Asset Management

FEATURE: Europe's Wealth Managers Are Just Not That Into Venture Capital

Tom Burroughes Group Editor London August 30, 2012

FEATURE: Europe's Wealth Managers Are Just Not That Into Venture Capital

An investment sector that has been the toast of Silicon Valley and is sometimes fawned over by politicians hoping to fix economic problems, venture capital is not feeling loved right now. Will wealth managers learn to like it again?

For an investment sector that has been the toast of Silicon Valley and is sometimes fawned over by politicians hoping to fix economic problems, venture capital is not feeling loved right now. Will wealth managers learn to like it again?

While the UK government, for example, has sought to boost tax-deductible investment portfolios for fledgling businesses (Enterprise Investment Schemes, for instance), in general, the climate for venture capital has been poor. For example, the market for initial public offerings has been slow – and the recent debacle of the Facebook IPO hasn’t helped. And yet at a time when traditional bank funding has been squeezed by tighter bank capital rules, there is a need to find alternative sources of financing for the Googles, eBays and Apples of the future.

Venture capital falls into that broad asset class known as private equity but as far as many European clients are concerned, venture capital is far less attractive than other private equity species, such as buyout funds or distressed debt vehicles. (There appears to be a more significant interest in venture capital among US clients, where the sector is better established.)

One obstacle is clients’ demand for liquidity: venture capital is not a liquid asset class, given that a fund can take up to 10 years to bear fruit. Jonathan Bell, chief investment officer at Stanhope Capital, the European private investment office, said his firm puts as much as 9 per cent of his more aggressive clients’ money into private equity, but venture capital does not get much of a look-in.

“Venture capital and private equity investments do not suit the majority of our clients given the liquidity constraints, risk profile and work involved in investing in them,” he told this publication. “We prefer to avoid venture capital investing entirely given the higher risks involved, this means that we will not be seed investors in the next Facebook or Apple. However, we aim to invest in good growth businesses at the development capital stage,” Bell said.

Bell said that as far as his clients are concerned, they prefer distressed credit funds with a two-year investment period and a total life of five years and in distressed property related funds with similar lives. Most of the funds clients invest in have a target internal rate of return, after fees, of around 15 per cent, and a multiple on invested capital at around two times. (IRR is the standard industry measure of returns, designed to capture the complex timing of deals.)

William Drake, co-founder of Lord North Street, another private investment office catering to ultra high net worth families, said that unless a wealth manager can get access into the best venture capital funds – not an easy task – the sector holds few charms.

“Basically, very few people have managed to make any money out of venture capital over the years, the exceptions being a few well known and very oversubscribed funds in the US. The problem is you need a huge success every now and then to make up for all the companies which fall by the wayside; but you can never predict when or if the success will happen,” Drake said. “If you can manage to get access to the top VC funds in the US you should do so, but probably not otherwise.” (Drake is a member of this publication's editorial advisory board.)

Robert Farago, head of asset allocation at Schroders Private Banking, echoed Drake's point. 

“The reality of venture capital is that there are a small handful of firms, pretty much all of them in the US, with strong records. If you have invested in them, then you have done phenomenally well," he said. But Farago said that getting access to the best funds is often very difficult. “They can easily fill their coffers every time they raise a fund,” he said.

Rock stars and wannabes

Part of the problem is that the spread between the venture capital rock stars and tone-deaf no-hopers is wide. According to Preqin, the research firm, the gap between performances can be so large that it reminds would-be investors to avoid the sector unless they have the nous to spot the best managers early. That is no easy task.

With such long-term investments, the key is to check the “vintage” year of a fund – the date it was set up – and then track performance. Funds started in the mid- to late-1990s showed some terrific performance, not surprisingly perhaps as these were the dotcom boom times. For funds launched in 1997, top-quartile funds delivered annualised IRRs of 71.9 per cent; the median IRR for vintages of that year was far lower, however, at 25.2 per cent; the lowest-quartile IRRs were a measly 2.6 per cent. (These figures are after fees.) Move to say, 2009, the latest year for which full figures are available, and the top-quartile IRR was only 15.3 per cent, the median number was 3.8 per cent and the lowest quartile actually was in the red, at -7.1 per cent. When these IRRs are put onto a graph with vintages from 1982 through to 2009, the lines resemble a sharp Alpine mountain peak around the late 1990s, followed by a cliff, and then a flat plain with the odd small bump.

Still grounds for hope

But Preqin is certainly not going to write this sector off. “Industry-wide performance for the venture space is relatively flat right now, but despite this outperformance is still possible,” it said in a note to this publication.

“With a great deal of innovation occurring in fields such as social media, healthcare and with companies outsourcing their research and development to start-ups, there are certainly opportunities for investors in the venture capital space. The key issue for institutional investors is fund manager selection. Due to the significant gap between the top and bottom performing venture capital funds, investors have to be confident in their abilities of sourcing those managers that can offer the highest potential for investing with ‘home run’ companies and deliver higher than average returns,” it added.

That there is a need for seed financing and support for small firms is not in doubt. A few days ago, it was reported that Bibby Financial Services discovered a “huge shortfall” in the level of funding available, despite claims by banks that they are approving most applications for lending.

According to the European Private Equity and Venture Capital Association, in 2011 fund-raising increased by 80 per cent to €40 billion (about $52 billion) from 2010’s level. Interestingly, venture capital contributed to this trend with its 50 per cent increase in 2011 from the previous year. Among early-stage venture capital funds, €1.9 billion was raised in 2011, a rise from €1.0 billion a year before; among late-stage venture capital funds (focusing on older firms), the amounts were €1.0 billion and €600 million for 2011 and 2010 respectively. In contrast, private equity buyout funds raised almost €26 billion last year, although that amount is way below the €65.4 billion for 2008.

Meanwhile, 135 venture capital funds were raised last year, the association said, with government agencies providing the single-biggest chunk of money, at 34 per cent. As for family offices, they only provided 2.1 per cent of venture capital funds last year; private individuals accounted for 14.1 per cent, and banks made up 9.8 per cent (not all of such banks might be acting for wealthy clients, however). Data on investments as a share of GDP show that in Europe, not a single country has an example of venture capital investments making up more than 1.0 per cent of GDP. (The largest, Luxembourg, has a percentage ratio of just 0.24 per cent).

The European Commission has weighed in on the subject of why Europe’s venture capital industry is not – yet – following in the footsteps of Silicon Valley legendary firms such as Sequoia Capital or Kleiner Perkins Caufield & Byers. (That’s not to say there are not significant European firms, such as Index Ventures.) The Commission notes on its website that Europe’s market is still fractured by separate rules and tax codes among different EU member states. The Commission says it is looking at how to forge a more unified market. This will take time, as demonstrated by the length of time to create a pan-European funds market.

European venture capital is not yet a big draw for the wealth management sector even though high and ultra net worth individuals do commit to venture capital and in non-trivial amounts. If wealthy investors are going to get behind the vital growth engine of venture capital, it is likely to only happen when people cease to demand such a high price for liquidity and when the market environment for encouraging small firms to take flight turns far more favourable. Let’s hope the wait is not too long and budding entrepreneurs get the funds they need.

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