UK venture: Catching on

With only 4% of institutional money going into venture capital in the UK, compared to more than 30% in the US, the industry is woefully lagging behind. This gap, though large, is narrowing. The UK government has been attempting to resolve this issue for years, and the launch of its latest scheme, the £1bn UK Innovation Fund is its latest effort. There is, however, evidence to suggest that the European Commission's AIFM directive will make matters worse for the venture capital market.

A lack of both capital and investor interest has been cited numerous times as the problem behind venture in the UK. The Innovation Fund is looking to curtail this with the £1bn it plans to raise to provide both seed and follow-on funding for early-stage technology companies. The government has committed £150m to the vehicle as a cornerstone, with the remainder to be secured from both domestic and international private backers. "There has been a perception that these are risky assets and, as a result, a lot of these businesses may fail because of a lack of funding. But really, they benefit the economy proportionately much more than your average SME - technology start-ups grow more quickly and employ more people," says a senior official for the government department of business, innovation and skills, which committed £100m to the vehicle.

But some in the industry believe these efforts will just not suffice: "This fund won't make one bit of difference. We're talking about peanuts. Foresight is raising a solar fund equivalent to the total amount of capital the government plans to raise for its inaugural fund. The vehicle is also bound to be constrained," says Bernard Fairman, managing partner of Foresight Group.

According to recent BVCA research, figures suggest that only £109m will be invested in early-stage technology companies this year. With the UK one of the most technologically-innovative countries in the world, the message is clear: venture capital needs a drastic lift.

As ever, it comes down to money. Historically, venture funds in the UK have made too many investments, resulting in them not having enough capital to see companies through to a lucrative exit. The scale of the US venture market, with its vastly deeper pockets, is one of the reasons it continues to be successful: backers can continue to back businesses through to IPO or sale more often than in the UK. With the amount of funds invested in the US, the rewards reaped stand to be much bigger.

Fairman agrees: "We've seen different sorts of government interventions in the past and the result has been by and large the same every time. There has been no government money provided for the buyout market and there is still money there. It's about the returns, which coincidentally, are nowhere near US venture." When faced with the choice, international investors will choose to commit their capital to US funds in the interest of getting the most value for their money.

Catching up

Lately, in fact, European venture performance has surpassed that of the US, but that is largely down to the marked decline across the pond. While most LPs remain sceptical, some are starting to poke around the market here, convinced that the UK is not that far off from the US. "Although venture capital in the UK has challenges, it is still developing and the situation is not all bad. UK venture capital compares well with the rest of Europe and although less established than in the US, if you were to take Silicon Valley out of the equation you would get a very different set of results," says Calum Paterson, managing partner of Scottish Equity Partners.

He continues: "The industry here is still emerging. Ultimately, venture capital is really all about commercialising innovation - that's where the big opportunity lies and we have a high level of confidence in that."

But the fact of the matter is that the Silicon Valley is an instrumental part of US venture that cannot and should not be disregarded. "Silicon Valley is self-sustaining. Despite numerous attempts in the UK, no such thing has yet been developed," insists Fairman. So far, Oxford and Cambridge are the only two places that have even come remotely close to Silicon Valley, but they are no where near there. Fairman continues: "The technology successes are as long as your arm in the US, whereas here there are maybe only three."

Manish Madhvani, partner and co-founder of GP Bullhound, an investment bank focused on emerging growth companies in the tech, digital media and internet sectors, believes that the situation in the UK is improving: "The government in the US has been a strong catalyst for its venture industry by supplying capital to a large proportion of the US VCs, where they will take the first losses through the SBIC scheme. The UK government has implemented something similar with the ECF funds and this new vehicle will improve supply of capital and encourage further private money into the sector."

"European and UK VCs are now delivering some large returns to their investors such as Bebo, MySQL, Core Valve and Q Cells - all £500m+ exits. Such homeruns have been the holy grail of US venture," he adds.

Even if returns in the venture capital industry are improving, this is not to say it is a result of government-backed schemes. Because of a reduction in tax benefits and increasing regulation, VCTs are predicted to raise a mere £200m of early-stage capital this year, indicating that tax breaks are insufficient to attract funds.

According to the BIS official, this UK government has invested more than £40bn in science and research and is keen to see this investment safeguarded. "Government interventions haven't been that successful in the past because of the restrictions that were placed on how funds would operate to comply with state aid rules, meaning that the government would only invest at the riskiest stage (up to £2m per company), expecting private investors to come in at the later stages," he explains. This fund, however, will see no state aid restrictions, as the government will invest on an equal basis with the private sector, acting as an ordinary LP. The new vehicle will therefore be able to invest at any stage in a business and also has remit to invest in companies with headquarters that are based abroad, as long as they have significant operations in the UK.

The EVCA announced its support for the new fund on 14 October, when the trade body proposed the creation of pan-European fund-of-funds to raise EUR1.5bn over 10 years to incorporate public money and stimulate private investors to invest in the venture asset class. The proposals form part of EVCA's Innovation Act expected in the Spring of 2010 that is expected to help meet the goals of the EC's new Risk Capital Action Plan for 2020. The idea is that the best results are achieved through private, not public, money and that any public money will be fed through privately-managed fund-of-funds.

The question, though, is whether the Innovation Fund will be able to meet its perhaps overly ambitious £1bn goal. While the BIS official admits that it may be a "stretching target", he says that it needs to be set in order to inspire and motivate people, and that the aim is to get as close to it as possible. The fund-of-funds structure is also meant to incite first-time investors, spreading the risk across a number of different vehicles. In reality though, European investors have always been more risk-averse in their nature than their US counterparts. And any way you dice it, venture will inevitably always be risky.

UK makes; EC breaks

But while the UK government may be attempting to develop the venture capital industry, the European Commission is threatening to stifle it. The directive to regulate the alternative investment industry, while targeted at hedge funds, may have unintended consequences for venture capital. The requirement to use independent valuers and custodians for investments, along with the greater capital and disclosure requirements, could potentially put the smaller venture firms out of business. "The proposals aren't helpful or necessary for the venture capital industry. They are out of alignment and should be targeted elsewhere. If we've learnt anything over the last year, it is that regulation has failed spectacularly with regard to some incredibly large financial institutions, which had catastrophic results for the global economy. It is ironic and unfortunate that the knee jerk reaction to all of that includes targeting areas which have never actually been the problem," says Paterson.

Fairman is of the same mind: "The directive is potentially disastrous. This is a 'one-size-fits-all' approach that just doesn't fit for venture. Compliance costs will prevent venture firms from actually making investments. It places the UK at a major competitive disadvantage and is the exact opposite of an entrepreneurial culture."

A number of venture capital firms are now pushing for a "light-touch" regime that would involve fewer requirements for smaller houses. The need for greater disclosure could be particularly dangerous for venture given commercial sensitivities. In fact, the US has realised this potential harm and has dropped its plans to regulate venture firms as part of a new bill that reins financial risk. With US venture out of harm's way, the new EC directive runs the risk of not only turning people off from raising venture capital funds in Europe, but also of pushing investors away from the continent.

Despite all the pitfalls of venture in the UK, some players have actually remained relatively active during the past 18 months. Foresight, which has recently ramped up its cleantech focus, has made six new investments this year, while SEP has already invested two thirds of its last $300m vehicle closed in 2006. In fact, Paterson predicts that deal flow will increase over the next year, with Madhavni seeing strong activity in the internet and cleantech sectors. This unquote" issue alone saw the completion of 11 early-stage venture deals, all in a matter of two weeks. It seems that if UK venture is to ever reach the levels in the US, venture firms on this side of the ocean will have to persist in their fight to decrease both regulation and taxation to keep this industry alive.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Send to  

• Topics
• Investments
• UK / Ireland