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Martin Essex reports on the importance of venture capital, the money injected into start-ups and small companies. It is hard to imagine a more important element in the creation of a vibrant economy than a plentiful supply of venture capital to enable new businesses to prosper. It gives the investor a stake in the business and, more important in economic terms, it gives the company's management the funds to invest in capital, staff, research and development, and all the other prerequisites to turn a good idea on paper into a thriving, successful and profitable enterprise.
Not only is this true in theory, but the facts support it. In the UK, for example, there is a thriving private equity industry, private equity being the broad term for venture capital and the injection of funds from outside the public markets into larger, well-established companies in return for a share of the business.
In Germany, by contrast, there is precious little private equity, the culture there being one in which most corporate finance is provided by the banks in the form of debt. The result is that the UK economy is growing at a healthy pace while the German economy is sluggish.
Of course, there are many other factors behind this UK out-performance - the monetary policy regime, fiscal policy and a need for market reform in Germany, to name just a few. But the importance of the ready supply of venture capital in the UK should not be underestimated.
It is that which turns an idea in the mind of a university scientist, for example, into the next technological wonder or the drug that will alleviate suffering.
In the UK, this is widely recognised and start-ups can often attract both government funding and venture capital as long as there is the prospect of a commercial return and an exit for the investor through a route such as a share listing on a public market, a trade sale or a disposal to another private equity firm.
Looking at UK private equity as a whole, the so-called 'buy-out' market is buoyant. According to a study by the Centre for Management Buy-out Research at Nottingham University Business School, £16.2bn was invested in 2003, and in the first three months of 2004 the rate had increased to £5bn invested from a total of 155 buy-outs. In the following quarter investment was £7.9bn, ensuring that 2004 would exceed 2003.
This prompted Mark Pacitti, Private Equity Partner at Deloitte, the financial services firm that co-sponsors the Nottingham centre, to state that the statistics give further, and much welcomed, evidence of a sustained recovery in the buy-out market. "Following a year of volatility and fragile signs of recovery in 2003, we have now had two successive quarters where the value of deals has been over £5bn. This is the best performance since 2001," he said.
Tom Lamb, Managing Director UK at Barclays Private Equity, the other co-sponsor, noted: "The recovery is broadly based and, encouragingly, is not dependent on a small number of jumbo deals."
However, the report was not entirely good. Private equity firms continued to have difficulty exiting from the companies they had already invested in, prompting Lamb to say that a further decline in exit activity was certainly not in the script. "With the stock market on a stable footing and the economy in good shape, venture capitalists expected to open their doors to find an orderly queue of trade buyers. In fact, the trade buyer looks more like becoming an endangered species with only 13 trade sales to date this year. The run rate of trade sales is now at an alarming 13-year low," he warned.
Another concern is evident from the data collected by the British Venture Capital Association. BVCA figures showed that UK private equity firms increased their investment activity and fund raising in 2003: its Annual Report on Investment Activity, based on a survey of its 164 member firms, revealed that they invested £6.36bn, an increase of 16 per cent on the previous year. Funds raised also increased, from £7.82bn to £8.89bn.
However, more than 90 per cent of the funds raised were expected to be invested in buy-outs (an 87 per cent increase), with 58 per cent of the £8.89bn total going to buy-outs valued at more than £100m. Just three per cent of the capital raised - or £301m - was intended for early-stage and expansion technology investments, according to the survey, down from five per cent in 2002.
BVCA Chief Executive John Mackie says it is too early to tell whether this decrease in funds available for technology investment is a cause for concern. He says the excesses of the technology boom in the late 1990s are still working through the system but that a number of early-stage venture-capital firms are likely to hit the fund raising trail during 2005.
This concern was also evident in the data for European venture capital activity collected by the VentureOne business of professional services firm Ernst & Young and the media group Dow Jones. These figures showed that an improvement in European venture capital investment levels at the end of 2003 proved to be short-lived. After recording 303 deals totalling e829m in the fourth quarter of 2003, there was a sharp fall in the first quarter of 2004 with just 172 deals, and the amount invested reached only e619m. Even comparing like-for-like periods, that was a sharp fall too on the 286 deals totalling e786m in the first quarter of 2003. The decline was more modest in the UK, which remained the largest European market, but the number and value of deals was still lower.
So what can be done to improve the situation? The legal environment in which venture capital investment takes place is just as important as the size of a country's stock market in stimulating investment in the sector, according to research from Cambridge University's Centre for Business Research.
It had been thought that the depth and liquidity of capital markets was the key factor controlling the supply and demand for venture capital, said the report by academics John Armour and Doug Cumming. However, while their research confirmed the importance of stock markets and economic growth, it concluded that legal factors are of equal importance. Favourable tax and legal environments help the establishment of private equity funds and increase the supply of capital, the research suggested.
Against this background, it is perhaps not surprising that the Chairman of the European Private Equity & Venture Capital Association, Herman Daems, said after his appointment in June that the priority for his 12 months in office is to ensure that venture capital is fed into high-technology companies. "If there were only one priority, it would be to make sure we get the level of high-tech investment and fund raising for high-tech companies back to a good level, because it's been under pressure," said Daems.
As for how that can be achieved, the Chief Executive of the German Private Equity & Venture Capital Association has little doubt. Germany needs less bureaucracy and more entrepreneurs. In particular, there should be a better understanding that risk-taking must be rewarded, said Holger Frommann.
In the UK, arguably, there is already less bureaucracy and more entrepreneurship. Moreover, the Labour Government and the Conservative Opposition are united in their support for the venture capital industry. Yet Oliver Letwin, the Conservative Shadow Chancellor, is convinced further improvements are possible. A Conservative Government in the UK would consider changing the tax regime to boost venture capital, he says, and would make it easier for private equity firms to exit from their investments by floating them on the public markets. But there would be no new regulations to benefit the industry.
"Our attitude is more open and a good test case of whether we are serious about making the tax system simpler and deregulating," said Letwin, sentiments that would no doubt be welcomed by the managers of many start-up businesses keen to attract funds from the UK venture capital industry. Biography
Martin Essex is editor of Real Deals, Europe's private-equity and venture capital magazine. He previously spent two years as senior economist, specialising in the euro-zone, at Capital Economics, a London-based consultancy. He has worked as a financial journalist on radio and television, and for newspapers and magazines, including periods at the BBC and Reuters, IFR and Euroweek, The Scotsman and Sunday Business, where he was Economics Editor. He is co-author of the Reuters Guide to World Bond Markets, published in 1996.
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