Venture funds seek a home

Now venture returns are showing signs of improvement, LPs are looking for ways to channel their venture allocations, but many are left feeling frustrated as most venture fund sizes are small and those few accomplished venture funds that have delivered results are finding their fund offerings hugely oversubscribed despite limiting access to new investors.

According to the European Private Equity & Venture Capital Association, venture funds (all venture stages) returned 35.3% last year, outstripping buyouts, which returned 29.6%. And last year, venture-backed companies in the UK raised £1.4bn, up 27% on 2005. So no wonder LPs are desperate to find the best funds for their venture allocations. But five-year returns are only just recovering.

John Gripton, head of investment managemet Europe of Capital Dynamics, says: “When you look at historical returns for venture in Europe, they are not great, but that is looking backwards. If you start to look forward, you need to analise the changes taking place that makes the fundamentals looking forward much more positive.”

Looking back in 2000, there was a large wall of money targeted at venture. A lot of that was raised by new entrants, particularly in Continental Europe. And we all know what happened next – prices crept up, there were overpayments and then the bubble burst. But the market has taken a turn and the outlook is more positive than it has been in a long time.

Firstly, there’s been a shakeout (see Venture shakeout on page 10) that’s left us with a relatively small number of quality managers in Europe who now have a manageable amount of money to invest. They are very cautious about pricing and throwing their money at any old deal, but they also have sufficient funds to follow on investments in their portfolio.

And many of the teams who have survived the shakeout now have more experienced managers in commercial technology, not just nationally, but on a global level. Gripton says: “Here in Europe, managers have realized you cannot get the level of returns you were getting in the US during the 90s unless you place these companies on the world stage. Although it’s still European technology and Euro-driven, the European venture market is very much looking towards the global arena.”

However, while venture returns are experiencing an upturn, they are still failing to beat public markets over a five-year period, according to research from SCM Strategic Capital Management. Stefan Hepp says: “The improvement in returns was primarily driven by valuation gains as distributions are still much smaller compared to other types of private equity.” And while liquidity events have increased steadily and the number of venture-backed IPOs is on the increase, in particular in Europe, the amounts raised tend to be small and the listings often provide only limited liquidity to venture capital backers.

Asia draws funds in

One region defying the norm in terms of venture is Asia, which is experiencing a fund raising boom. In China, for example, venture capital is growing at three times the rate of the UK. The lure of the potential of Asia’s high growth economies has tempted many investors to back new teams, which are now celebrating exits in Asia’s booming stock markets. The multiple of funds raised versus funds invested during 2005-2006 for Asian venture capital was over six times, which also suggests a significant capital overhang and so the jury is still out as to whether this money will find lucrative homes.

The lesson for LPs in today’s environment is that an investor cannot hope to profit from any asset class by abandoning ship in the tough times or piling in when valuations are high. But looking at venture funds raised in 2006, it appears investors in Europe are doing just that having sunk €17.5bn into venture in 2006, compared to €10.9bn in 2005 and €8.8bn in 2004. It is those investors who have stuck with venture funds through both the good and the bad times who are able to make their allocations work well for them, having nurtured their GP relationships and waited patiently for the rewards to come rolling in.