European venture’s biggest problem at the moment is capital. Or more precisely, a lack of it. Some practitioners claim that return prospects for today’s funds have never been better: more experienced entrepreneurs, more internationally-focused businesses, less competition for assets. But the fact remains: returns from European venture have been so poor for the last decade that many institutional LPs have given up on it altogether. So while governments can help to prop up the smaller end of the market, there’s a lot less capital floating around at the larger end – which clearly makes it much more difficult to build really big venture-backed businesses in the region.
So what’s the best way to attract some of these large institutional investors back into the asset class – at least until such time as returns start to speak for themselves (assuming that day ever comes)? Two interesting ideas emerged this summer in the UK, courtesy of Amadeus Capital Partners and Octopus Investments.
Amadeus said in July that it had held a $75 million first close on a new fund, Amadeus IV Digital Prosperity Fund, which will make late stage venture and growth capital investments in technology businesses seeking to profit from growing demand in emerging markets. Since so many consumers in these markets use their phones as their primary way to get online, the focus will be on ‘mobile-first’ technologies that ‘leapfrog’ desktop applications, according to Andrea Traversone, the Amadeus partner heading up the new fund.
The most unusual aspect, however, is that the fund’s cornerstone investor – in fact, the only investor, at the time of the first close – was MTN, a big African telecoms company. In the coming months, Amadeus hopes to match MTN’s contribution with a similar sum from institutional investors, taking the final fund size to around $150 million.
Anne Glover, managing partner of Amadeus, told Private Equity International that MTN had initially approached the UK-based firm (among others) about doing an Africa-focused fund – but were persuaded by Amadeus to increase the scope. “We said: ‘That’s great – but to attract the leading companies globally and scout technology globally, it needs to be bigger than that. The demand is global; it’s not in the centres of innovation. But we can be the bridge between [those two].”
This arrangement is a good illustration of some of the big trends in European VC at the moment. As other institutional LPs pull back from the market, corporates are becoming an increasingly prominent source of capital: many are sitting on big piles of cash, and are getting more involved with venture in a bid to make this money work harder. But their wish-list tends to different from the traditional VC investor: they’re less interested in blind pools, preferring tighter, more focused mandates that could have strategic as well as financial upside.
Happily, this should also have the effect of de-risking investment for institutions. Amadeus’s argument to other potential LPs will be that having MTN as a partner gives it a competitive advantage – in terms of both access to these markets and understanding of the potential opportunities. What’s more, since Amadeus can start investing the new fund right away, these new LPs will also be able to have a look at some of the businesses being bought (or looked at) before committing. So it mitigates blind pool risk.
BLIND POOL WORKAROUND
A similar idea underpins another new structure developed by Octopus.
The UK-based group typically manages venture capital trusts (VCTs), London-listed vehicles intended to incentivise retail investors (via tax breaks) to invest in early-stage companies. The trouble is that VCTs have certain restrictions for managers, including a stipulation that ‘qualifying’ companies – which must account for 70 percent of the VCT’s investments – cannot have assets of more than £16 million at the point of investment, making it challenging for the VCTs to invest further in their most successful investments.
Octopus is trying to get around this constraint with a novel new structure. In effect, it is transferring its four biggest assets – snack delivery business Nature Delivered (aka Graze), estate agent Zoopla, online travel club Secret Escapes and fund management software business Calastone – into a newly-formed £40 million fund. Technically speaking, the VCTs are selling these businesses to the fund; around half the proceeds will go back to the VCTs (to fund distributions, buy-backs, new deals and follow-on investments in other portfolio companies), while the remaining half – about £14 million in total – will be rolled over into a new subsidiary that will act as a limited partner of the new fund.
The rest of the capital in the new fund will be provided by two institutional investors: DB Private Equity & Private Markets, the private equity platform of Deutsche Bank’s asset management division, and Seligman Private Equity Select, a fund of funds that invests in small European private equity funds. The new fund has been structured as a closed-end fund with a two-year investment period and a five-year life – but it won’t invest in any other companies.
The benefits of this for Octopus’s two new LPs are clear. Blind pool risk disappears entirely; they’re buying into a group of proven assets (without even a potentially disruptive change of ownership or control to worry about). VCT shareholders are happy, because they can take some profits while retaining a share in the growth of the portfolio’s best performers. And for Octopus, the structure allows it to keep owning businesses it would otherwise have had to sell – while potentially also bringing in fresh capital to these companies (Carlyle has already invested in Graze) without risking the VCTs’ tax advantages.
No wonder, then, that Alex Macpherson, chairman of the Octopus Ventures investment committee, hopes to use this model for other businesses that outgrow the VCTs in the future – or that he believes it could be transformational for the industry.
“This can potentially change the venture model in Europe … [It] enables retail funds, like VCTs, to be used to support companies through until the Series A round – before they move across to a new fund that can bring in institutional money to support them through their next stage of development.”
According to Octopus, this idea definitely resonated with potential investors. In fact, Macpherson says the firm actually selected these two LPs – neither of whom had previously invested with Octopus – following a “very competitive process”, as he puts it. “We spoke to a number of interested institutional parties, and the overriding message we received back was: this is a great opportunity to gain access to a high-growth set of assets.”
It’s clear that fundraising is going to be tricky for the vast majority of European venture firms for a while yet. Until that changes, they need to focus on finding new sources of capital, and/ or trying to de-risk the proposition for institutional investors. So expect to see more unusual structures like these in the coming months.