When a £1bn fund is too much of a good thing

Venture capital is the friendly face of the industry and in times of hardship such as these, far from being pilloried as providing food for fat cats, it is seen by many as an important mechanism to jumpstart the economy.

With this in mind, the UK government has committed to seed a fund which it hopes will ultimately channel £1 billion (€1.2 billion; $1.7 billion) into UK venture. In order to encourage investment in high-tech early-stage companies, the Department for Business, Innovation and Skills has committed £150 million to a fund of funds named the UK Innovation Investment Fund (UK IIF). Established funds of funds managers have been invited to put themselves forward to manage the vehicle and it is hoped that the selected manager will leverage the state money with third-party capital to take the figure up to £1 billion.

Funds of funds managers have until September 18th to submit a proposal, which should include details such as where the third-party capital will come from and when a first close can be reached. Final selection and appointment of the manager is scheduled for December.

There is no doubt the intention behind this initiative is laudable. Everyone in the industry would agree that Europe needs more capital to reward innovation and to commercialise the world-leading intellectual property emerging from its universities.

There are, however, a couple of kinks in the UK IIF plan as it stands. The size of the fund is certainly eye-catching, but is almost certainly unrealistic. The notion that even the most highly-regarded funds of funds manager could pull in £850 million of commercially focused third-party money to invest in UK venture capital is questionable at the best of times, let alone in such a tight fundraising market. To put the figure in perspective, the amount raised by early-stage venture capital funds across the whole of Europe in 2008 was €2.2 billion. The figure for all stages of venture capital across Europe was €5.5 billion.

Furthermore, if the fund did reach its £1 billion target, it seems unlikely that this enormous slug of money could be invested discerningly in UK venture without distorting the market in some way, especially if it were to narrow its investment remit by stage or sector, as is intended for the UK IIF.

A more realistic prospect for the fund would be to widen the geographical remit to the whole of Europe and retain a minimum allocation to UK-focused funds. It could go even further and diversify the asset mix into other asset classes, with a portion allocated to venture.

The reason that LPs have not been clamouring to get into European venture funds is because performance has simply not been there. According to a report released in May this year by the British Private Equity & Venture Capital Association, over the period 1991 to 2007, VC returns were on average 6.9 percent per annum in Europe compared to 18.9 percent in the US.

An unwelcome question as it may be, it is worth asking whether a state-backed injection of any amount would make a long-term difference to the European venture scene? It would not, for example, address the issue of the small and fragmented EU stock markets that make it tough for venture capital-backed companies to raise significant sums of capital to fund expansion. As pointed out in the aforementioned BVCA report, Europe needs its own fully-functioning NASDAQ.

And then there is a cultural gap between the UK – Europe's largest market for venture capital – and the US. For those in the US, a start-up failure can be worn by the entrepreneur as a badge of honour; in the UK it is more often seen as a black mark against the name, and a reason to avoid the risk.

Not with standing the various barriers to developing the European venture scene, the UK government is without doubt moving in the right direction in aligning state capital with private sector cash to foster venture activity. I have learned that the European Private Equity and Venture Capital Association is currently working on a white paper which will propose a pan-European initiative based on a similar private/public model as the UK IIF but without national restrictions. It will be a tough task persuading various European authorities to place their trust and money in the hands of the private sector at a time when the political wind is blowing in the opposite direction, however. I wish them luck.