurag Chandra from Lighthouse Capital. GE has also been active in Europe but is believed to have taken a back seat for now.

“The key here is that in the good times, many players may enter the debt market. However, the best VCs know that in bad times, you want a true venture-like partner holding the debt of your portfolio companies, not a bank or traditional lender that is likely flee the market,” says Algren at EVP. “For a bit more on the monthly payment, it is almost always worth it for them to work with someone that has been around and will be here in 10 years.”

Anecdotal reports suggest there are tensions among the VC community relating to the fact that venture finance products are stopping some taking a greater equity stake in their portfolio companies. “There are certain companies where the investors want to put more money into it so there’s potentially some conflict,” says Tsao.

“Reliability is the most important issue,” says Ian Lobley at 3i in London. “We look for reliability and flexibility. They understand that they are treading the ground between debt and equity and the venture world is a bumpy ground. One of the big issues is whether these players can follow a pan- European approach,”

This is a sentiment shared by the four active venture finance companies in today’s European market. “Rolling out across Europe is a completely different consideration than rolling out across the US,” says the ETV Capital executive. “You have to lend in local languages and in local law.”

That said, most VCs in Europe have now come across the concept of venture finance and the take -up is increasing, according to those active in the market. “A number of our companies are starting to work with venture financiers as they start to reach the revenue-generating stages of their businesses and have receivables. It is equity- efficient. Managers and company founders are more comfortable with this,” says Martin McNair at Advent Venture Partners in London.

In general, the warrant elements are structured and offered at reasonable terms and with negotiation, they are generally not intrusive products, he adds. “Perhaps a bigger concern of these instruments is the relatively high set-up rate and monitoring fees of some of these products,” he says. “Management of these companies have to be incredibly vigilant about the cost of money and the P & L impact because they can be very costly. Another thing people do need to keep in mind, including management, is that these products are not meant to fuel losses.”

“Historically, trying to find leverage for the companies we invest in has been very difficult. Venture finance is one of the few forms of leverage for equity investors in early -stage companies,” says Ernie Richardson, at MTI Partners. The company has four portfolio companies that have taken out venture lease facilities. “It does tend to be asset-backed in one way or another. Very young companies often need chunky equipment that we can get funding for,” says Richardson. “We’ve also had some discussions about venture debt for some of our companies.”

While there is the view that leasing costly equipment frees up capital for growth and personnel development, the concept of early stage companies taking on debt, however, does not sit well with some VCs. “On the venture side, for relatively early stage companies, debt is not really a factor,” says Calum Paterson at SEP in Glasgow. “We want our companies to be well funded, with contingencies. Ambitious companies with strong growth potential should be allowed to grow and not have to focus on credit facilities and loans.”

“In some circumstances, venture finance can play a role but fundamentally, equity finance is the most appropriate for early stage and early growth technology companies,” says Paterson. “Venture capital when done well involves significant value- added as well as funding. Venture leasing needs to be more than just funding. It’s not inexpensive money because it carries significant risk; t. The risk of failure and the risk of recovery of asset values.”