European M&A Still Feels Summer Heat

A summer burst of M&A activity put European venture capitalists into a cheerful mood in time for the holiday season.

A total of 34 VC-backed companies were bought for a total disclosed price of $744.2 million in the second quarter, up from 29 VC-backed European startups acquired for a total disclosed price of $481.1 million in the same quarter last year, according to Dow Jones. While it’s true that M&A is still well below pre-financial crisis levels—VC-backed M&A totalled $1.44 billion in Q2 2007—market analysts expect the numbers to grow. Investment bank UBS forecasts that overall European M&A will rise by 15% to 20% by the end of the year.

At the root of the upswing in acquisitions are several coinciding factors, says Howard Palmer of European law firm Taylor Wessing. “There are vintage funds from 2002 and 2003 nearing the end of their lives,” he says. “There is increased appetite from bigger U.S. companies sitting on piles of cash, which they need either to repay to shareholders or use to invest in opportunities. And valuations have been lower over the past 12 to 18 months, so it’s a combination.”

IPOs, which also declined sharply after the 2008 financial crisis, have yet to make a convincing comeback in Europe. Some recent attempts, such as fashion retailer New Look and online grocer Ocado, have flopped, discouraging other aspirants. New Look is 60% owned by Private Equity houses Apax and Permira, while Ocado is owned by a broad collection of VC and other investors, including Al Gore’s Generation Investment Management, TetraPak’s Jorn Rausing, Procter & Gamble and three Goldman Sachs bankers.

“Where you have a venture capital success story, and you need extra funding, you either go to your shareholders or you look towards M&A,” says Palmer. “There are many companies which are doing very well. They have a strong business pipeline, they’re out-performing the market, but they can’t raise debt from banks to expand at the rate their customers want them to.”

Others point to changes in legislation as a potential trigger for increased M&A activity. Patrick Wilkins, regional director at Venture Structured Finance in the United Kingdom, argues that the new British government’s plans to raise the capital gains tax could spur activity. “It could kick-start the M&A transactional market, as many business owners have sat on their assets for the past 18 months,” Wilkins says. “This may force them to act.”

Once companies realised that we were out of the recession, they said to themselves, ‘OK, our business is secure, we have large piles of cash, so the only way to achieve growth is through acquisition.’”

Anne Glover

Spike in July

The flurry of large scale deal activity that took place in mid-July, including a $4.5 billion bid for U.K. conglomerate Tomkins, helped to create an atmosphere of possibility.

Wilkins points to other, more fundamental issues that need to change, however. “Greater business confidence and improved levels of sensibly priced debt finance are essential ingredients for higher M&A activity,” he says.

Anne Glover, CEO of European venture capital fund Amadeus Capital Partners and an executive director of the European Venture Capital Association (EVCA), believes higher rates of M&A are inevitable. “Once companies realised that we were out of the recession, they said to themselves, ‘OK, our business is secure, we have large piles of cash, so the only way to achieve growth is through acquisition,’” Glover says.

From Glover’s vantage point at Amadeus, M&A prospects are relatively rosy. In June this year Amadeus sold portfolio company Secerno, which provides data security, to Oracle for an undisclosed price. Secerno raised $3.8 million VC funding in 2006 followed by a further $16 million in 2008.

Amadeus is having “continuing conversations with other acquirers,” Glover says. She concedes, however, that other venture capitalists may not be so confident. “Some think we’re on the verge of a double dip [recession], some are ‘worry warts,’ and some are in very hot markets,” she says. “It’s very sector specific. If you’re in iPad applications, that’s a very interesting space at the moment.”

We feel that Europe is a fertile place for acquisitions right now, especially for the large U.S. IT companies who are very cash generative but are concerned about falling behind in the tech race. A company like Symantec needs to transition to cloud technology, so it needs to buy.

Simon Clark

As Glover notes, consumers are adopting technology at a rapid pace. “Even in poor and under-privileged countries, they’re still buying phones and applications,” she says. “And in general, the move from voice to data is inexorable. It’s a long-term trend.”

For all the gradual uptick of deal making and confidence, there remain some significant barriers to market rejuvenation. Assessing a company valuation is currently problematic. Volatile stock markets mean that using share price to determine value is impractical. Few IPOs have taken place, making these forms of comparison difficult. Continued banking conservatism compounds the issue. Even using discounted future cash flow is a problem, with more than usual uncertainty over trading conditions.

“Markets work well when all avenues to liquidity are open,” says Simon Clark, chairman of the Venture Committee at the British Venture Capital Association (BVCA) and managing partner at Fidelity Growth Partners. “So having a flourishing IPO market is good, partly because it keeps buyers honest. But we feel that Europe is a fertile place for acquisitions right now, especially for the large U.S. IT companies who are very cash generative but are concerned about falling behind in the tech race. A company like Symantec needs to transition to cloud technology, so it needs to buy.”

Loosening the Purse Strings

With more VCs seeing liquidity for past investments, they are now putting more money to work in new and follow-on deals. Second quarter figures for European venture capital investment came in at $1.4 billion across 289 deals, against $1 billion by value for the same quarter last year according to Dow Jones.

In 2006 and 2007, VC investment in Europe was routinely above $2 billion per quarter, but nobody is currently predicting a return to these levels within the next 18 months.

[The British government’s plans to raise the capital gains tax could] could kick-start the M&A transactional market, as many business owners have sat on their assets for the past 18 months. This may force them to act.”

Patrick Wilkins

Still, recent deals indicate renewed confidence among VCs, such as the $38.5 million investment in Internet publishing company Squarespace by Index Ventures and Accel Partners; the $9 million financing for tech company Tagsys by DFJ Esprit and other investors; and the $9 million investment in online fashion retailer my-wardrobe.com by Balderton Capital.

Clark of the BVCA says that Europe’s bankers have already factored in a rise in M&A deal making and that the average size of venture-backed deals is likely to continue rising. The average size of European venture capital deals was $2.94 million in the first half of this year, up from $2.4 million in the first half of 2009, according to Dow Jones.

The increased deal size is ascribed to a growing risk aversion, as investors seek out later stage opportunities and turn away from seed and early stage investments that were popular in headier times. “Acquirers want to see enough scale,” notes Clark. “They may decide to buy a small company for its technology, but often they want something larger that will ‘move the needle.’ Growth equity is a popular investment position, going in at a later stage and holding onto the investment for longer.”

This trend away from startups is confirmed by figures from the U.K.’s National Endowment for Science Technology and the Arts (Nesta), which released a report in July showing that investment in early stage companies has fallen 40% since summer 2008. Nesta Chairman Mike Lynch argues that while venture capital is a cyclical business, “There is a structural change that is more worrying. Venture capital firms that would have been happy investing £1 million to £2 million in a startup have shifted to backing £100 million private equity deals,” he says.

Yet for every raincloud there is a silver lining. “This is the best time to invest, because you can get in at a good price,” says Lynch.