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Institutional investor profile: John Holloway, Director of Operations, European Investment Fund

Holloway on the improving exit market in Europe, on why venture capital is still an asset class worth considering, on the importance of equality among LPs and on where the EIF is planning to invest its new capital from the European Investment Bank.

Based in Luxembourg, the European Investment Fund (EIF) is one of Europe’s largest investors in venture capital and private equity funds. Its main shareholders are the European Investment Bank (EIB) with 60 per cent; the European Commission (30 per cent); and 30 banks and financial institutions (ten per cent). Its remit is to support the growth, creation and development of small, entrepreneurial companies in Europe through committing to private equity funds and by providing financial institutions with portfolio guarantees. The EIF started its private equity investment programme in 1997 and has since committed in the region of E2.5bn to 200 funds. It invests in all types of European private equity with an SME focus, although it mainly targets early and late-stage venture capital. The EIF recently received a E1.4bn boost from the EIB and was awarded a mandate from the German economics ministry to manage a co-investment mandate of E500m targeted at German technology companies. Holloway joined the EIF in 2000 and previously held a number of different posts with the EIB, having begun his financial career in the then International Division of National Westminster Bank in the mid-1970s.

How is your portfolio of private equity fund investments split?
‘We started investing in private equity at the end of 2000 and at the time we were given guidelines, which roughly translate into six words: early-stage, high tech, independent teams. And that’s mainly where we have invested our money. We have roughly E2.5bn committed to 200 private equity funds in Europe, of which 48 per cent has been drawn down. That translates into roughly 2,000 portfolio companies. At the end of 2003, of the E2.5bn invested in private equity, two-thirds was invested in technology-focused funds, predominantly early-stage.

‘In 2001, we committed E800m to 57 funds, two-thirds of which were first-time funds – that is, people with experience in the sector, but working together as a team raising institutional finance for the first time. In 2002, we committed E470m and in 2003, we committed E135m. That investment pace shows that we are not a volume chaser. We don’t invest simply because we have the money to invest. I’d rather be selective because everybody knows that simply going for volume causes problems later on in terms of returns and monitoring the portfolio. I’d far rather commit less on a selective basis than spend weeks and months on hospital cases. We do have some, of course. Of our 200 funds, there are fortunately only ten or so hospital cases and we are keeping a close eye on these, and we’re doing our best to sort them out.’

Do you ever do secondary transactions?
‘We have recently done one – the first one we have actually completed to date. We took over a small part of the Abbey portfolio that was recently put up for sale. We chose to do this because it allowed us to have a greater interest in two funds that we had already committed to. We knew the funds, the teams and the valuations very well. So we are interested in these types of secondaries because they are relatively easy for us to do.

‘We won’t make many secondary investments overall, however. This is partly because there are limits to the amount of positions available in funds in which we’d like to increase our participation. But there are also certain circumstances that mean that discounts on secondary sales are tightening. In those cases, it then becomes less interesting.’

Do you make direct investments?
‘We don’t do direct investments at the moment, although we haven’t totally excluded the possibility of doing co-investments. What we won’t do, however, is bypass the fund altogether and look for direct investment opportunities ourselves. For the moment, the EIF remains a fund of funds vehicle. It is where our expertise lies, and we are not equipped for the time being to establish and monitor direct investments effectively.’

How do you intend to invest the new capital you have been pledged?
‘We are still awaiting final confirmation that the EIB will free up in the region of an additional E1.4bn, which we plan to invest over the next four to five years. We will commit that partly to early-stage funds and partly to mid to late-stage funds, the latter as part of a portfolio rebalancing exercise whose aim will continue to be SMEs predominantly in the tech sectors.

‘We’ve also been awarded a mandate by the German economics and works ministry. This is a co-investment facility for which the EIF has put together a team of people. They will specialise in the German market, manage the existing German portfolio and make new commitments. Under the arrangement, the ministry has pledged E250m and the EIF will match that euro for euro. It is our responsibility to identify and conduct the due diligence on funds. It then goes to our board of directors for the final nod. Hence, the final power of decision lies with the EIF.

‘This is our first external mandate and, of course, a very important one if you take into consideration that a country such as Germany is in effect delegating investments into high-tech VC to a European operator like the EIF. We are looking to do more of this kind of work. The only difficulty we have is that we are still very heavily in the investment phase because we only seriously began investing four years ago with the existing mandates from our shareholders. As a result, we don’t have a huge number of exits to show potential partners. But we can demonstrate that we have the expertise and capability to find and invest in deals that should work.’

What’s your level of involvement in Central and Eastern Europe?
‘When we started out in 2000, part of our mandate was to find and invest in opportunities in Central and Eastern Europe – that includes the ten acceding countries and the two accession countries (Bulgaria and Romania). We have now committed to around eight funds in this region and we will continue to increase our involvement, especially once the acceding countries become member states.

‘Of course, there are very few venture capital funds there, so our investments have mainly been in funds that focus heavily on buy and build strategies. But by doing this, we believe that we are helping to build economies and ultimately create the fabric of a venture capital market.’

How do you view the exit market going forward?
‘Of the 2,000 or so companies in our underlying portfolio, there are quite a few that are ready to be sold and have been for a while – there just haven’t been buyers on the scene in the recent past. But there are signs now that buyers, trade buyers in particular, are coming back to the market. There are a lot of corporates that have got their balance sheets back in order after they lost their ratings in 1999 and 2000. They are now buying again – they need to because they haven’t bought for so long. In fact, in the second half of last year, many of the funds in our portfolio started telling us that the corporates were back on the phone. The corporates know which companies are in VCs’ portfolios and they know the ones they are interested in. There haven’t really been many sales yet, but I’m optimistic that we’ll start seeing some of that trade sale activity coming back.

‘I’d love to see some IPOs, but I don’t think there will be many of them over the coming year. It would be madness for anyone to go for an IPO unless it was absolutely certain to be a success, otherwise it would queer the pitch again for everyone.

‘My concern is that, as the VCs haven’t sold anything for so long, they try to drive a very hard bargain on the valuation. The big corporates that return to the market won’t be offering very high prices. So there may be a pricing gap between what they are willing to pay and what the VCs believe the company they have worked with for so many years is worth.’

Limited partners are still very nervous about European VC. What do you believe will bring them back to the market?
‘There are a lot of VC funds looking to raise this year and next. Many of them would have liked to have raised capital last year, but realised that the market wasn’t right. I don’t know whether all those firms will be successful. What I think will happen, and this should ensure that we have a healthy market, is that the flakier teams that were able to raise money in 1999 and 2000 will disappear. Among those LPs that are willing to put money into this area of the market, there will be a flight to quality. In 1999 and 2000, there were so many people clamouring to get in on the act. My feeling is that LPs are now much wiser, much more selective and conservative and much more likely to negotiate with general partners over terms and conditions.

‘What I would really like, and what I think would be a boon to market, would be if LPs sought to identify each other and talked to each other much more.

‘The good GPs will still raise money. I have no doubt about that. It will be difficult, they may not manage to raise quite as much as they might like and they may have to be flexible to some degree on their terms and conditions. This time around, they will have to work much harder to convince LPs to commit to venture capital. They will also have to accept that some LPs just won’t invest in European venture capital again for quite some time.’

What would you say to those cautious about the market?
‘This is still an asset class worth looking at. Of course, our philosophy of investing in SMEs and providing capital to help them grow is very important to us. That won’t be every investor’s philosophy. But I’d emphasise the strength of the SME market – these companies are the backbone of Europe’s economies. Look at the Mittelstand in Germany, the SMEs in the Po Valley and Reggio Emilia in Italy. Look at what these companies contribute to GDP.

‘It’s in our interest, of course, that other LPs remain interested in these sectors. We’ll do anything we can to try and sensitise other LPs to the idea that this is still an asset class they should be considering. One thing we are doing this year is talking more to LPs in the same funds as us to discuss various issues. We are attending a Nordic investors’ summit this month, for example, and that will give us a good opportunity to talk to other investors.’

What do you look for in a fund?
‘We have a very stringent process and as a result, we have a very high turn-away rate. I would estimate that we turn away three in four funds. Some of these will be turned away because they do not fit our criteria: we get sent information about funds that operate in, say, Singapore. We can’t invest in these types of fund. Our mandate is to commit to funds that invest predominantly in Europe in small and mid-sized companies.

‘So, when assessing funds, we look for the soft factors: the psychology and fit of the team, the stability of the team, the investment policy, track record, CVs, etc.’

How important is track record to you bearing in mind the fact that many firms will have had poor recent vintages?
‘You can’t assess the viability and quality of a team based solely on their track record, especially in venture capital. The classic track record has always been to look at how many companies have been sold and at what return. That simply doesn’t work under current circumstances. No-one has had a decent track record over the last three years. I have asked the fund managers how they can convince me to commit in the absence of a track record. The answer I have had from most of them has been: look at what we have invested in, look at whether we have done what we said we were going to do, work out what the fall-out ratio on our portfolio is, look at the health of the companies that are still in the portfolio. That’s what we’ll have to do as a starting point for assessing any fund.’

What terms and conditions do you insist on?
‘We work to ensure that the funds we invest with follow best practice – that means that we don’t have one set of criteria for funds in, say, the UK, and another for French funds. But we look very closely at terms such as bad leaver, good leaver, hurdle rates, carry split.

‘What we are looking to do is to ensure that all LPs are pari passu. We should all be sharing the same risk/return profile. We don’t like investing in funds in which other investors have special deals of some kind and as the EIF, we don’t look for special deals, either. I don’t want to be in a position of seniority any more than I want to be in a position of subordination. We all need to be on a nice flat table with no hidden agendas.’

What do you think that the European venture capital market can learn from the US?
‘I think that there is a lot that Europe can learn from the US; but there is equally a lot that the US can learn from Europe. It’s not a one-way street. That’s one of the things about venture capital. It’s incredibly fragmented and nationalistic. If you look at the venture teams that have tried to be genuinely pan-European and that have set up offices in various countries, the recent experience of many of them has been poor. Many of them have had to shut down offices because it hasn’t worked – there are all sorts of cultural, legal and infrastructure differences that make it very hard to build pan-European VC. Even in the US, there are many teams, and some of the most successful invest only in a 30-mile radius. So, there are things that markets can learn from others, but not all those lessons can be applied to local markets.’

What do you believe is the biggest issue in the market?
‘Exits are the biggest issue in the market. The system is blocked right now and the only way to relieve that blockage is for some sales to happen. If one or two good exits come out soon, that will be so good for optimism. Firms have been so battered for three and a half years, but things are starting to pick up. I don’t think we’ll see a huge number of exits – many funds will try to exit their investments, but they won’t all succeed this year.’

How do you see the market developing?
‘I don’t see any major changes happening over the short term. We have to get through this next period before we see much in the way of development. However, additional transparency would surely help the market develop, and provide comfort to some potential investors. There is a lot to be done in this respect.’

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