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Are LPs willing to take a chance on Israel?

It has been 11 years since the Israeli government launched the nation's venture capital industry with the creation of nine venture capital funds. Over the last decade these firms have weathered the superlative highs and lows of the venture cycle and are now ready to hit the fundraising trail for the fourth time. But with global investor appetite for the asset class, cautiously optimistic at best, why should limited partners tentatively re-exploring the venture space, look to a politically turbulent nation with a population of just six million? Amy Carroll reports.

The Israeli government launched the country's venture capital industry in 1993 when it kick started the creation of nine venture capital funds. Many of the firms founded through the Yozmar project, such as Pintango, Gemini, Vertex and JVP, have since become industry leaders and are about to hit the fundraising trail for the fourth time. These firms last appealed to investors in the heady days of 1999 and 2000, when the industry was still confidently flaunting its Midas touch. But with the memories of what followed still fresh in the minds of investors, the Israeli venture industry is having to sell a rather more gritty reality to potential limited partners this time around.

Israeli firms are aiming to raise an aggregate total of $1.5bn by the end of 2005. This represents a fraction of the $5.5bn raised during the boom years. But with just $1.15bn left for investment from the last round of fundraising and with average annual investments reaching $750m, it is clear the coffers will soon be empty if investors cannot be persuaded to commit.

Many of the big corporations and other non-classical investors that poured capital into these funds five years ago are steering clear of the industry this time around and Israeli firms are having to cast their nets wide in order to attract new LPs into the market. But at the Israeli Hi-Tech Venture Conference in London last month, it appeared that these investors might just be taking the bait.

Why Israel?
Investor appetite for global venture capital can at best be described as cautiously optimistic. It is widely believed that the market has hit rock bottom and is now emerging on the other side. But as Ray Maxwell of INVESCO commented, 'When you have had your patient on life support for two years, if you can find a pulse at all, then you are very happy indeed.'

Why then should limited partners, tentatively re-exploring the venture capital space, look to a politically turbulent nation with a population of just six million and a private equity track record spanning only eleven years?

The answer, in part at least, is that the alternatives for investors wishing to gain or maintain exposure to venture capital are currently limited. The US venture capital industry does appear to be gaining some momentum again and investor confidence in the sector is certainly improving. But the venture funds currently being raised in the US are far smaller than those raised during the boom years and competition among LPs for access to the best funds is fierce. The result is that there are excess flows of capital available for investment in alternative geographies and asset classes. Israel hopes to become one of the key net recipients of this surplus.

Israel is, in some respects, an obvious second choice. The US and Israeli venture markets are closely interlinked and share significant common ground in terms of investment approach and entrepreneurial philosophy. One of Israel's key selling points is that it is able to leverage this relationship to take advantage of the benefits of the more mature US industry, in particular the NASDAQ stock exchange. 'The Israeli industry has a really strong American side to it,' said William Tyne of the Bessemer Trust. 'The companies that Israeli venture firms generate tend to find it relatively easy to establish US operations and to access US capital markets. America is clearly the traditional homeland of venture capital, so if you are going to be tied to anything, it may as well be that.'

With the US market still struggling to regain its footing after the damaging excesses of recent years, it could even be said that the Israeli market has some advantages over its mentor. The US is a more mature market with a weightier supply of capital. Valuations are consequently more robust than in Israel driven by the sheer weight of money in circulation. Israel also has a lower cost base than the US. The labour force is comparatively inexpensive and venture capitalists are therefore able to put companies together for less money than would be possible elsewhere. This combination of low valuations and a cheap operating environment means that Israeli start-ups can prove to be relative bargains in the global marketplace.

But while top tier US venture funds may be having to fight off LPs, European venture funds certainly are not. Many LPs remain unconvinced of the European venture market as a viable investment proposition and a growing number of LPs are, in fact, choosing to look at Israel as part of Europe for strategic purposes. This allows the LP to fulfil a European venture allocation from a geographic perspective while in reality investing in a region that is far closer to the US in flavour.

'The momentum is really building for Israel,' said William Van Eesteren of Wilshire Associates 'A lot of investors who have been looking for exposure to European venture are struggling to find enough funds of sufficient quality and are turning to Israel instead.'

'There isn't really such a thing as a European venture capital industry,' said Maxwell. 'It's diffuse, a cottage industry. Every government wants its own flag carrying venture capital market, but the result is that they never reach the required critical scale. There is a long way to go before European venture gains any real appeal for investors.'

The much-hyped Asian market represents another potential source of competition for Israel. Chemi Perez, the head of the Israeli Venture Capital Association and a general partner at Pitango, conceded that Asia was unlikely to remain content with being an international manufacturing facility for much longer. 'Asia will not settle for being a factory for the rest of the world forever,' he said. 'Asian nations aspire to be globally acclaimed centres for research and development. This will create a great deal of competition for everyone, from Silicon Valley to Tel Aviv.'

But despite Asia's obvious potential, the region is unlikely to provide any direct threat to Israel this time around. Although much touted as the next big thing, Asia's venture capital industry remains undeveloped and is not yet ready to take on the role of global number two. 'There is a lot of speculation about Asia,' said Van Eesteren. 'But at the moment its simply too soon. Good technology is not enough to secure a healthy venture industry. You need good lawyers and good accountants. You need the whole supportive infrastructure.'

With US funds shrinking in size and European and Asian markets failing to incite any real excitement among LPs, Israel is clearly in with a chance. But simply having no obvious alternative home for a venture allocation is hardly likely to be justification enough for an institutional investor to hand over large quantities of capital to an unsuitable fund manager. The Israeli's, like the Americans, are natural self-marketers. But in order to secure commitments GPs will have to prove themselves worthy to an increasingly sceptical breed of investors.

On the plus side…
While the Israeli venture industry is clearly less mature than its US counterpart, it is certainly no longer in its infancy. A great number of the firms currently on the fundraising trail have raised and invested three previous pools of capital. They have experienced the excesses of the boom years and have weathered the subsequent lows. 'Our experience as fund managers is much broader now, and we are much better investors than we used to be,' Perez said. 'The best Israeli funds are playing side by side with the best US funds. We are disciplined, creative and successful, just like any other top-tier fund around the world.'

'Israel is increasingly standing out as a third hub of venture activity, after Silicon Valley and the Boston Route 128 area,' said Paul Gompers of US fund of funds, Spur Capital. 'Israel now has the framework of technologies, managers and support infrastructure that has the potential to grow and foster successful companies. There are definitely opportunities for Israeli funds to generate handsome risk adjusted returns at least as attractive as those generated in the US.'

'There are a number of really high quality venture capital firms in Israel,' agreed Van Eesteren. 'Israeli venture teams have always tended to have a high degree of entrepreneurial experience and now they have a great deal of investment experience too. We very much like what we see.'

The Israeli venture market also benefits from a supportive governmental approach. It was Israel's government that launched the industry 11 years ago and the government is now talking about injecting an additional $325m into the industry to help leverage foreign investment and to bring in skittish domestic investors. The large number of major international corporations, which have set up research and development units in Israel, have also helped benefit the nation's venture capital market. Companies such as Siemens, Nokia, Phillips, Intel, IBM, Hewlet Packard and MotorRola have all launched corporate venturing initiatives in Israel, providing a vital boost to the industry.

But perhaps the Israeli venture capital industry's greatest asset is the Israeli people themselves. Israel is a tiny nation with no real natural resources besides its brainpower. It relies heavily on the value it can create through innovation. As a result Israeli culture is infused with a deep-rooted entrepreneurial spirit. 'We have no alternative but to be the best that we can be,' Perez said. 'Israelis are natural entrepreneurs,' Van Eesteren added: 'They are resourceful, focussed and willing to take risks. And above all they are strong company builders.'

While students in Europe and the US are progressively moving into the arts and softer sciences, the Israeli education system remains very much orientated towards science and technology. The fast tracking of bright young people through the Israeli army into technological development and management has also helped in creating a deep pool of skilled entrepreneurial talent. In addition, a significant number of Israeli nationals who had moved to the US to start businesses have since returned, armed with their experiences, to start new companies at home. In fact, Israel has a higher proportion of serial entrepreneurs than in any other market in the world.

'Israel is a country populated by a strongly educated, highly motivated, intelligent workforce,' summarised Tyne. 'Israel is a very small nation but it has good brain power and that counts for a lot in the venture capital game.'

And on the down side…
Despite the Israeli venture capital market's many advantages, it does also, quite clearly, have some very obvious risks. There is no denying that Israel is a politically turbulent nation at the heart of the troubles in the Middle East. This high profile geopolitical uncertainty has prevented many LPs from investing in Israel to date, and if newspaper coverage is anything to go by, the situation is, quite possibly, deteriorating. 'There are certainly political risks that you have to take into account when investing in Israel,' said Tyne. 'The geo-political situation is definitely something you need to think about,' agreed Van Eesteren.

But for Israeli GPs and for those LPs who have decided to take the plunge in this market, the political risk is something they feel can be mitigated. And many feel that the threat that the situation represents from a venture capital point of view has been very much overblown. 'To most of us, the region's political instability is not really an issue,' said Ed Mlavsky, of Gemini Israel Funds. 'Investment in Israel has continued to grow over the years. In 2002 it was over $2.5bn, up from $537m in 1992. There has been no perceptible interference in any high tech activities in Israel, despite the notion that normal day-to-day life is somehow impeded.'

'The political risk in Israel is often exaggerated,' said Robert Genieser of Vertex Management. 'People tend to forget that there is also very real political risk in markets such as China and India. There are always ways to work around that risk.' Perez agreed: 'In today's world, where there are terror bombings taking place everywhere, Israel's political violence is becoming less and less of an issue.'

Another key perceived risk associated with investing in Israel is its size. Israel is a tiny nation with no domestic market to speak of and this is something that concerns some LPs. Israeli companies tend to be what Van Eesteren terms, 'two legged.' The research and development facilities are based in Israel, but the production facilities are more often than not based elsewhere. This can be deemed both a risk and a reward.

'Israel is like Cambridge on steroids,' said Herman Hauser of Amadeus Capital. 'The brainpower is certainly there but it is sometimes difficult to connect it to world markets. This has become a global game,' he continued. 'The days of national champions are over. If you want to build a successful company, you have to look worldwide.'

But for many LPs, this is precisely where Israel comes into its own. The lack of customers within Israel's own borders, mean that companies have no choice but to think global from the outset. From their very conception they are geared towards an international marketplace. 'In Israel there is no domestic market, so everyone is looking at the bigger picture from the very start,' said Maxwell.

'In Europe and the US, start-ups try to capitalise on their immediate market first but Israel is a lot more global in its perspective,' said Perez. 'Our challenge is to manage these global operations, but that is also our greatest opportunity. It is what sets us apart from other markets and it is why investors continue to show their support for Israeli venture. I see no reason at all why Israeli funds will not reach their fundraising targets and I see no reason why we will not continue to generate handsome returns for our investors.'

Today's global private equity fundraising environment is, perhaps, as challenging as it ever has been, but Israeli GPs remain confident that they will reach their aggregate target of $1.5bn without difficulty. And perhaps they have good reason. High tech venture capital activity in Israel alone is equal to half of that in the whole of the rest of Europe, Israel lists more companies on NASDAQ than any other country outside of North America and as a percentage of GDP, Israel invests more venture capital than any other nation in the world.

As Maxwell explained, 'Venture capital has become such an integral part of economic growth in Israel, fuelled by the symbiotic relationships between government, industry and sources of capital, that it can only get stronger in the future.' While Israel's geopolitical turmoil will no doubt continue to deter a great many investors, it would appear that a great many others are willing to take a chance on the tiny nation's unique set of circumstances.

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