A venture capital odyssey: part I

You might think that, sitting in a roomful of seasoned European venture capitalists – representatives of an industry and a region that has been particularly scarred following the bursting of the technology bubble – it would not be a good idea, even in the interests of positing a controversial conversation starter, to ask: “Is European VC a good idea at all?” So it comes as something of a surprise when one of our roundtable participants voices that very thought.

But there again, it is not actually that surprising given the down-to-earth realism and gritty determination that marks the mood of those attending this roundtable. Having survived the tough times, these VCs are frank in their assessment of their industry, of their own place within it and of the relationship with their counterparts in the US. They are also keen to consider the strengths and weaknesses of this branch of the private capital industry.

Their consideration is candid but also measured, delivered with a shade of qualification. Although VCs traditionally aren't renowned for their reticence, it's noticeable that these practitioners, partly because of the blows dealt by the recent past, partly on account of having implemented changes that have yet to prove right or wrong, appear more hesitant and less assured about making bold statements or predictions. Ambivalent? Not really. But hopeful, rather than overtly confident? Yes.

Conversations prior to the session had quickly supplied a number of core themes PEI wanted to see shape this discussion. Central was to find out how European venture firms were adjusting to life post-bubble. Other issues included the validity (or necessity?) of growing portfolio companies in the US; how to tempt sceptical investors back to the sector; and what the future looks like – at present.

It's not as if there aren't sceptics about European venture per se. Readers may recall the concerns voiced by HarbourVest's George Anson (PEI, September 2003) on the sector. “European venture has unfortunately taken a giant step backwards along its evolutionary path because many firms were caught out by the crash and many GPs are now wondering, “what happens next…?” What we have found is that a lot of the tourists have left, and you are left with a core group that looks more like a cottage industry than an asset class. I'd like to say we'll have as much as 20 per cent [of the firm's most recent international fund of funds, the $2.8bn HIPEP IV] in venture but I don't know if we'll get there.”

So are we then meeting with a group of cottage industrialists? If so, they're a feisty bunch, each having reviewed and renewed their commitment to venture investing.

Two of them have, tellingly, made fundamental changes to their basic strategy. Commenting on how firms have reacted to the dramatic changes in the venture industry, Michael Elias kicks off by describing the thinking behind Kennet Venture's recent shift in investment focus: “We came to the conclusion that investing in really early stage businesses in Europe was a very risky proposition for a number of different reasons, the most important one of which was that it had got to the point where buyers of products and services were wary of purchasing anything from early stage companies.”

The other group to have reshaped its strategy recently is Schroder Ventures Life Sciences. And here it's not stage but geography: Kate Bingham early on in the roundtable makes clear that the firm has chosen to increase investment in the US to the detriment of European activity. The decision seems to have been made after a fair amount of soulsearching in-house. Whereas previously Bingham reckons investment might have been 60/40 US to Europe, “now it's more likely to be 80/20 in favour of the US and if things continue to be difficult in Europe, we might shift even further. Life sciences investing [in Europe] in the absence of a US strategy is very dangerous – and to date, as an industry, European biotech investing has not resulted in consistent returns.”

Bingham is forthright on this shift and one gets the sense it is a message she has practised with her limited partners: “We've just gone round to our European investors and basically told them that we're going to de-emphasise Europe. We're going to have an increased focus on the US, at least until we can get some results over here.” Notably, these investors (unlike Kennet's, initially) were positive about the move: “We actually found the opposite response: they were very pleased with that decision and supportive of it.”

Maurizio Caio has a slightly different perspective on the meaning of being a European VC today. Although he has long been involved in European venture, his current firm, TLcom, is at a crucial stage of its evolution as a fund manager, investing a debut fund and preparing to raise a second. The firm made a deliberate decision when it set up five years ago to concentrate on a particular region, and the signs its managers have seen so far are relatively encouraging: “When we started up, we took a view as to whether or not Europe/Israel was a good place to find start-ups in terms of the origin of the company and not necessarily just the exit potential – and the region has produced some very interesting companies. Investing in Europe is like a hand of poker in which you have to change four cards – it takes time and it takes experience.”

“That's all very well,” Bingham interjects, “but where do you end up growing those companies?”

“Mainly Europe,” replies Caio. “If you're in broadband/wireless technology, you have to go East – you have to go to Europe, you have to go to Asia, before you go to the US. The US is important, but it's not the Promised Land.”

Having seen both sides of the coin – he spent eight years working for Hambrecht & Quist in Silicon Valley – Danny Rimer of Index Ventures reminds the group how nascent, in relative terms, the European venture market still is. But to him, that's no bad thing: “Bill Hambrecht, one of the grandfathers of Silicon Valley, says that one of the problems he sees out there today is that the actual job of a venture capitalist has gone from building a company to winning the deal.” Rimer's desire to go back to the basics of venture investing – building companies – brought him to Europe, where his firm “decided ten years ago that we were going to adopt the Silicon Valley model in Europe and see if it's going to fly.”

Rimer is infectiously positive on the quality of European innovation, on its engineers and on business management. But Bingham challenges him on how all those good things will actually translate into returns.

“I'm really happy that you asked me that Kate, really glad,” Rimer jokes in reply. He then continues more seriously: “I think there have been a lot of European companies which have demonstrated that they have been thought leaders and business leaders in their segment and have gotten huge premiums for that. In fact, we recently sold KVS, a 245-employee email archiving company – started in Reading, England grown in Reading, England – to Veritas [the US software giant] for $225 million in cash. It's a good example of a company that found its segment, had a better team than anyone else out there, found a natural acquirer for its technology and was rewarded for being the best in its space.” So good returns can be had in European tech: but perhaps the odds are steeper?

At this point of the conversation, Index' decision of formulating a strategy and sticking to it is applauded by Paris-based Sofinnova's Olivier Protard, but he also emphasises the importance of being flexible. According to Protard, his firm reflected, and then renewed wholeheartedly its commitment to early stage and start-up investing.

However, one change the firm has made is to adopt a wider, pan- European focus: “Sofinnova is just discovering a whole range of new opportunities across Europe. We're looking at trying to pick up the best deals not just in France, but across the continent.” The implication is that quality deals – and quality exits – oblige a more than national mindset and approach today.

THE RIGHT SUBSTANCE FOR IPOS
Unsurprisingly everyone at the roundtable agrees that it is the ability to execute quality exits via an IPO that is key; but the reasons why so few European portfolio companies have achieved this is then much more closely debated. Is it the infrastructure, the investors in the public markets or the companies themselves that are causing this? And doesn't the US market again offer a more compelling environment?

Although recognising the importance of the US market, Caio says that it doesn't make sense for European companies to register in the States purely in order to IPO on NASDAQ, while the majority of their customer base is located in Europe – a theme to which Advent's Peter Baines warms to as well: “I don't buy this idea of the “Delaware flip”. There's no “one size fits all” – it very much depends on the company, management and the state of the markets. The US is definitely a key market for customers, but it's not the only one and it's certainly not the answer to take every European technology company and just transfer them to the US.”

A whole range of new opportunities across Europe

Olivier Protard

The big issue with the European IPO arena for Protard is the lack of stability across European markets and also the attitude of the intermediaries involved: “Since the market collapsed three years ago analysts have disappeared, investment bankers aren't interested and even if we, as venture investors, do our job 100 percent right, there is no stable IPO market to exit on.”

Rimer is less convinced by this argument. Describing himself as being simultaneously “a little jaded and Panglossian” – Rimer has taken companies public in both the US and Europe – his view is that “markets to take companies public are always there, if you have appropriate companies. The challenge for us is to find the right companies that can go public, no matter what market they're on, rather than being too worried about the actual state of a securities exchange in a particular country. We cannot blame the markets for the lack of an exit environment, for companies not going public. If you find the right quality of company, the rest will follow.”

Caio agrees with this, observing that although the infrastructure and resources for grooming companies to go public are superior in the US, fundamentally, it all comes back to the quality of the company: “If you show up with the right substance, it's going to be very hard for all those people who are waiting for the right substance, not to recognise it when it comes along.”

But even so, will public market investors still buy a European tech offering in today's post-crash environment? And are there any other factors that have caused difficulties for the European stock markets?

For Elias, it isn't just market forces that have prevented the formation of a credible IPO platform in Europe. Nationalism has also been a contributing factor: “During the spell 1997 to 2000, every country in Europe wanted to have their own technology exchange. In addition, there was a real quality issue – you had a load of crap companies going onto those markets at that time. If you could fix both those problems, I believe there are enough decent companies in Europe to populate a quality exchange.”

Rimer also predicts that the institutional investors who shape the public markets are bound to return as buyers of growth company stocks. Why? Because that's the only way they are going to achieve the returns they want. “These people are addicts to growth, they love high-growth companies and it's where they make their returns. They may not dive straight back in, but they'll be back.”

Bingham vigorously disagrees with this assertion, convinced that, in the life sciences sector at least, European investors of the bubble class of 2000 (who, she reminds, lost almost twice as much as their US counterparts) are likely to be much more circumspect about looking at such companies in future. “I think they have much longer memories than we think and they're saying, “Show us some returns from the last set of companies we invested in and then we might come back in again”.”

NO HOME RUNS?
Few need reminding that the history of VC-backed companies that have delivered stellar IPOs will include many that have transformed a fund's IRR. This transformational home-run principle does not, however, work in Europe according to Elias: “Here you make your money not in home runs the way you do in Silicon Valley, but by developing a steady stream of exits, consolidating and building returns more gradually. Europe hasn't produced really large [VCbacked] businesses, but there are lots of examples of promising companies that have been bought out for big multiples.”

Caio agrees: “Around 80 percent of exits in Europe are trade exits. It's more of a land of consistent performance. M&A exits are a very important ingredient in the overall performance of a European VC fund.”

Caio also sees discipline in portfolio valuation being critical to the future of European VC – something that is also endorsed wholeheartedly by Protard: “Post-money valuation is much lower here than in the US and it's not as cyclical. This has a big impact on multiples and I think that LPs realise that prices are much cheaper here than in the US.”

There is also a question of scale: whereas VC firms have in the past raised successively larger funds (and, many would add, struggled as a result with over-large amounts of capital to deploy), many funds in Europe are far more attuned now to raising a fund of an appropriate size. Is there an optimal fund size for European VCs now? Says Elias: “I don't think there is a “one size fits all”, but I think one can say with some confidence that the right size for funds raised in 2005 will be less than those raised in 2000.”

And harking back to that principle of building companies mentioned earlier, Rimer adds: “There's only so much money you can put to work and legitimately be of value to your companies on a per-partner basis. Our view is that you can't really sit on more than five to six boards at a time, which equates to about €50 million per partner, maximum. After that, it gets into nosebleed territory.”

OVER THERE OR OVER HERE?
Reminding them that this discussion is part one of a two-part look into the global venture capital market, we ask our roundtablers what topics they would broach with a similar collection of US VCs. Responses range from asking how to get an invite to “the next Google” to Peter Baines' wish to discuss the US capital overhang and how US VCs see opportunities to make money given the high entry point valuations of some of the deals.

From a life sciences perspective, Bingham wants to ask the Californian VCs if they now expect to only back clinical-stage companies to the exclusion of earlier, discovery stage operations or whether the move in the US was towards hybrid, multi-stage investors.

Rimer's question relates to succession and how US venture capitalists are coping with generational change and the passage of control and leadership from firm-founders to a new generation. Elias queries whether US VCs are now starting to look East to Asia, rather than Europe, for opportunities, which leads Maurizio Caio to ruminate more broadly about the state of the industry and openly ask: “Is European VC a good idea at all?”

Well, is it? “Yes, with qualifications”, seems to be the verdict. The world is a tougher place now for venture capitalists and the prospect of rapid and startling returns is much more remote. But VCs are toughened as a result: focussed, disciplined – and conscious that both current and prospective LPs are watching. Although Bingham and her colleagues at Schroder Venture Life Sciences see a need to commit largely to the US, the others at our roundtable are going to persist in Europe, quietly doing what they do best in their own, individual ways – spotting talent, building companies, growing portfolios and bringing the right companies to exit – by trade sale or (hopefully) via the public markets.

If they do succeed, and you get the sense that the people who matter believe they will, there's good reason to expect that European venture will stop being a dirty word. European venture capitalists – those that have survived – believe they have a strong story to tell the market, and they are getting ready to go out there and tell it. It's worth listening to if you get the chance.

PREVITHE PARTICIPANTS:
Peter Baines

General Partner

Advent Venture Partners

One of the first UK venture capital managers, Advent was formed in 1981 and currently has around £400 million under management. The firm invests in information technology and healthcare in the UK, Western Europe and (selectively) the US and does both early and later stage investments. Advent is currently investing from its £300 million Advent Private Equity Fund III, which closed in February 2001. Baines joined Advent in 1999 and is a general partner within the firm's information and communication technology team.

Kate Bingham

General Partner

Schroder Ventures Life Sciences

The firm, soon to be rebranded as SV Life Sciences, has advised funds investing in the life sciences sector since the early 1980s and launched a dedicated life sciences practice in 1993. With offices in London, Boston and San Francisco, the firm advises or manages over $1 billion in three funds and one publicly quoted investment trust. Bingham, general partner in the London office, says the firm is undergoing a shift in focus away from Europe, concentrating on making more investments in the US.

Maurizio Caio

Founder & Managing Partner

TLcom Capital Partners

TLcom was set up in 1999 and from its London headquarters invests in information and communication technology companies across Europe and Israel. The firm's team of five senior GPs currently manages total commitments of €184 million and will soon begin raising its second fund. Before setting up TLcom, Caio headed up Bain & Company's technology telecom practice in Europe. Although the firm carries out some investment activity in the US, it concentrates primarily on investing in companies that originate in Israel and Europe.

Michael Elias

Managing Director

Kennet Venture Partners

Kennet is a transatlantic venture capital investor with offices in London and Silicon Valley. The firm invests exclusively in technology and currently manages approximately $300 million in two funds. The firm has recently changed its focus, moving away from very early stage investment to providing slightly later stage funding according to London-based managing director Elias.

Olivier Protard

Managing Partner

Sofinnova Partners

Headquartered in Paris, Sofinnova Partners is the independently owned European sister firm of Sofinnova Ventures, which is based in San Francisco. Sofinnova Partners manages around €500 million and is currently investing Sofinnova Capital IV, a €330 million fund. Sofinnova invests in companies in information technology and life sciences in France, across Europe and in the US, focussing on start-up and early stage commitments. Protard, formerly a journalist, joined Sofinnova in 1989 and is a managing partner in the firm's information technology group.

Danny Rimer

Partner

Index Ventures

Geneva-headquartered Index Ventures focuses on venture technology and has been making life sciences and IT investments across Europe and in Israel since the early 1990s. The firm manages over $500 million and is currently investing from its third, $300 million fund. Rimer, who started up the firm's London office, joined Index in 2002 having previously worked for The Barksdale Group and Hambrecht & Quist.

KEY TAKEAWAYS
“What are the most important lessons of the past three years?”

“Choose your co-investment partners carefully” is the key takeaway for Advent's Peter Baines. Olivier Protard and Kate Bingham also emphasise that getting deal syndication right is key, with Bingham making her feelings clear on the inadequacy of most corporate venture partners whose internal strategic goals may not (read: will not) align with those of the company or the VC.

Bingham also notes the importance of not solely relying on public markets for exits either. She says that another key lesson is not to underfund portfolio companies – something she feels has been a problem in Europe. Danny Rimer concurs, but also advises caution: “It's really important to take your time before ploughing money into something. It's vital that you get to know the company before investing, not after.”

The key lesson for Maurizio Caio is all about making the right choices of individuals. “Deal with the highest possible quality: talented individuals in and around companies – managers, advisers, intermediaries, VC coinvestors – don't just follow brand names.”

Michael Elias' message is almost a philosophical one: don't talk about technology so much and instead concentrate on building sustainable businesses. Like the majority of the group, he believes that in three years time “not that much will have changed, but Europe will have gained more equilibrium.”

Besides wanting to have raised another fund by then, Baines also thinks that there will be less of a “boom and bust” mentality across European VC, especially now that there is great potential for those GP groups that have come through the tough times.

The final, upbeat word goes to Rimer, who, happily describing himself as the optimist of the group, believes that “within three years we will see the first [VC-backed] technology billionaires coming out of Europe.”

That's a bold call, and there clearly is a lot of work to do for everyone. PEI's guests are determined to get it done over the coming years. All six have agreed to reconvene with us to review these forecasts in 2007 – a statement of intent in itself.

HAS THE BUYSIDE GIVEN UP ON EUROPEAN VENTURE?
The temptation is to think that most – if not all – investors in private equity have little interest in allocating to European venture capital: too unpredictable, too small a choice of funds, too long a wait for too small a potential upside, that kind of thing. We asked our roundtablers, several of whom are either already fundraising or about to fundraise, whether this was near the truth or not.

Olivier Protard sums up the problem when he says: “I think we all agree that big institutions, international LPs, still question the value of committing to venture capital in Europe. When we're out fundraising, we always face the same general question: “Is Europe a suitable market for early stage investing?” And also: “Where are the demonstrable patterns of success?” One IPO here, one good transaction there… there isn't a pattern yet.”

Maurizio Caio pushes on this point further: “The reality is that if you are an LP in Europe and you look at the numbers, European VC is one of the least attractive places to put your money, right? The one thing that makes LPs say “no thanks” to European VC is that as a sector, it hasn't been very rewarding so far. We need to convince them with evidence about why VC in Europe is pertinent and has the potential to generate significant returns going forward.”

Michael Elias believes that it is not just the sector that is still having to justify itself – every individual firm has to evidence compelling performance as investors gravitate towards trophy firms (just as they tend to with buyout): “We hear people saying all the time: “European VC? I'm not interested unless it's one of these firms.” And everyone has their own view as to who those firms are, but there is an emerging upper tier in Europe, that just didn't exist before.”

Not all investors are the same though – there are different types. Peter Baines identifies what he describes as a now “nonnegligible” segment of LPs who automatically exclude European VC from their allocation. The implication is that the universe of genuine prospects has become smaller, not larger. Who are these non-starters? “Some of the newcomers, some of the ones who listened to US GPs who told them to forget Europe and some who just invested in the wrong funds and lost confidence.”

Besides these refuseniks, as well as another group Baines describes as “contrarian investors” who see now as good time to invest in European VC on account of its depressed state, the man from Advent thinks the majority of potential investors are “very wary, very cautious. They're not quite sure, but feel it might be an interesting opportunity. They also feel that having been burned previously, they need to do an awful lot of due diligence.”

Caio at TLCom has encountered some of that really indepth due diligence from investors, but is of the opinion that incisive, meaningful research by investors with a genuine appetite for the asset class is to be encouraged – even if it obliges the firm to lay its soul bare. “We have had more than one investor who came in and spent more than two days analysing our portfolio – doing a blood analysis if you like – to give us their own point of view of the portfolio.”

But investors clearly can confuse an appetite for granular information with obsessive fact gathering. Kate Bingham describes some of the “bizarre” requests she has received from prospective investors, none of which she feels have any bearing on whether or not their fund was worth investing in: “When we were fundraising, one investor asked us to produce management accounts for every single one of our portfolio companies. How the hell is that ever going to help the actual investment decision? Investors would be better off if they had a look at your track record, did some sensible due diligence, made some calls to the people who are your competitors or coinvestors and spoke to your current fund investors. That way they can get a better feel for whether or not you're doing the right things and are worth backing.”

Baines believes that the lengthy nature of the due diligence currently being carried out by investors is not just down to post-crash caution, but also, crucially, to the way in which these investors have lost money: “The due diligence now is angled by investors' previous experience. Some have been burned by teams blowing up, so they come in to see you and they're convinced that you all hate each other and you're all going to go off and do something else; others have been burned by collapsing syndicates, so they concentrate on your co-investors – each investor has their own idea about what makes a good fund manager and what can go wrong.”

Clearly each participant have their own war stories to tell but all nod in agreement when Kennet's Elias remarks on the striking parallel this LP/GP dynamic has with the one between VCs and their investee company management: “It strikes me, as I'm listening here, that this could be a conversation that could equally well be being held by any of the CEOs of our portfolio companies about us.” Clearly the hand that feeds can also prove the hand that holds – a bit too tight.

Danny Rimer points out that European VC will only establish the track record that investors are looking for if adequate capital is allocated to it. “Until there's maturity in terms of geography, it's a bit of a chicken and egg situation – if investors could see a track record, numerous great liquidity events for funds, then they probably wouldn't be as stringent on boxchecking. It'd be more like: “These guys haven't screwed up for two funds, so we'll come in on the next one.””

That is, so long as investors manifest sufficient awareness of the long term nature of these investments. Elias believes there have been a number of examples of LPs who have come into the European VC market with “incorrect expectations about the timing for returns.” He goes on to say that this is not a problem endemic to just investors, believing that it is a problem right through the industry: GPs a few years back felt the J-curve was shorter and shallower too. Declares Elias: “I think from top to bottom, there needs to be a re-setting of expectations of what venture capital is all about.”

So what will capital raising be like in 2004 and 2005? Olivier Protard hazards a prediction: “I think we will see European institutions making more, albeit small, investments in European VC funds. For investors, the picture has clarified as to where you can invest and how much: they think – right or wrong – that we're now at the right moment in the cycle because valuations are low, lots of funds have disappeared and those that are left are pretty stable. They will definitely test the waters.”