Institutional Investors Have New Array of Firms to Back

Always the early-birds, Merlin, Galileo and Amadeus headed for Wellington to meet up for breakfast at the Arts Alliance.
A medieval meeting? Actually, it’s a quiz of sorts, to see if you recognize the names of a few European venture capital firms launched in the last several years to fund start-ups:
Amadeus Ventures, Arts Alliance, and Merlin Ventures, of London; Earlybird Ventures and Wellington Partners, of Munich; Galileo Partners of Paris.
Some of their names may strike the American ear as a tad quirky.
But is has definitely been a good kind of quirky for those U.S. investors fortunate enough to be limited partners in top-performing European venture capital funds. Upper-quartile firms in that category brought limited partners a 97 percent internal rate of return last year, and a 50 percent annualized IRR over the last five years, according to the European Venture Capital Association.
“ An entrepreneurial culture is finally taking hold” in Europe, says George R.Anson, the London-based managing director of Harbour Vest Partners LLC, the Boston fund of funds manager that has been ratcheting up its exposure to European start-ups. “It’s not just pockets of it here and there”.
Indeed, Europe is now the second largest venture capital market in the world, behind the United States, and probably the fastest-growing. According to EVCA, early-stage venture capital firms alone raised EUR 5.1 billion ( $ 4.8 billion) for fresh investments in 1999. That was more than four times the 1998 total.
This year is also seeing plenty of fund-raising action. A host of early-stage European VC firms have either launched new funds this year, or plan to – many of them second- or third-generation efforts. The table on page 48 identifies seven such firms with a collective fund-raising target of $1.3 billion. What’s more, several U.S. firms have begun heading across the Atlantic with dedicated pools of capital in tow. Benchmark Capital, Menlo Park, raised $750 million this year for its debut European fund, while Accel Partners, Palo Alto, is expected to raise a fund of similar size this summer.
For institutional investors attracted to Europe, but not prepared to select individual managers, both Castle Private Equiy AG, the Liechtenstein financial advisor, and Partners Group, the Swiss financial advisor, are drawing up plans to launch funds of funds that would provide U.S. investors access to European VC funds.
Ivan Vercoutere, an investment manager with Castle Private Equity, says his firm’s decision to make a European VC fund of funds its first product aimed at U.S. investors speaks to the opportunities the firm sees for the asset class.
“There’s no reason the European market shouldn’t be the same size as the U.S. market”, Mr. Vercoutere says. “ It’s just going to take longer”.
Indeed, limited partners and general partners alike say that the conditions are right in Europe for the venture capital market to grow well into the early part of this century. Among them:
The development of stock markets that cater to technology companies. The success of Germany’s Neuer Markt, which listed 283 companies as of June, as well as that of other new technology stock exchanges, has broadened exit opportunities for European VC firms. At the same time, long established stock exchanges have become more technology-friendly. Last fall, for example, the venerable London Stock Exchange carved out a special market called techMark to bring greater visibility to technology companies. To help technology companies qualify, the London Stock Exchange relaxed one of its key requirements for listing.
The planed consolidation of European stock markets. The fragmented nature of Europe’s stock
markets has made it difficult for companies to gain the same kind of exposure that a listing on Nasdaq brings. But that is poised to change, thanks to several initiatives. One of the most ambitious has Nasdaq Europe Ltd.; London, teaming up with London Stock Exchange and the Deutsche Börse to offer European investors, through a single market, access to companies listed on Nasdaq ( the Nasdaq 100 companies), Neuer Markt, techMARK and other international exchanges.
Successful role models that have encouraged business people to jump from relatively safe corporate jobs to far riskier start-ups. Venture capitalists often point to a $3 million investment
in Germany’s Mobilcom by London’s 3i Group in 1994 as a milestone deal that convinced a lot of executives that being an entrepreneur was worth the risk. After a successful flotation by the German cellular phone service provider on Neuer Markt in 1997, early investors earned a fortune. 3i Group sold its own stake for $160 million.

Obstacles remaining

Despite their success in the past few years, European early-stage venture capital firms face several obstacles in maintaining healthy returns for their limited partners.
The patchwork of different languages and cultures prevalent across Europe pose the most obvious challenge, by significantly raising the cost of engineering pan-European strategies.
Kennet Capital Ltd., a London-based early-stage firm, confronted this challenge after investing $3.5 million this past fall in Urbia.com. The Cologne, German-based online company sells children’s furniture and other merchandise to young families.
Launched in the United States, such an enterprise would immediately have a potential audience of 40 million people, says Kennet Director David Carratt. By contrast, Urbia.com is available in only three countries- France, Germany and the United Kingdom – in part because the firm must hire a separate editorial team, and sometimes also a separate management team, for each European country that it wants to expand into. “You have to customize for each language an each culture”, Mr. Carratt says.
Another problem facing VCs is that most European countries still levy income tax on executives at the time they exercise stock options. The practice makes it more difficult for start-ups to use non-cash incentives to recruit senior managers - an important consideration when cash is tight. ( Recognizing this problem, EVCA has proposed that the European Commission encourage countries to levy only a capital gains tax on entrepreneurs when they sell their shares, as in the United States.)
Venture capital firms also face the difficulty of hiring experienced partners given the relative immaturity of the investment specialty in Europe.
The difficulty is compounded by the fact that there is no European Silicon Valley, but rather a scattering of venture capital hotbeds in Helsinki, Munich, London, Paris Stockholm and elsewhere. Consider that after setting out to double its rate of early-stage investing, and to expand its geographic reach, 3i Group felt that, rather than hiring and training staff, it would be easier simply to make acquisitions.
The firm has since begun buying up other venture capital firms – including, most recently, SFK Finance, a Helsinki-based venture capital firm with about a dozen investment professionals.
Earlier this year, in one of the largest venture capital firm acquisitions ever, 3i bought Technologieholding VC GmbH, a Munich-based venture capital firm with DM 500 million ($240 million) under management, for DM 333million. The acquisition gave 3i Group an additional 24 investment professionals with which to staff its seven German offices.

Great Opportunities

Challenges aside, European early-stage venture capital firms have proven they have ample deal flow in a market that is still less well funded, and therefore less pricey, than that in the United States.
At the same time, they have been enjoying the same global bull market that – at least until stumbling this spring. – helped carry the average U.S. venture capital firm to nearly triple-digit returns in 1999.
Perhaps the most important contributor to the growth in European venture capital has been a shift in attitudes. It has simply become more acceptable for business executives to take on the risks of becoming entrepreneurs. The change in attitude has contributed to a surge in deal flow at European venture capital firms. Wellington Partners, for example, is seeing upwards of 3,500 deals a year, up from 300 just four years ago. “The number is quite amazing”, says Founder Rolf C. Dienst.
The popularity of choosing an entrepreneurial career also has made recruiting easier for VCs.
When Kennet Capital this December purchased a 12 percent stake in Aspective, a London-based application services provider, for Pound 3.2 million($4.8 million), the firm needed to fill out the senior management team. Several managers agreed to jump aboard from established technology companies including CFO Michael Banwell, previously a financial controller for Oracle Corp., and CEO Javaid Aziz, who previously was a vice president at the European division of Silicon Graphics.
“We were able to offer (Mr.Aziz) a business that had some significant management challenges”, as well as “a business intending to be international from day one”, says Kennet’s Mr. Carratt. “He believed in the business model, and felt it was the right time in his career to take a risk”.
The entrepreneurial bug has even extended to European academics, once known for looking down their noses at the business world. “Seven or eight years ago, there was an enormous reluctance on the part of top scientists in the United Kingdom – in particular in biotechnology – to commercialize their ideas”, says David Leathers, a director at Abingworth Management Ltd., London, a specialist in early-stage biotech investing. They felt it would somehow “taint the science”, he says.
But, after witnessing the success of Cantab Pharmaceuticals, Cambridge, an other biotech companies that went public in the mid-1990s, scientists have largely gotten over their concerns. In the past two years alone, Abingworth has started three companies centered on research that emerged from university laboratories. Among them is Astex Technology, a Cambridge-base company whose X-ray defraction technology is used to determine the structure of proteins.

Funds on Demand

The current good times for European venture capital are a far cry from the late 1980s, when many of the region’s VC firms closed their doors after logging disappointing returns. You can still catch a fading view of those less-buoyant days by looking at the 10-year return numbers of early-stage venture capital firms.
According to EVCA, top-quartile venture capital firms over that period logged a 37 percent annualized IRR – respectable, certainly, but a far cry from the nearly triple-digit returns of last year.
Together, all European venture capital firms over that 10-year period logged a 14 percent annualized IRR, hardly stellar stuff compared with public equity returns over the same period.
For now, however, the European venture capital firms are enjoying a renaissance that invites comparison with the what’s happening in the United States – including one similarity limited partners could do without. Sure, Wellington Partners, like other European VCs, found plenty of room for U.S. investors in its EUR 210 million ($ 195 million) second fund closed in May. Among others, commitments came from Brinson Partners Inc., Chicago, HarbourVest Partners LLC, and Massachusetts Bay Transportation Authority. But the fund closed too soon for some U.S. investors that wanted to get in, according to Wellington’s Mr. Dienst.
“By the time they woke up, we were sold out,” Mr. Dienst says.


By David M.Toll