The fund raising environment for technology is not one for the faint of heart. Ask an LP what he thinks of investing in European venture tech and he/she is likely to respond ‘what European venture tech?’ It’s become a truism to say that the last few years have not been kind for venture capitalists, and it will be next year, when the VCs go to the market, that we will really find out whether the situation is improving. Tom Allchorne goes in search of LP interest.
All the talk of the last 12 months has been that venture is due to come back and that VCs are cautiously optimistic. But what is this based on? Certainly, venture in the US is doing pretty well, but the US is a wildly different market compared to Europe, structurally, culturally and operationally. Just because something happens in the US does not mean it will happen over here.
Venture returns have been poor in Europe, just look at the IRR data on these pages. The bursting of the bubble came at a bad time. In the late 1990s, Europe was catching up with Silicon Valley in the successful technology companies it was producing. The US, with its 30 to 40-year history of venture investing, was seeing VCs make enormous returns on investments, and while Europe may not have been on the same level as the top tier of US firms, it was innovating and the gap in investing and returns was closing.
Just as Europe was coming into its own, a global recession hit, and it’s largely to do with this lack of history that makes LPs so cautious. Jim Martin, co-founder and managing partner of Add Partners, says: “Europe has not had a chance to prove itself that technology venture can be an attractive asset class, and this is what is making LPs sceptical. But once they overcome this hurdle they will know that, despite it having had a hard time, it will get better.”
One thing everyone keeps shouting about is the quality of entrepreneurs. Europe has the basis for a thriving technological market. According to the Third European Report on Science & Technology, which was published in March 2003, the EU produces a larger number of graduates and PhDs in science and technology than the US (2.14 million in 2000, compared to 2.07 million in the US and 1.1 million in Japan). The problem Europe faces is keeping them: 75% of European PhD recipients leave to work in the US. The report attributes this to the more competitive career and employment opportunities offered in the US.
As Pete Magowan, a partner at Alta Berkeley, says: “The raw materials are here in Europe. It is just about harnessing them.” The challenge is to attract these people back. “A lot of them are migrating back to Europe and it is these people who are creating a shift in the market. We are getting a wave of people now who have been there and done it. Europe is in a more fertile position now than it was four or five years ago,” says Magowan.
What this touches on is crucial to European tech venture. There could be the best VCs in the world plying their trade here, but if the expertise isn’t there on the ground, then the companies aren’t there. The general opinion seems to be that the entrepreneurs and the knowledge are there, it’s just that producing ground-breaking technology is one thing, while commercialising it is quite another. But it is also important to accept that there are going to be hundreds, if not thousands of poor companies out there. It’s because of bad investments in the bubble days that so many LPs have been put off investing in European tech venture, and it’s these poor investments that show up on performance data.
This isn’t to say there were not and do not continue to be poor investments made in the US. It’s just that, with its 40 years’ history and the exceptional returns generated by the upper quartile VCs, these poor investments are diluted when looking at statistical data like IRR performance.
One of Europe’s downfalls is seen to be the lack of market acumen present among its technology companies. They are almost completely focused on developing the technology but are failing to pay enough attention to the commercialisation. This, combined with the US habit of VCs getting in early and giving companies lots of money, compared to the European drip-feed method, means that European companies have struggled to make that next step up where they can compete on a global level. The lack of a European NASDAQ is also an issue, but one which can be overstated. Between 80% to 90% of exits, both here and in the US, are via trade sale. For others, the lack of a NASDAQ is moot: it just isn’t going to happen. It has been much discussed over the best part of a decade, and there seems little reason to believe it will happen in the next. Nevertheless, the absence of the IPO market has been a severe hindrance to the development of European venture, and Martin is sceptical whether it will truly recover. “We desperately need the IPO market to improve but the question is whether most of the successes in Europe will float here,” he says. “Most of our companies are Inc. registered. About half have got American CEOs. They know that their main market is going to be in the US and probably the exit market too.”
There have been some successful exits this year. February saw the listing on the London Stock Exchange of CSR, a developer of Bluetooth systems that enable short-range radio communication between mobile PCs, mobile phones and other devices, which priced its IPO at 200 pence per share, at the top of the 160-200 pence range set by the company. Investors in the company were 3i, Amadeus, Gilde, Intel Capital, Mustang Ventures and Razorfish. In March MTI exited from its five-year investment in Advanced Composites Group Holdings, a supplier of high performance advanced composites, with a £44.25m (€63.07) sale UMECO plc. In September, Cazenove, Lehman Brothers and Mosaic Venture Partners sold the UK’s KVault Software to US software company Veritas for US$225m (€173.21m).
The problem, as ever, is there have not been enough of these exits, certainly not enough to warrant some of the “tech is back” headlines that were seen before the summer.
Much has been written about the cultural and structural differences between the US and Europe in terms of venture investing and they don’t need to be rehearsed here. While they are important, their significance can sometimes be overstated. LPs don’t care about that really. They just want to make money, and so look at the place that is generating the best returns, and Europe has obviously not been producing on that side. When looking at data on US venture, European mid-market buyouts or Israeli venture, putting your money into early stage European funds is not that appealing.
This attitude surely can’t and won’t continue. An interesting development that could affect fund raising is the increasing difficulty of access to the top tier US funds. Because of their good performance, LPs are desperate to get into US venture. But many US funds have returned to the market with either a very similar target size as their previous fund, or smaller. Frank Kenny, founder of Delta Partners, says: “With the top quartile US funds all over-subscribed, LPs are asking themselves: Why should we be investing in second or third-rate US funds and not a first-rate European fund?”
The upper quartile in the US has done exceptionally well, of that there can be no argument, but the remainder are arguably on a par with the top European firms. Saying all this does not of course mean that LPs are going to invest in Europe. The sentiment one LP insider gave was that the LPs have money to spend, but they are keeping it very simple and are looking for proven teams that have produced returns.
Proven teams in Europe are hard to come by. At the Capital Creation Conference in Cannes in September, André Jaeggi of Adveq said: “It’s not an issue of allocation but of opportunity. The level of entrepreneurship has grown dramatically but we are still lacking enough VCs who know what they want to do and what they want to be. It’s not just a question of the technology (which has always been good in Europe), it’s a question of what to do with that technology. Should you develop it locally or build it into a global company, in which case, what extra skills are needed? We see many hybrid funds who don’t know who they are.”
These next 12 to 18 months are a critical time for many funds. A large percentage of the funds about now were raised during 1999 and 2000, so this year and next they pass the halfway mark in their lifespan. Expect to see a lot of first time funds either not even attempt to raise a new one and pass quietly into the night (perhaps having to return money), or a few brave souls attempt, fail, and shut-up shop.
This isn’t to say that some of the new entrants won’t be successful. Abbey Road Ventures, for example, appears to be quite highly rated, helped by founder Paul Harvey’s reputation. Venture is to an extent a people business, and while it is no substitute for a good track record, having a highly rated person at the helm can be important.
But the new guys are surely going to find it very tough going. Next year, with both venture and private equity firms out fund raising, why is any LP going to want to put money into a poorly-performing asset class over a consistently healthy one? It has been estimated that two-thirds of the 150 buyout firms in Europe are either fund raising or will launch in the next 18 months. This is an incredibly high level of competition. European venture funds will also find themselves competing with their outperforming US and Israeli counterparts. The question European tech VCs must be asking themselves is ‘how are we going to stand out from the crowd?’ LPs demand the same standards from European VCs as they do from US or Israeli VCs. They want liquidity and returns. Worryingly, LPs don’t see this in Europe. The recently published Global Private Equity Barometer asks LPs to rank asset classes in order of expected investment opportunities over the coming year. European venture comes bottom, below Asian and North American venture, and Asian, North American and European buyouts.
The end of the buyout honey pot
For buyouts though, the dream maybe coming to an end. There is a very real feeling among both industry practitioners and observers that the amount of money being pumped into the market cannot last. Hugh Stewart, founder and CEO of Strathdon Investments, says there does seem to be a growing enthusiasm for European venture and puts this down to reservations over the sustainability of buyouts. “People are getting a bit twitchy about buyouts”, he says. “Debt is up from 4/5x to 6/8x. A lot of buyouts are secondary buyouts. There is a lot of reshuffling and when the party stops, is anyone going to be happy? To create wealth you have got to do more than just shift assets around.”
Ernie Richardson, CEO of MTI, agrees. “One of the facts of venture fund raising over the last few years is that it has faced competition from mid-market buyouts and we haven’t been able to move for mid-market-funds. Trying to get the attention of investors has been tricky. At the SuperReturn conference people were saying that generally the volume of money in the mid-market means returns will decline. The momentum of money in buyouts is starting to slow down. Can you really put that sort of money into buyouts without affecting returns?”
The answer to that is no, and most LPs do expect returns to come down slightly over the next few years, but this doesn’t automatically mean everyone will be clambering aboard the venture train. Buyouts will continue to produce good returns, that much is certain; for European venture, the track record is not so good. Richardson argues that LPs aren’t as anxious about it as they were: “All LPs want is liquidity, and a lot of them are still nervous because of what happened in the tech crash. The only real test of how you are performing is exits, and you have seen some anxiety among investors for their funds to show exits. The exits this year have made them more reassured. Exits at the moment are not so much about the money but just about having something to show.”
Although LP sophistication has increased, it should be remembered that most institutional investors (ie not fund-of-funds) take a generalist attitude towards investing, looking at a range of asset classes. Some LPs will not be putting money into private equity at all next year, be it buyouts or venture, US or Europe. Others, like Standard Life, are getting out of the game altogether. Many that are planning to invest in private equity will look at Europe without properly understanding its structure or (lack of) venture history and simply look at past returns.
The growing sophistication is making it more important for VCs really to prove themselves. While LPs’ liquidity expectations have generally changed since the days of the bubble, this has been accompanied by an increasing scrutiny, which has of course led to the rise of investor relations. LPs now do a lot more due diligence, especially the fund-of-funds, whose rise in number has made them a much more important player in the LP gallery than they were during the last fund raising period. LPs are now much more interested in the underlying companies, with some even going to visit them. This is undoubtedly a realisation that many LPs made some pretty serious mistakes in the dot.com boom, pretty much giving money to anyone who was asking for it. Michael Elias, managing director of Kennet Venture Partners, says: “Years ago people were deploying capital into European venture in a fairly unsophisticated way. It was very rare for a European VC not to raise a fund. What I see happening now is that there is a much more acknowledged quartile of venture firms.”
For Elias, Europe is a good place to invest: “It is much less competitive than the US. Competition in the US is the hallmark of every transaction and that is a real problem. It affects the mindset of the VC. Getting the deal is the biggest issue; actually taking care of the company comes second.”
Also, what some see as a negative aspect of the European market, its complexity due to different countries having different laws and regulations, Elias sees as a benefit. “It means there is a lot more opportunity because not everyone is going to have that breadth of expertise,” he says. “Here in Europe there are a lot more opportunities for players to capitalise on their realisations.”
Elias is one of many American VCs who have come over to Europe to ply their trade, and this too would seem to suggest that there is something attractive about European venture. What this attractiveness is seems to be based on a number of factors: that, despite its immaturity as a market compared with the US, performance figures were actually approaching US levels before the dot.com crash; that there are a lot of good entrepreneurs in Europe; that there is a lot of technological expertise in Europe; and that things can only get better. The latter argument can be summed up by the old adage that you buy when the price is low and you sell when it’s high.
It couldn’t get much worse, they cry in response. Well maybe. At the EVCA’s tech conference in Barcelona in October, both LPs and GPs alike seemed to acknowledge that the European market has passed its nadir. The symposium came about two months after Benchmark had closed it US$375m European fund, making everyone feel that some sort of corner had been turned.
In truth, the market couldn’t get much worse. The attitude expressed by LPs is a simple one: “Our money goes where the returns have been”. A lot of VCs feel this is unfair because of the tough time they have been through since the crash, but LPs will only invest where venture is working, and for the moment, Europe doesn’t have a lot in the way of hard evidence to change this attitude.