Introduction

After the dramatic market corrections of 2000 and 2001, the European private equity and venture capital industry appears to be returning to a steady state, more reminiscent of the early to mid-1990s. For most firms, the pace of capital development has slowed, and with mergers and acquisitions (M&A) and initial public offering (IPO) markets quiet, portfolio exits are few and far between.

This has been a challenging year for the industry. The virtual shutdown of the IPO market has been exacerbated by renewed fears for the global economy and few are predicting much resurgence in capital markets activity during the next two years. But the slowdown has not been all bad news and the drop in investment rates is having some positive repercussions. First, venture capitalists are spending much more time with their portfolio companies - both before and after investments take place. This is good news for portfolio companies and for the limited partners in venture capital funds. The investment process is now more long-term: instead of funds closing deals in a matter of weeks, they now typically spend several months working with a company before committing to an investment.

Another benefit of the slowdown has been a renewed emphasis among venture capitalists on collaboration and the syndication of investments. Exits are more difficult to achieve in the short term, and interim financings less certain. Lastly, the slowdown has re-emphasized the importance of high-quality management in portfolio companies. Today's longer investment horizons require venture capitalists and managers to consider companies' needs (financial and strategic) over a much longer term. In other words, the industry has returned to fundamentals - steadily building sustainable businesses to achieve profitable exits.

A LONG-TERM BUSINESS

As it takes stock of developments, the European private equity and venture capital industry can take pride in the strength it has displayed through what have undeniably been difficult times. After all, fundamentals remain strong, the best funds are still attracting commitments and exciting deals are still getting done. And, looking ahead, there is certainly no lack of opportunity. For venture capital, the rich culture of emerging - and converging - technologies is creating some extremely interesting medium- and longer-term prospects across a number of sectors, including life sciences, nanotechnology and wireless. while in later stage companies, corporate restructuring, the privatization of state-owned companies or public companies and ownership and management succession requirements are all looking to private equity for solutions.

It is important to remember that private equity is a long-term business. The capital markets will, eventually, return to full function, even if it takes them several years to do so and, in cyclical terms, present market conditions make this the perfect time to be making shrewd investments. Bearing this in mind, investors and entrepreneurs are starting to take a much more realistic view on the management of investments, and the spotlight is on building sustainable financial support for the investee companies. Deals are being put together that make sense for investors, companies and the markets, and private equity firms are now prepared to stretch timelines to build longer-term deal structures. In this new environment, realization has become a key concern.

During the bubble period, high-tech companies could raise repeat funding on the strength of little more than platforms or concepts. The new back-to-basics mentality pervading the European venture capital industry means that portfolio and target companies have to be able to convert ideas into technology, technology into products and products into sustainable businesses. The focus now is on demonstrating marketable applications for technology. As normal cycles re-set up themselves, the European venture capital industry is switching back to the fundamentals of five- to seven-year investment cycles where technology investments are concerned. Adding value is a core concern, and the skills of the experienced private equity community will play an essential part in this process. Looking ahead to 2003, those teams that can build on experience gained from the downturn will be well placed to take advantage of the renewed market opportunities offered by corporate restructuring and more reasonable entry valuations.

2001 IN REVIEW: A MARKET IN TRANSITION

In the course of the last two years, and irrespective of pronounced market volatility, the private equity industry has remained both active and resilient. 2001 was a year of reorganization and stabilization of private equity portfolios, after the record levels invested and raised in 2000. The 2001 figures show comparable levels of activity with 1999, underlining the fact that the industry is returning to market normality. (See: fund raising and investments per annum)

The European Private Equity and Venture Capital Association (EVCA) Annual Survey of Pan-European Private Equity and Venture Capital Activity (undertaken by PricewaterhouseCoopers and covering 28 countries, including seven pilot countries) showed that €38.2 billion ($32.7 billion) of funds were raised in 2001, the second highest amount after the €48.0 billion raised in 2000. This represented an increase of more than 50% on 1999, and 20% less than in 2000. Of these funds, 56% (€21.5 billion) was earmarked for buyouts compared to 51% in 2000. Fundraising for future investment in high-tech, early stage and expansion companies decreased from 32% to a quarter of the total amount in 2001. Non high-tech early stage and expansion fund raising remained constant at 14% of total funds raised in 2001. (See: expected allocation of funds raised in 2001)

During the year, €24.3 billion was invested in 8,104 companies, in line with 1999 levels, but a drop of 31% on 2000. The UK continued to lead by amount invested, with 29% of the European total, followed by Germany and France. But, Germany led in terms of total number of companies attracting investment (1,969). (See: European private equity investment per country)

Of the total number of companies financed by private equity across Europe, over 45% were initial investments. This compares to the figure of 62% the previous year and indicates that a greater proportion of funds have been allocated to follow-on investment. Despite the tough economic environment, the total amount invested in venture capital (seed, start-up and development stage companies) was over €12 billion in 7,014 companies. There was sustained investment in the early stage (seed and start-up) field where 3,306 investments were recorded, accounting for 41% by number of all investments made. Expansion stage companies attracted €8 billion in investment, comparing favourably with 1999, when €7.4 billion was invested. The trend towards a more controlled back-to-basics investment distribution, the use of specific milestones, a greater number of (typically smaller) follow-on investments and realistic company valuations was highlighted by the drop in average investment size to €2.3 million, compared to €2.7 million in 2000. Specifically for venture capital deals, the average investment size was €1.3 million in 2001, compared to €1.7 billion in 2000. (See: stage distribution of investments in 2001)

Given market conditions, it is no surprise that high-tech investment fell in 2001 compared to 2000. The amount invested in companies operating in high-tech sectors was €6.9 billion, down by 38% on the previous year. Within high-tech, computer-related companies were ranked first by number, with 2,578 (€3 billion) attracting private equity. The highest amount of technology investment was invested in the communications sector. Investment in biotechnology decreased from €1 billion in 2000 to €844 million in 2001, but remained above 1999 levels.

The trend for pension funds to assume a significant financing role continued. Of the €38.2 billion raised for future investment, pension funds led as the foremost source of capital, accounting for 27% of funds raised (€9.8 billion), up from 24% in 2000. Banks followed with a 24% contribution (€8.7 billion) and insurance companies represented 13%. The amount of funds raised from non-European countries remained unchanged in 2001 at €12.8 billion, but its share of the total amount increased significantly from 27% in 2000 to 34% in 2001. Once again, in 2001 the largest proportion of non-European funds raised originated in the US (€9.6 billion). The UK remained Europe's principal fund-raiser, with 54% of the total - linked to the fact that many of the large pan-European firms are based in the UK. France followed with €5.5 billion, then Germany with €3.7 billion of funds raised throughout the year.

The amount divested in 2001, measured at cost, increased from €9.1 billion to €12.5 billion. Trade sales continued to be the principal exit route (accounting for €4.2 billion). The closure of the public market window was starkly defined by the sharp drop in IPO investments (from 249 in 2000 to 47 in 2001). Write-offs accounted for 23% of total divestment, up substantially from €700 million in 2000 to €2.8 billion in 2001.

INVESTMENT ACTIVITY IN 2002: A SILVER LINING FOR BUYOUT HOUSES

Continuing economic turbulence in 2002 has resulted in a tougher climate for venture capital, but it has also provided increased opportunities for buyout houses. The findings of the EVCA quarterly activity indicators for quarter 1 and quarter 2 2002 (produced in association with PricewaterhouseCoopers and Thomson Venture Economics) point towards an industry that continues to identify and exploit opportunity, both by looking to buyout investment and exit alternatives to the public market, as well as sustaining the support of entrepreneurs with extended follow-on investment. The decline in start-up financing continues, as venture capital firms increasingly focus on their existing portfolio investments and, under these circumstances, it has become more important than ever for entrepreneurs seeking start-up finance to be able to show the three M's - solid management teams, proven market and a level of seed money already in place. During the first half of 2002, €7.4 billion in new funds were raised. There was a difference of -70% during the first two quarters, from €5.3 billion in quarter 1 to €1.6 billion in quarter 2. This drop was related to a significant decrease in funds raised by independent firms. The total amount invested in the first half was €8.6 billion. Quarterly data indicates an increase in the second quarter of 39% on quarter 1, with almost €5 billion invested in quarter 2 (compared with €3.6 billion in quarter 1). During the same period, the number of companies receiving private equity investment rose by 2% to 1,260, compared with 1,236 in quarter 1. This surge in investment activity was explained by several large buyouts. Start-up companies, once again, felt the full force of the difficult economic conditions. €790 million was invested in early stage in the first half of 2002. Both the amount invested and the number of companies went down quarter-on-quarter. In quarter 2 2002, €340.2 million was invested in 864 early stage companies, against €450 million invested in 473 early stage companies in quarter 1. The expansion stage, however, had a different story to tell. Although the total amount invested in these companies fell by 3% against quarter 1 totals, the number of investee companies rose by 16% over the same period. This can be explained by a move towards the distribution of total investment into smaller financing rounds according to the achievement of certain milestones.

The heightened focus on management is borne out by the growth in the number of companies receiving follow-on investment (rising by 3% between quarter 1 and quarter 2). Total funds invested in follow-on rounds were €2 billion. The level of funds dedicated to new investment (€6.5 billion) was heavily affect ed by the amount of buyout activity in quarter 2, increasing by 64% to €4.0 billion from €2.5 billion in quarter 1.

Total divestment in the first half of 2002 was €2.4 billion. It was a sign of the times that the amount divested at cost during quarter 2 increased by 28% on quarter 1. A total of 774 companies were divested in quarter 2, compared to 490 companies in quarter 1. And although 25% of this can be accounted for by write-offs, the increase in divestment also shows how the private equity industry has been industrious in cleaning up portfolios and continuing to successfully find exit solutions in trade sales. What was interesting to note was that the number of exits through IPO increased from eight to 10 IPOs in quarter 2 compared to quarter 1.

ENTREPRENEURSHIP REMAINS AN ENGINE FOR ECONOMIC GROWTH

Whatever the short-term consequences of the present market slowdown, promising entrepreneurial businesses will remain key engines for growth throughout Europe. EVCA's 2002 "Survey of the economic and social impact of venture capital in Europe" underlines the importance of entrepreneurial business for economic growth, as well as highlighting the ways in which venture capitalists contribute positively to the rapid growth of companies to increase sales, employment, investment, research and development (R&D) expenditure and exports. Venture-backed companies harness the entrepreneurial spirit, provide tomorrow's technologies and create jobs. Since 1995, there has been a dramatic increase in venture capital investment in companies that are in their seed, start-up or expansion stages. The total invested in these young companies has grown from €2.6 billion in 1995 to €12.2 billion in 2001, and over the same period, venture capital's share of total private equity investment has, over the same period, also risen from 47.2% to 50%.

The responses of venture-backed companies in the survey prove that venture capital investment is crucial to the existence and success of entrepreneurial businesses. Overall, 94.5% of respondents said that venture capital investment had been an essential ingredient in their creation, survival or growth. 72% of respondents said that, without venture capital, they would never have come into existence.

The creation and growth of these young companies had a significant impact on new employment opportunities across Europe. A total of 16,143 additional new jobs were created after the investment by the 351 companies responding to the survey. On average, this equates to 46 per jobs per company. Venture capital investment was used to fund long-term, value-adding developments such as R&D, marketing and training. The largest post-investment increases in expenditure were in R&D. Marketing expenditure almost tripled post-investment in those companies that used venture capital to fund expansion.

Venture-backed companies view healthy cashflow, new product development, market acceptance and highly-trained employees as the most important value-creating factors. And to that end, venture capital investment plays a vital role in ensuring that companies achieve significant increases in their budgets for R&D, marketing and training.

POLICY PRIORITIES FOR EUROPEAN PRIVATE EQUITY GROWTH

One of the continuing aims of EVCA is to foster and expand growth in entrepreneurship and the development of successful businesses funded by venture capital and private equity across Europe. And, to this end, it continues to work closely with the EU, both through the Commission's Risk Capital (venture capital) Action Plan (RCAP) and its Financial Services Action Plan (FSAP), as well as through the activities of the Innovation Directorate of DG Enterprise. The ultimate objective of this activity is to close the 'venture capital gap' that exists between the US and Europe. Since the RCAP was launched, venture capital has multiplied in Europe by a factor of four and early-stage funding is much more widely available. There is also, on a European level, a steadily increasing emphasis on entrepreneurship.

Increasing incentives for entrepreneurial investment

For a truly entrepreneurial culture to develop, regulation and bureaucracy should be kept to a minimum. In some European jurisdictions, the procedures for company formation are unnecessarily convoluted and therefore act as a deterrent to enterprise. By simplifying the requirements for company formation and lightening the burden of regulatory and compliance costs, European governments can eliminate potential obstacles to enterprise. A strong understanding of the financial and managerial needs of entrepreneurial companies and of the mechanisms and requirements of venture capital and private equity investment among lawyers, accountants and management consultants is a prerequisite for the development of a genuinely entrepreneurial environment at all levels of the business community. Greater emphasis must also be placed on venture capital, private equity and entrepreneurship in secondary and tertiary education. If this environment is to become the norm, countries across Europe must also be prepared to ease legislation, where it exists, prohibiting individuals who have undergone bankruptcy from playing active roles in new company formations. The US framework, which recognizes the 'right to fail' as a part of the business learning process is already finding favour in Europe, and this trend needs to continue.

REFLECTING THE ROLE OF PRIVATE EQUITY AND VENTURE CAPITAL

The needs of entrepreneurship and the role of private equity and venture capital should be taken into consideration in the formulation of all national and pan-European policy. In legislative and regulatory contexts where total private equity (venture capital and buyouts) is directly targeted, policy-makers already engage in consultation with relevant experts and representative groups. But this approach will not be effective where legislative and regulatory measures have more general application, or are apparently unrelated to entrepreneurship. For example, EU merger control regulation (ECMR) should be amended with the intention of:

• preserving and, where appropriate, expanding the 'one-stop-shop' principle on which the ECMR is founded so as to set up a fully functioning internal market in private equity;
• reducing the regulatory burden on private equity providers in making unnecessary notifications, given that these transactions rarely raise any competition law concerns and the burden of notification frequently has the effect of tipping the competitive scales in favour of trade purchasers; and
• improving legal certainty for private equity providers by clarifying the scope of application of the ECMR to typical private equity transactions.

Given the residual lack of competition concerns raised by typical private equity transactions, these investments should generally fall outside the ECMR by operation of an exclusion similar to that for credit and other financial institutions. In the short term, the solution would be to provide a block exemption for private equity.

FACILITATING FUND FORMATION

For governments looking to reap the economic benefits of an entrepreneurial climate, fund formation is the best single tool at their disposal. But, despite the fact that most funds invest in more than one European country, and many individual investments are themselves cross-border, investment vehicles vary from country to country because fund structures are inextricably linked to taxation, which is in turn inextricably linked to national regulatory regimes. Because not all European fund structures are recognized throughout Europe, additional complications arise for funds investing in several national markets, imposing severe fiscal and regulatory burdens, and necessitating complex and expensive structures. Good news for lawyers, but not for the industry. Individual countries need to address the issue of fund facilitation by different routes, but with simplicity, efficiency and transparency as key common objectives.

DEVELOPING LONG-TERM CAPITAL SOURCES

Access to long-term sources of funding, such as capitalized pension funds and insurance companies, is essential if private equity and venture capital is to play a key role in fostering sustainable long-term economic growth. In particular, the development of pension funds is of critical importance to European society as a whole. The proposed EU Pension Fund Directive raises some key issues, notably where the adoption of a 'prudent person rule plus' is concerned. An inadequate implementation of this rule would jeopardize the development of the European private equity and venture capital industry by leading to severe disturbances in those countries that have already adopted a qualitative prudent person rule. Any forthcoming regulation should therefore leave these states with an opportunity to keep their present regulation so as not to incur massive divestments from the private equity and venture capital asset class by their pension funds. That being said, the 'prudent person rule plus' could represent an improvement to the existing situation in those states that do not allow their funded pension funds to invest in private equity. Any new regulation also needs to take account of the objectives set during the Lisbon Summit in 2000, and reiterated at the Barcelona Summit in March 2002 concerning the competitiveness of the European economy. Private equity and venture capital has a crucial role to play and therefore, and due to the importance of pension funds in the development of the industry, those institutional investors located in countries not having adopted a qualitative prudent person rule, should have the freedom to allocate at least 7.5% of their total capital to the private equity and venture capital class. The new Basel Capital Accord could also have an adverse impact on the financing of small- and medium-sized enterprizes (SMEs) through credit, as well as on equity investments provided by private equity and venture capital funds. Banks play an important role in the funding of SMEs, and the proposed Accord, by placing emphasis on banks' internal methodologies for achieving enhanced flexibility and risk sensitivity, could well rule out private equity and venture capital as an acceptable asset class in some circumstances. At the same time, it could reduce the direct involvement of banks in the private equity and venture capital industry via their own subsidiaries, as well as reducing the amount of bank-originated debt dedicated to young venture-backed SMEs and to buyout companies that have been restructured and revitalized by private equity funds.

ACHIEVING RESULTS ACROSS EUROPE

Although the EU remains positive about EVCA's policy priorities, due to the European system of passing regulatory changes a lot of work is still needed at the local level to lobby governments to modify their tax and legal environments.

EVCA is working to achieve this by using the transfer of examples of best practice on core issues relevant to the development of the private equity and venture capital industry (fund structures, merger regulation, pension funds, company tax rates, company tax rates for SMEs, capital gains tax for individuals, tax incentives for individuals investing in private equity, taxation of stock options, taxation of carried interest, entrepreneurial environment, and fiscal incentives for R&D) and is supporting the national associations with cross-border information.

In the present European environment, the absence of an efficient structure for all member states creates additional transaction costs arising from the use of foreign structures. This clearly results in a sub-optimal solution - for the private equity firms, and for investee companies. It is hoped that, in time, this benchmarking exercise will help to create a level playing field in Europe, benefiting the European economy by boosting entrepreneurship across the region.

For more information on EVCA's policy priorities for private equity, please contact +32 2 749 9510 to request a copy of the EVCA White Paper.

European Private Equity and Venture Capital Association
Minervastraat 4
Zaventem B-1930
Belgium
Tel: 32 2 715 0020
Fax: 32 2 725 0704
Website: www.evca.com