Global VC trends

VCs stockpile cash, overhang reaches $60bn, China & India make their mark, exits and liquidity strengthens.

Venture capital investing sustained its momentum in 2005 in the major markets of the U.S., Europe and Israel, according to the annual year-end analysis by Ernst & Young LLP and Dow Jones VentureOne. TheChilli highlights and analyzes several key trends in the global venture capital market.

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VC fund-raising surpasses 2004, fund rises by 24 percent YTD
During the course of 2005, fund-raising by venture capital firms increased significantly with venture capitalists stockpiling the most investment capital since the bubble era of 2001.

At the third quarter mark, $19.4 billion (€15.6 billion) has been raised in new venture capital funds in the U.S., Europe, and Israel—an increase of 24 percent from the same period a year ago. Despite an overhang of world-wide venture capital funds estimated to be more than $60 billion, venture capital firms continue to find a robust level of interest from limited partners and are raising funds at a pace expected to surpass last year’s figure of $20.1 billion (€16.5 billion).

TheChilli perspective: with such a large amount of funds being committed to VC funds, it will inevitably create more competition for good quality deals. One cannot assume that all the committed funds will actually be called up, as this will depend on the ability of the VC’s general partners finding suitable deals in which to invest. The vast majority of funds outside the key technology cluster deals have a ‘use it or lose it’ mentality, which inevitably leads to some really poor quality deals with very little chance of reaching successful exits. One must also be careful to note that headline figures may hide some true destination of the funds, which may end up in leveraged buyout deals in non-technology related projects.

Exits up
Venture-backed company exits also grew in value and number. The U.S. and Israel saw increasing M&A valuations, while Europe experienced an increase in IPOs. In the U.S., 255 companies were acquired through the third quarter of the year for a total amount paid of $21 billion. This represents a 13 percent increase in the aggregate M&A proceeds even though 51 fewer companies were acquired compared to the same period last year.

The median amount paid for acquired companies in the U.S. rose to $60 million through the third quarter of 2005, up from a median $40 million for the previous year. VentureOne/EY expect to see 2005 finish with significantly higher M&A valuations, which are driven by more mature companies being acquired and increased competition from buyers.

TheChilli perspective: increasing stock prices of leading technology companies means they are increasingly able to use stock as trading currencies to buy out companies, which make up for the R&D deficit incurred during the lean years. Many of the M&A deals are for defensive reasons, where acquisition leads to ownership of key patent portfolios, rather than an addition to immediate top line growth. Sometimes the acquisitions are spurred on by their customers who can see a good technology fit but would like to buy it from a stronger, larger vendor, as opposed to a small venture-backed start-up.

Europe IPO healthy lead by AIM, VC fund-raising also trebles
In Europe, there has been renewed IPO activity this year. Thirty-five venture-backed IPOs were completed through the third quarter of the year, raising $1.1 billion (€889.1 million). In the same period in 2004, European venture-backed companies conducted 22 IPOs, which raised $628 million (€522.7 million). One factor that may have contributed to the IPO increase in Europe is the maturing of the AIM and new exchanges such as Alternext that are making it easier for smaller companies to achieve exits via the public market. At this pace, we can expect to see 2005 finish with IPOs in excess of 75 in the U.S. and Europe.

TheChilli perspective: some commentators feel that the relaxed ‘light touch’ regulation, the junior markets, may have swung too much to almost ‘no touch’, and if not addressed properly could lead to a hollowing out of this market, as happened previously with the Neue Markt in Germany. Quite a few companies coming on the junior markets are not fit and too premature for public funding. They suffer from poor liquidity due to lack of solid, post IPO performance. Inevitably, some will not be able to survive without a second tranche, which may not be forthcoming, unless they can deliver regular performance. Technology companies with heavy burn rates and R&D budgets should heed this before eagerly rushing to the junior IPO market.

The US markets’ disinterest in IPO is directly related to the cost of complying with Sarbanes Oxley regulations (SoX). Unless a company has reached around a $50 million revenue base, it would be difficult to justify the $1m to $2m cost and resources of complying with SoX. Besides, unlike the old days, companies going IPO will have to deliver solid results and constant growth for the next three or four quarters, and that measure of confidence isn’t there yet for a vast majority of venture-backed pre-IPO companies in the U.S. Instead, companies are finding it easier to create mergers, giving more time and delaying the inevitable twin drivers or barriers (depending on which way you look at it) of SoX and constant growth.

VC output almost flat
In terms of investment, 2,405 venture-capital financing rounds were completed in the U.S., Europe and Israel through the third quarter of the year, with $20.1 billion (€16.2 billion) invested, according to the venture capital financing details released quarterly by Ernst & Young LLP and Dow Jones VentureOne. This represents an overall decline of 10 percent in the number of deals and 3 percent in amount invested compared to the same period of 2004. Total venture financing in these three markets in 2005 is likely to be comparable to the $27.4 billion (€22.1 billion) invested last year—if this trend continues.

TheChilli perspective: European VC funds’ investments into technology companies for three quarters of 2005 was €2.5 billion, which is slightly below last year’s €2.7 billion for a similar period. The good news is that the amount of funds going into European VC funds for the three quarters of 2005 was almost three times higher at €2.4 billion compared to €800 million last year; this means that 2006 is going to be an exciting year for VC investments.

Emerging Markets – China and India
Developments in the emerging venture capital markets of China and India during this period underscored the increasing globalization of the venture capital industry.

“Venture-capital investment in China and India, as well as in the emerging markets of Eastern Europe and Russia, underscore the increasing importance of innovation and venture-capital opportunities outside the established hotbeds,” said Gil Forer, global director of the Ernst & Young venture capital advisory group.

Mr. Forer continued, “Investors are increasingly working with their portfolio companies to seize on the vast business development opportunities in the emerging markets. Private venture-backed companies must increasingly act as multinational companies earlier in their life cycle with a global approach to doing business, taking advantage of the new global ecosystem that matches the increased demand for innovation with international supply of talented human capital, innovative technologies and business models as well as capital. With modest exit markets for venture-backed companies and increasing global competition, capital efficiency will be a key success factor for portfolio companies and investors alike.”

On a global basis, China is becoming more and more of a factor in the venture capital market. “Overall, the venture capital eco-system in China is in its early days. The long journey to a mature eco-system, such as Silicon Valley, has started. The road has tremendous opportunities but also numerous risks,” said Mr. Forer.

What has been apparent is new deal flow in China, expected to reach up to $1.5 billion this year, and some already significant liquidity activity for Chinese companies in the U.S. markets, such as this year’s $109 million Baidu IPO and the $1 billion investment Yahoo! made in Alibaba.com.

In investment areas, it is expected that China will have several innovation clusters with the most popular focus being adapting technology applications to the local market. There has also been increasing fund-raising particularly with Silicon Valley and other U.S.-based investors initiating Chinese focused funds, opening offices in the country, or partnering with Chinese funds.

The decline in investment activity in China in the first half of 2005 has been attributed in part to the enforcement of a regulatory initiative by China’s State Administration of Foreign Exchange (SAFE), known as Circulars 11 and 29, that halted the establishment of the offshore corporate structures allowing foreign-venture capitalists—the largest source of venture-capital investment in China—to exit a Chinese company investment through an IPO on a foreign exchange.

In a development applauded by the Chinese Venture Capital Association and legal observers, SAFE recently issued new regulations (Circular 75) that laid out a new process for establishing offshore structures, restoring the exit path for foreign investors. As a result, Chinese venture-capital investment is expected to rebound.

In India, where the market is focused mainly on post venture private equity deals, activity by foreign venture capitalists in the first three quarters of 2005 helped to give venture-backed companies a boost. Deals in India include a $12 million investment by Nokia Growth Partners and New Enterprise Associates in Sasken, the Indian telecom company which went public earlier this month; a $10 million second round to the travel site Makemytrip.com from Softbank Asia Infrastructure Fund (SAIF); and a $10 million second round to HelloSoft, a U.S./India digital signal processing company, from investors such as TD Capital, Venrock Associates and Sofinnova Ventures. The increased interest by foreign VCs in India can be demonstrated by the recent announcement from DFJ about a new $200 million India fund.

There is also an increased R&D activity of Indian IT and IT-based services companies, as well as making acquisitions of western based companies and within Asia itself, thus creating its own regional technology clustering.

Stage of investment analysis
In the major markets of the U.S., Europe and Israel, a trend toward later-stage investment was apparent in 2005. In the U.S., the percentage of investments devoted to later-stage deals through the third quarter of the year grew to 50 percent, up from 45 percent in 2004. Europe experienced the same trend, with later-stage deals accounting for 50 percent of venture funding, up from 45 percent in the previous year.

Israel also saw a trend toward later-stage financings, with this round class accounting for 53 percent of capital invested in the first three quarters of 2005, up from 49 percent in 2004. The $9.8 billion of capital directed toward later-stage rounds in these three markets through the third quarter of 2005 was the most money devoted to this round class in this period since 2001.

“The large number of later-stage financings is a strong indication that the period of portfolio consolidation has largely ended,” said John Gabbert, vice president of worldwide research at VentureOne. “These investments suggest that venture capitalists are confident in the prospects of their portfolio companies and are willing to fund them to their next stage of growth with a view to a successful exit.”

Mr. Gabbert continued, “But also faring well for the continued state of venture capital is the fact that early stage investing began to pick up in the latter half of 2005 in both the U.S. and Europe. Seed- and first-round deals will likely represent a third of all deal-flow there by the end of 2005, proving that investors remain firmly committed to financing entrepreneurial innovation.”

While investments in venture-backed companies in 2005 remained relatively flat compared to 2004 levels, a strong trend toward later-stage financings suggests that investors are confident in the prospects of their portfolio companies and optimistic in regard to exit opportunities.

Internet related deals back in favour again: time for ‘Dot Com II’
In fact, in the U.S., nearly half (49 percent) of the companies receiving venture capital investment to date in 2005 had an Internet component, compared to 46 percent of the deals last year. In addition, those Internet companies received 47 percent of the investment capital, up from 41 percent last year.

By industry, biopharmaceutical and software companies continued to dominate venture capital investing in the U.S., Europe and Israel throughout 2005.

But certain areas of communications and medical-devices companies also saw significant new interest. For example, fiber optic equipment companies in the U.S. had 14 percent more deals in 2005 than in the same period a year ago. The number of deals for therapeutic devices companies was up 16 percent.

Also garnering significant interest from investors this year were products and services firms, which include a number of Internet companies. The number of U.S. deals in several key segments including business services, financial services, consumer services, and other online services posted increases over last year ranging from 13 percent to 100 percent.

Looking Forward
Looking forward to 2006, it is likely that the substantial fund-raising that occurred in 2005, a strengthening liquidity landscape, and investors’ global interests, will lead to an increased level of venture capital activity in the next 12 months. Because of the early signs apparent in 2005, the target for some of that investment capital may well be directed toward emerging areas such as alternative energy as well as renewed investing in the next wave of Internet start-ups.

© Chilli Publishing Ltd 2005

28NOV2005