Venture 2.0: A new breed

01 October 2008

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This month saw two new arrivals to the SME investor sector. Both Serena Capital and Newfund Management held a first close of their respective maiden funds. In the light of these developments, it is time to examine the current state of venture in both France and further afield.

Historically, the Venture Capital market had been playing second fiddle to the LBO market. However, with the buyout market handicapped by a lack of credit, is it time for venture to emerge from the shadows? Since the tech bubble burst venture has licked its wounds, learnt its lesson and most importantly, has seemingly inspired a certain degree of confidence from investors. Is venture capital suitably up to the task of reestablishing itself as a prosperous investment opportunity?

Funding fancy

LPs will always demand excellent track records as well as added experience such as a successful entrepreneurial background before investing. If venture is to take a step forwards it must be able to rely on a solid investor base and a host of potential future investors primarily at home but increasingly abroad. Unfortunately, venture funding has been something of an issue over the past year. The fact that LPs were not seeing the same amount of returns on their investments as their buyout counterparts combined with the credit crunch to cause investor unease. As a result, a few notable French venture houses had struggled with their fundraising targets over the last couple of years. Since venture capitalists were putting a lot of effort into fundraising roadshows it could well be the reason for a deal slow down in certain areas. LPs are seemingly waiting until the current financial situation calms and it may take a little time between a crisis and the point where the financial tap runs dry. Experienced teams are less likely to meet such troubles although in markets where competition is strong, smaller players may well be squeezed out. However, as Serena Capital and Newfund have proved, it is still possible to get funding in the current economic climate even for a maiden fund.

Sectors of interest

There has been a gradual shift in sectors of interest as entrepreneurs change their focus from information technology and healthcare to energy and information services. Cleantech is still the most interesting sector currently with a lot of innovation in the energy sector and investors trying to keep up with bankable developments. Since the internet bubble burst confidence in venture has never been the same. A number of firms have shut up shop after a few disastrous investments which fell flat. Marc Fournier from Serena Capital states that "as prices in cleantech are still high we will wait for the cleantech bubble to burst possibly in the next few years before investing in this sector. As far as sectors go, yes there are some which are currently hot but, providing you have the expertise, you cannot discount investing in other sectors, even some which are thought of as cold, because good investment opportunities pop up everywhere."

French government and venture.

The French government has a history of wrapping their economy in an awful lot of red tape, however investment in SME is at the forefront of the current finance minister Christine Lagarde's agenda. The government is providing incentives to private individuals to invest their personal money in specialised FCPI and FIP funds in return for tax breaks on the amount. FCPI funds are designed to invest primarily in innovative SMEs. The incentive lies in wealth tax reductions offered on the amount invested. The funds are usually offered to customers of banks and then managed by the bank's private equity subsidiaries. The innovative nature of a company is judged according to its spending on research and development, or whether it has been approved by Oseo-ANVAR, the French government-backed research and innovation association which provides funding and support to SMEs and VSEs at very early stages. Most funds will be seeking to make around 12 investments in such companies. FCPI funds plan to take full advantage of a new tax relief law for investors (Travail, l'Emploi et le Pouvoir d'Achat law of 22 August 2007). It is encouraging to see a government facilitating investment in SMEs however it is yet to be seen how these funds have been invested in and the returns they will yield.

The effect of the US

The US market has traditionally been leaps and bounds ahead of their European counterparts. This is often put down to better education and greater understanding of the venture concept, a higher tolerance of risk and a far bigger market. In the US however, approximately 80% of the returns have come from 20% of the top investors. Combining this with the current economic climate and the change in the perception of risk, investors have started looking elsewhere to invest rather than the US top tier venture houses. They see Europe as a maturing venture market and seem willing to take a measured risk in investing in European venture teams with high potential with a view to establishing a fruitful relationship. An influx of new foreign LPs from the US or even the Middle East would certainly ease any fundraising fears for solid venture houses.

Tight exits

The current financial situation has caused a shift in the traditional exit methods for investors. The low valuations of companies on the stock exchange has seen the IPO market fall flat. Companies are preferring to take on further financing rounds rather than going public. This was the case for Luneau Technology which deferred its listing on the Alternext indefinitely preferring to have a EUR3.1m investment round led by XAnge.

One of the results of the change in exit strategy is the rise of the secondaries market. A number of investors have created secondary-specific funds; recently ARCIS Group closed their fourth secondaries fund on EUR354m. Venture firms have funds from 1998 to 2001 which are nearing the end of their lifespan. Exits, however still need to happen as a bundle or even a discount if needs be since limited partners demand their returns. Unfortunately a number of portfolio companies are still illiquid. While new companies would on average become liquid in a little more than four years, now that time line is at about seven years and set to grow. With a number of companies getting too ripe for the vine, a growing number of investors are looking to unload them quickly in a direct secondary sale.

BNP private equity recently ceded its minority shareholdings in five companies after liquidating two of its venture capital funds, Antin FCPI 1 from 2001 and Antin FCPI 2 from 2002, earlier than planned. Two of the investments sold were early stage companies while the other three were more mature. The exits were said to have returned satisfactory gains. Similarly, Norwegian investor HitecVision sold three oil and gas portfolio companies to Cubera and this month Innovacom sold ten companies to Saints Capital for around $50m.

Trade sales are still the preferred option for Venture firms at the moment especially since LBO investors are seemingly favoring buy-and-build bolt-on acquisitions for their current portfolio companies in order to create value.

These are uncertain times for the European venture market. Large investment teams such as 3i leaving the venture market should not however be interpreted as rats fleeing a sinking ship. Providing funding stays in place and the markets continue to mature, venture could provide a serious alternative to LBOs which are currently struggling to find debt. The France government is leading the way with innovative methods to provide funding and should other countries follow suit this could prove a rosy future for venture.

Innovation clusters and funding

It is inaccurate to think of European venture capital in terms of regions. A more accurate description would be that of technology/innovation clusters with the Golden Triangle (London-Cambridge-Bristol) ranking in first place followed by Paris, Berlin-Munich and Stockholm-Copenhagen. For France, around 70% of the deal flow comes from Paris with a few notable hubs such as Grenoble.

In terms of aggressiveness, the further one moves south the more conservative investors' attitude becomes. The UK leads the French and Scandinavians for market maturity with Germany gaining rapidly. However, a different picture is emerging. In Spain, Madrid-Barcelona-Basque Country is showing growth and venture investors such as 360 Capital Partners are seeking out opportunities in Italy.