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High-tech hysteria or hiccup?

Venture capitalists in the early-stage, high-tech arena are looking and feeling pretty sick right now. Meanwhile, investors in their funds are standing by with reactions ranging from concern to mild panic. No-one said it was going to be this ugly. But look a little closer and you might find some cause for optimism.

Right now is not a great time to be a high-tech venture capitalist - or an investor in one of their funds. If there was one message that came out loud and clear from the European Private Equity and Venture Capital Association's Technology Investment Conference in Helsinki last week, it was that. High-tech VCs are a depressed bunch - and one of the most surprising things is that they are even admitting as much.

Many firms, having invested too quickly at inflated valuations over the last couple of years, now have some very needy companies in their portfolios. They are having to invest more time and money on those companies than they ever bargained for. So much so that, even if they have the money to make new investments, they generally don't have the time. This is especially frustrating for them when you consider that now is arguably the best environment for investing that we've seen for three years. Unrealistically high company valuations have dropped (although whether we've yet hit the bottom of the trough is another matter) and investors have enough time to do full due diligence on potential portfolio companies.

Upbeat and in the money
Unsurprisingly, the most upbeat delegates were the few who closed funds early this year. Unlike some others in the industry, they have the cash available to see them through a difficult period. Not that they were gloating. Without exception, they simply believed themselves to be very ‘lucky'. They must be breathing a huge sigh of relief - they won't have to face the prevailing tough fund raising market for a couple of years.

There was also talk of early-stage venture capitalists - those with the wherewithal to invest - changing their investment strategies. ‘We're going to have a tough 2002,' said one participant. ‘The question many VCs are asking is: do you take an opportunistic view and change your strategy to investing in later stage companies? There are a lot of opportunities right now in fallen angels. You can buy some listed companies for the amount of cash they have in the bank and you'll get the engineers thrown in for free.' This is a trend that institutional investors should watch out for. They may sound tempting, but most of these companies are likely to be in some degree of trouble. The skills involved in turning a company around are very different from those needed in early-stage investing.

Then there were the forecasts of VC firms falling by the wayside. Some have already fallen; others may be acquired. The worst of this is not over. ‘We will see many more firms disappearing over the next few months and even years,' said one delegate. ‘Most of these should have gone already, but because of the way that the industry is structured, they will be able to hang on because they can rely on cash flow from their management fees.' Most agreed that 25 to 30 per cent of early-stage venture capital firms in Europe would disappear over the next couple of years.

Collective deppression?
It's easy to see why the industry is collectively depressed.  It's equally easy to over-do the doom and gloom. What high-tech VC investment is now seeing is a correction as much as a downturn. Sure, there will be some terrible results from funds raised in 1999 and 2000. There's not too much to be done about this. And sure, we will see a consolidation of the industry. But this was badly needed. The last few years saw an unprecedented proliferation in the number of European venture capital firms. Half of the total early-stage industry is less than four years old, according to figures quoted by Chad Murrin of 3i. Some of these will be people who thought that venture capital investing was an easy way to make a fast buck. There are few who would argue that they deserve to survive.

But what of the remaining 70 to 75 per cent that do survive? Far from being depressed and careworn (as they seem at the moment), these survivors should emerge to form a stronger and more experienced early-stage venture capital industry. Many delegates believed that, although there were too many VC firms in the European market place, there was a dearth of experienced VC professionals. It's exactly this type of environment that gives VCs good experience and more meaningful track records. If they are able to manage during a downturn, they should be able do well during the good times. Europe will get its professional VC industry. It will just have to wait a few years.

Comparatively speaking
The other point to bear in mind is that much of the doom-mongering comes from comparing this year's figures to last year's. Yet this type of comparison is pretty meaningless. The stellar growth in Europe of funds raised and amounts invested and divested over the last couple of years was never sustainable. It was an anomaly caused by a bubble of investors flooding the market and by the knock-on effect of a booming stock market. That doesn't mean that we won't see growth again in the future - the European industry is still relatively immature and has plenty of room for expansion. But it does mean that, simply because this year's figures are likely to be lower than those for 2000 and perhaps 1999, it shouldn't be a huge cause for concern.

This was a sentiment expressed by EVCA itself. Announcing its private equity investment statistics for the first half-year, EVCA chairman Edoardo Bugnone said: ‘The statistics are not as bad as people had expected, and they're certainly not as bad as those in the US. We will have to watch out for the second half-year statistics - they're usually higher than the first - but these figures show that there isn't any panic and venture capitalists are continuing to make investments.' EVCA reported a 27 per cent drop in pure venture capital investment to E5.3bn from E7.3bn in the first half of 2000. However, this says more about falling company valuations than about a freeze on investments. The actual number of investments dropped by just nine per cent.

This surely has to be a good thing for VCs and their investors alike. It's true that venture capitalists will have to spend more time with their portfolio companies than they have over recent years. They will also need to provide follow-on financing in the right circumstances. But this is normality. The days of the quick flip may be over, but then so should the days of exaggerated pricing, rushed due diligence and the emergence of cowboy VC firms. Private equity professionals of all stages are keen on stressing the long-term nature of investing in the asset class. After all, with a ten-year fund (as most are) it should be possible to smooth out the inevitable ups and downs in the wider economy. High-tech VCs will only be able to do this if they stop being so depressed and start looking at the opportunities the current market could bring them. They - and their investors - should embrace a return to something approaching normality.

The European Private Equity and Venture Capital Association runs a series of conferences and seminars of interest to all industry participants. For more information, please visit www.evca.com

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