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Good news at last for European venture capital?

Limited partners are mildly optimistic; general partners claim that it’s the best time to be investing. Could it be that Europe’s venture capital industry has finally turned the corner?

The last three years have not been kind to the global venture capital industry. Some may believe that the suffering has been justified – it’s the price venture firms have had to pay for a number of years of excess in the late 1990s. Others will have been reeling from the shock of such a severe downturn and dramatic drop in company valuations.

Either way, the nascent European industry, in particular, has been through some testing times. Sure, it never reached the dizzy heights of its more established US counterpart and therefore did not fall quite so hard. But a downturn in any young industry is likely to have far-reaching effects. The question is what those effects are likely to be. Will it be a stronger and more mature industry as a result of the ‘experiences’ of the last few years? Or will it have been weakened by the struggle? These were just some of the questions raised at the recent AltAssets Venture Forum.

First, the good news. The fact that 70 limited partners and 50 general partners attended the event suggests the industry has a fighting chance. That so many LPs have an interest in European venture capital should hearten the region’s VCs. But what was possibly more encouraging for the industry was the confidence expressed by so many of these LPs. We’re all used to GPs talking the talk and remaining eternally optimistic; it’s quite another thing to see LPs, many of whom will have lost out in the last bubble, start to talk in more positive terms about this area of the private equity industry. They seemed to agree with Sofinnova Partners’ Jean-Bernard Schmidt when he said that there is a ‘feeling that we are coming out of the down part of the cycle’.

What is causing this gentle optimism? Some of the good news may be coming from their own portfolios. John Holloway of the European Investment Fund, for example, commented: ‘We are starting to see a plateau. We’re not hearing so much bad news about portfolio companies. In some cases NAVs are increasing.’ He went on to describe the EIF’s attitude as ‘mildly optimistic’.

This mildly positive sentiment could also stem from a belief that now is a good time to be investing in venture capital. Valuations have come way down from their 2000 highs and there is a sense that the bottom has been reached (reflected in the fact that NAVs are starting to increase). This feeling was articulated by Knightsbridge Advisers’ Judith Elsea: ‘Pre-money valuations are now at the lowest they can be. If they went any lower, then entrepreneurs would bootstrap the company. In certain cases, we’re also seeing post-money valuations starting to creep up.’ She was talking about the US venture capital market but, judging by more private comments made by LPs, the same is starting to be true of Europe. Amadeus Capital Partners’ Anne Glover reflected this. ‘In more usual times, most venture capital funding rounds take 25 per cent of a company,’ she said. ‘These days it’s more like 33 per cent. We must have reached the bottom. You can’t take much more off valuations if you want to leave something on the table for entrepreneurs.’

The other positive is the increased level of experience among European VCs. The kind of 20 to 30-year veterans seen in the US are obviously still rare in Europe. But those that manage to survive the downturn – in theory, at least – should have invaluable experience that they can bring to bear on future investments. They should be able to spot the warning signs of a company in trouble much earlier, for example. They should also know what to do about troubled portfolio companies. And before even that, they should take greater care over the due diligence process in advance of writing a cheque. ‘We can compare what we have been through to previous cycles,’ said Bernd Seibel of Techno Venture Management. ‘But it is different in a couple of respects. We now have much more experienced players in the venture market than previously and we also have a much more stable investor base. These are both positive.’

It’s a view shared by Amadeus Capital Partners’ Hitesh Mehta. ‘Venture capital has only existed as a market in Europe for six years,’ he said. ‘There was never a better time to train VCs. In fact, European VCs have learnt in the last six years what it took Silicon Valley VCs 20 years to learn.’ The challenge, according to Ernie Richardson of MTI Partners, will be to apply that new-found knowledge. ‘A lot of very tough lessons have been learned that are applicable going forward,’ he said. ‘We as an industry need to use that experience.’

Yet despite the general consensus that Europe’s VCs are now a more experienced lot, it’s unlikely that they’ll have an easy ride. LPs may be more positive about the prospects for the future, but they are under no illusions that the European venture capital industry is out of the woods just yet. They, too, have gained more experience. ‘This has been a learning process for us all,’ said Apax Partners’ Peter Englander. They have also been the ones to shell out for the VCs’ training course. ‘The sad thing is that we have had to pay the bill for your learning experiences,’ pointed out NIB Capital Private Equity’s Joost Holleman. And, as a result, they will be more circumspect about the commitments that they make in this area. ‘Due diligence now takes as long among LPs as it does when we are looking at a target company. That is a major change,’ said Seibel. ‘LPs are now looking, for example, at whether a GP has the right ecosystem in place for success.’

One of the problems they face, however, is a lack of meaningful track record for most European VC groups. The performance of these groups has, in most cases, been so poor that most LPs will find it hard to justify any decision to commit on the basis of track record alone. It’s a point picked up by Holloway. ‘What are GPs going to show to LPs to attract them to their new fund?’ he asked. Gillian Brown of Hermes Private Equity had a few answers. ‘We’ll be looking at what you were doing during the bubble. How much capital did you chuck at the market at the peak? How have you reacted to the fall? How aggressive have you been on cutting your losses? How are you managing your own business? Are you keeping on the people who didn’t work out?’

It’s on these qualitative, rather than quantitative, measures that LPs will have to judge European VCs until they have a decent track record under their belts – both in terms of quality of performance and of a meaningful timescale over which to judge that performance. And it seems as though some LPs are willing to take the gamble on this. ‘There are very few advantages to having invested consistently over the last few years,’ said KfW’s Marc Brugger. ‘But one of them is that we know the GPs very well. It has been very interesting to observe how different GPs react to difficult situations in terms of their actions and the level of communication they have had with their LPs.’ This point was echoed by Holloway: ‘The teams that have impressed us have been those that have recognised problems earlier on rather than throwing infinite amounts of money into problem companies.’

These are important points to bear in mind for European VCs. The indications are that 2004 and 2005 will be some of the most active years for fundraising. A recent VentureOne/Ernst & Young Outlook study predicted that 48 per cent of Europe’s venture capital firms would start out on the fundraising trail next year. And in many senses, this means that the next couple of years will be make or break time for the European industry. The decisions that Europe’s VCs make will determine whether it has a long-term future because investors, having given them one chance, are unlikely to be so generous again if they fail to deliver. ‘Next year is a vintage that venture capitalists have to make work,’ said Richardson. ‘There can be no more excuses. It simply isn’t good enough to put certain vintages down to experience.’ If that is true of the industry as a whole, it’s even more so of individual firms. ‘Some teams have been around for a while,’ said Holloway. ‘The test will be whether they will raise another fund next year and beyond. 2004/2005 will be a defining point for many of these teams, but they should also be good vintage years for investors.’

Judging by the mood at the forum it does, indeed, seem as though the industry has turned the corner. With LPs (as well as GPs) more optimistic about European VCs’ prospects for the future, the fundraising figures for 2004 should make less grim reading than those for the last couple of years. The challenge for the industry will be to ensure that they put their new-found experience to good use and that they start delivering some good news to their investors. We would like to thank everyone who attended and participated in our Venture Forum and helped make the day such a success.

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