Glum Yet Hopeful

Fund-raising has been on a downward spiral since 2006, and things could get worse before they get better.

Worldwide, fund-raising plummeted to €22.2 billion ($30.4 billion) last year, down almost 47% compared to 2008, while European funds raised just €5.4 billion ($7.4 billion), down 35%, according to data from Thomson Reuters (publisher of VCJ). In the first three quarters of 2010, the amount raised across Europe is 9% lower than the same period a year ago.

Some firms are finding it easier than others. At the start of this year, Fidelity Growth Partners Europe, the venture capital arm of mutual fund manager Fidelity International, picked up €117 million ($160 million) for its first fund dedicated to investments on the continent, reflecting what the firm sees as the maturity of the European venture capital market.

“We’re lucky—we have Fidelity behind us,” says Simon Clark, a partner at Fidelity Growth. “It’s a long-term investor and a great believer in the asset class.”

Still, Clark shares some concern for the industry overall. “A lot of people are struggling to raise funds just now,” he says. “You need to maintain a level of funding for the industry to be viable and to be sure that you can fund businesses as they grow. Too much money is bad news, but too little money is also bad news. [Fund-raising] will always be painful, but what we don’t want is agony.”

The reason for the problem is two-fold, according to Clark, who is also chairman of the venture committee of the British Venture Capital Association (BVCA). Clark points to poor performance and a lack of liquidity as reasons why fund-raising has dropped and will remain glum.

Poor Performance

In the end, it’s all about delivering great results. Then investors [will] see that they do want access to the asset class after all. And that’s up to us as an industry.”

Simon Clark

It wasn’t that way 10 years ago, he points out, when firms raised a combined €24.2 billion ($33.2 billion) in Europe.

“But the industry hasn’t done very well in the last decade,” he says. “[The money has] been washing through the system. Now, there just isn’t an awful lot of money about. A lot of people are over-allocated in illiquid assets.”

The denominator effect has compounded the problem, says Mike Chalfen, a general partner at Advent Venture Partners in London. Following the collapse of global stock markets, portfolio managers were forced to rebalance to achieve their required asset allocation, as the proportion of public equities in the overall portfolio—or the denominator—shrunk. Given that venture funds aren’t priced as often, their allocations appeared to have held and billions of pounds worth of private equity and other alternative assets.

That position has improved of late, but the root of the problem remains. “As public equities have stabilized and, in some cases, appreciated, it’s become less bad,” says Chalfen. “But there’s still a huge liquidity problem. It’s hard to sell assets. Illiquid assets are more illiquid than they used to be.”

Chalfen also says that there used to be a belief among limited partners that performance would come through and that proceeds from private equity would fund further commitments to the asset class. That hasn’t happened to the degree needed to achieve the same large commitments that funds raised from 2005 to 2007, and LPs have grown impatient.

It’s perhaps not surprising that according to one institutional investor, the average European venture fund is taking 17 quarters (or over four years) to reach a final close. “It’s a massive change,” says Chalfen. “Not that long ago, no one expected to close a fund in more than a year.”

Significant pools of capital are coming in. Along with performance, that gives us reason to believe that the environment will improve.”

Mike Chalfen

Money on the Way

However, there are signs that things are on the up. Scandinavian public sector pension schemes have come to the market for the first time, and appetite is growing among family offices and sovereign wealth funds. “Significant pools of capital are coming in,” Chalfen says. “Along with performance, that gives us reason to believe that the environment will improve.”

But what will it take for the tide to really turn? “In the end, it’s all about delivering great results,” says Fidelity’s Clark. “Then investors [will] see that they do want access to the asset class after all. And that’s up to us as an industry. We need to see investors in the industry backing good firms and not backing bad ones. I’m worried that we [don’t] have enough experienced investors in the industry to make it work. It’s a bit close for comfort.”

The industry needs more success stories like Betfair, the online gambling site. Balderton Capital and Index Ventures, two of London’s leading venture capital firms, both sold a small portion of their stakes in the company when it made its public debut on Oct. 22 in a high-flying IPO that valued Betfair (LSE: BET) at £1.39 billion ($2.07 billion). Founded in 1999, the company now employs more than 2,000 people worldwide and processes more than 5 million transactions per day, more than all of Europe’s stock exchanges combined.

LPs also need to know that their money is in safe hands. As they reduce the number of relationships they have, they’re placing a higher burden on proof points—stable teams and sound processes, Chalfen says. “Everybody has recognized that discipline is required, and we need processes to make sure that discipline is continuously executed,” he says. “The days of doing what we want are over. People are held accountable for their [investment] strategies.”

Against this backdrop, good companies will still be able to raise money at attractive prices. For instance, one of Advent’s investments has attracted six expressions of interest from trade and private equity buyers in the past month, says Chalfen.

The [VC] sector’s exit track record is going to change dramatically at some point—for the better. I don’t know if that will be 2011 or later, but the underlying performance of the businesses in venture portfolios is very, very good.”

Richard Anton

One of Europe’s original transatlantic venture funds, Atlas Venture, moved its European operations to Boston earlier this year, and there is industry consensus that further consolidation is likely.

Consolidation Isn’t Bad

“I’d like to think that in 2011 we’ll see the really good firms performing well and proving that they know what they’re doing, and the not-so-good ones will slowly disappear—that’s clearly happening,” Clark says. “Those that lose the confidence of their own investors—big or small—will be unable to raise a new fund and will disappear. Some of the small players are the ones who’re growing right now.”

PROfounders Capital, the entrepreneurial VC firm backed by Brent Hoberman from and Michael Birch from Bebo, has invested in four tech companies since it launched last summer: games-based educational site; made-to-order furniture retailer; buying club Keynoir; and mobile and desktop applications business TweetDeck.

While the IPO market might remain subdued, Richard Anton, a partner at Amadeus Capital Partners and vice-chairman of the BVCA, says he believes the cash-rich private equity sector will increasingly acquire venture-backed businesses.

“On the supply side, private equity firms have lots of cash,” Anton says. “And, on the demand side, venture-backed companies are much more mature than they have been historically. Many have reached the stage where they have good forward visibility—visibility of revenue growth and cash generation—and those are the ingredients that private equity firms need.”

To wit, VC-backed Sophos Plc, an IT security and data protection provider, inked a definitive agreement in May to sell a majority interest to U.K. PE shop Apax Partners for €605 million ($830 million). The deal represents an exit for TA Associates, which paid $61 million for a minority stake in Sophos in 2002, according to Thomson Reuters. Another recent VC-backed company to get acquired by a PE investor is EPiServer Group AB. In November, IK Investment Partners, the Pan-European private equity firm, bought EPiServer from Amadeus Capital and Northzone Ventures, which had invested an undisclosed amount in the Swedish software company. (EPiServer had planned to go public in June, but a weak financial market compelled the company to withdraw those plans.)

Despite the gloomy environment for fund-raising today, eternally optimistic venture capitalists are confident that returns will improve, bringing LPs with them. “The sector’s exit track record is going to change dramatically at some point—for the better,” Anton says. “I don’t know if that will be 2011 or later, but the underlying performance of the businesses in venture portfolios is very, very good.”