A Tough Cookie

The financial chaos of recent weeks has turned deal-making on its head. Dealflow has slowed down dramatically in recent weeks; mega-buyouts are a thing of the past and £500m has become the new £2bn. However, venture has been conspicuous by its absence from the headlines.

Indeed, it has been a good year for venture. On the fundraising front, a number have held closes above target. The second Eden fund, Capricorn Cleantech and MTI's UMIP Fund all attracted strong LP interest: UMIP's first close on EUR42m made it the largest institutional fundraise for a single university spinout vehicle. Capricorn held a final close earlier this year on EUR100m, and even re-opened to admit the Finnish Innovation Fund Sitra as a strategic partner to the fund. Finally, Pentech announced a final close on £45m just last month, nearly twice its target - an impressive achievement in today's climate.

"I wasn't surprised that Pentech closed its second fund above target - They have the expertise and network to find good deals that still exist in their early-stage area" says John Holloway at the EIF, Europe's largest venture fund investor, which invested £10m into Pentech's latest vehicle. Furthermore, they are able to attract funding because of promising pipelines - something that might make some buyout houses salivate.

There may be a negative knock-on affect, with VCs avoiding certain parts of the market as investors' risk appetite wanes. "People will be hesitant investing in unproven business models," says Graham O'Keeffe from Atlas Venture. "Investors may be more careful with follow-on rounds as the current climate can easily lead to a higher failure rate."

Holloway is less negative: "Venture capital firms are playing it a lot safer since the dotcom bubble burst. Their attitude towards balancing the portfolio has changed, but their active support in first rounds of funding remains strong."

Resilience

Despite the fact that venture does not directly rely on leverage, it is indirectly affected by the crunch. "The situation in the financial markets will affect our portfolio companies and their customer base. But slowing from 50%+ growth gives us room," says Simon Cook from DFJ Esprit. This may mean that young firms will need more support from their institutional backers in 2009. The investors might also have to hold portfolio companies longer than expected due to the companies' hurdles en route to profitability.

Other market trends may bode well for venture. For example, the current lack of bank lending is not limited to leveraged buyouts - even commercial lending has dried up - but this can be seen as an opportunity for venture capitalists seeking dealflow, according to Cook. "Companies are often struggling to get money from banks, so they need private growth equity investors if they want to grow their business."

And though the main exit route for venture capitalists, IPO, is firmly shut, there are other avenues. Social networking site Bebo was acquired by AOL for a hefty $850m earlier this year, while email security business MessageLabs was just sold to Symantec for a whopping £397m (see page 31). But these may be exceptional and not the rule.

"Now is not the time to be a seller," Holloway says. But if you have to sell, "the most likely way would be to a trade player or in a secondary." Selling to a strategic might mean an adjustment in valuation, since the trade buyer would expect vendors' price expectations to be more in line with the market, and vendors currently expect 5-6x EBIT. "Falling valuations have yet to feed through the system," Holloway says.

So what does venture have to look forward to? With no or little need for leveraged financing, venture capital has a major advantage. But O'Keeffe does not think venture capital can take bread out of the mouths of buyout firms. "There is definitely the opportunity to acquire stakes in later-stage companies at early-stage prices, but venture capital will continue to put small amounts in interesting companies." Cook agrees; "We are no financial engineers - that requires a different set of skills, we build value based purely on growth."

A change of perspective, no longer aiming for the screaming headlines of bigger better bolder, but appreciating that small can indeed be powerful, seems to be the new trend.

"While the credit crunch has not yet had a huge effect on venture capital, where leverage is in any case not a predominant part of financing rounds for portfolio companies, and that is something really positive, its general collateral effects will not be avoided," Holloway concludes. While the financial world is licking its wounds, venture capital may yet prove the toughest cookie in the jar.

NUMBER CRUNCHING

At present, it is hard to find anyone in the world of finance saying the coming months are looking bright. However, venture capital is bucking the trend and actually doing quite well.

According to data from unquote" database Private Equity Insight, the volume of UK early-stage and expansion deals has remained fairly stable over the past four quarters (see graph). In the same period, UK buyout deals dropped in volume and value by more than a third in Q3. Unsurprisingly, non-leveraged deals paint a rosier picture - particularly in Europe, where early-stage investment is on the up (largely owing to activity in Germany).

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