United Kingdom: Market introduction

Author: | Published: 4 Jan 2001
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Last month the BVCA held its annual dinner for the UK private equity and venture capital industry. A staggering 1400 people attended. It was three times the size it was just three years ago. This is representative of the growth, success and popularity of our industry. BVCA members invested almost £8 billion ($12.8 billion)in 1999 and over £1billion of that was in high-technology companies. Both were record figures. However, recent statistics show that we are on track to beat those figures this year.

1999 WM/ BVCA Performance Measurement Survey

Below are the results from the 1999 WM/ BVCA Performance Measurement Survey. WM first conducted the annual survey for the BVCA in 1996. By the end of 1999, around 95% of BVCA member funds that raise money from institutional investors participated in the survey. This makes it the most complete single country-specific survey on the performance of venture capital and private equity in the world.

   No of funds  1999  3 years  5 years  10 years
 Early stage  28  40.9  15.8  16.7  8.7
 Development  48  43.8  30.4  27  12.6
 Mid MBO  43  23.5  19.9  22.1  17.4
 Large MBO  44  23.9  31  26.4  23
 Generalist  46  50.3  39.2  32.3  22
 Total  209  33.6  31.1  27.2  20
 UK  189  37.3  32  28.1  20
 Non-UK  20  26.5  29.1  24.3  20
 Technology  45  40.8  24.5  19.4  11.3
 Investment trusts  20  83.9  32.1  28.7  16.8
 FTSE All-share    24.2  20.4  20.3  14.9
 FTSE 100    20.6  22.2  21.8  15.6
 FTSE SmallCap    53.8  15.5  15.6  10.8
 WM All Funds Universe    21.3  17.3  16.3  12.5


Economic impact of venture capital

For companies that receive venture capital, it marks the beginning of a relationship that will generally span three to seven years or more. Venture capital firms not only commit funds, but also contribute their experience, contacts and advice to companies in which they invest. A survey conducted by BVCA and PricewaterhouseCoopers found that over the four years to 1998, on average, venture-backed companies' sales rose by 40% per annum (more than double FTSE 100 companies). Their exports grew by 44% per annum, compared with a national growth rate of 8% per annum, and their investment increased by 34% per annum, compared with a national increase of 7%.

They also increased their staff levels at a rate over three times that of FSTE 100 companies and almost 60% faster than companies in the FSTE mid-250. The number of people employed in venture-backed companies increased by 24% per annum, against a national growth rate of 1.3% per annum. Over 2 million people in the UK are estimated to be employed by companies backed by investment from UK venture capital.

Changing structures and strategies

The UK private equity and venture capital industry is the second largest to the US, and leads the way in Europe, accounting for almost half of all European private equity investment. In the second half of 2000, the first signs of a changing market in Europe are beginning to appear. The number of buyouts, as a percentage of all European private equity, is declining, although average values continue to soar. This is evidence that the emergence of a US-style split between a venture capital market and a larger buyout market is becoming more pronounced. According to research company, Initiative Europe, early stage venture capital investment has risen by over 450% in value terms over the last five quarters. The internet, telecoms and software sectors have been the major driver behind this coming of age of the European venture capital industry.

Initiative Europe has also found that around half of the capital raised so far this year has been for venture capital funds with a technology bias. The rush to fund innovative new technology companies has attracted a raft of investors into the market, including estimates of over 200 new incubators in Europe, as well as encouraging existing players to build technology focus into their fields of interest. Corporate-venturing activity in Europe is on the increase. Many of the large US technology corporations, as well as a growing number of European players, have funds designated for investment in new technologies. It is likely that the investment activity in high-technology companies will be maintained over the next few years, despite fluctuating attitudes to internet investment outside the private equity sphere. However, venture capital organizations are now focusing more on opportunities in internet enabling technologies, telecoms and wireless.

Drivers behind the early stage/ technology investment boom

There have been a number of drivers. The first is most certainly the growth of the internet and the globalisation of the technology market. Secondly, we have seen an improving attitude towards risk in the European culture. Thirdly, better liquidity for early-stage investments is afforded by the secondary stock markets. And lastly, market/ shareholder pressure to restructure businesses has become stronger.

Relying on funding from overseas

While the investment activity of the UK venture capital industry continues to increase, the investment into it by UK pension funds has declined. Our industry relies on overseas investment, particularly from the US. In 1999, 69% of our investment money came from overseas sources, the majority of which was from the US. Less than 10% came from UK pension funds.

In January the BVCA commissioned one of the most important pieces of research supporting our industry's efforts to obtain recognition of UK venture capital and private equity as a mainstream asset class. The London Business School's independent report was entitled UK Venture Capital and Private Equity as an Asset Class for Institutional Investors. Encouraged by the NAPF to address any misconceptions, the BVCA asked London Business School to produce a full and independent report on the UK private equity industry.

The report analyses and answers the questions raised about returns, risk, cash flow, volatility, liquidity, and of course the issue of the impact of the minimum funding requirement (MFR). London Business School found that while a private equity investment will only lead to a very small deterioration of the MFR position for first-time investors, it has biased trustees' asset allocation decisions against private equity. The MFR has provided a barrier to meeting the government objective of encouraging institutional investment in private equity funds. The report also says that a diversified private equity portfolio can be used as a long-term cash generator, suitable even for mature pension funds.

Recent evidence, since the report was published, suggests that a number of the larger UK funds are beginning to recognize the opportunity that venture capital presents, and to increase their allocations accordingly. We are hopeful that this downward trend will now begin to reverse. We particularly welcome the Paul Myners' review of the fund management industry, commissioned by the Treasury in the last Budget, investigating any barriers, regulatory or fiscal, that prevent institutions investing in our asset class. We look forward to his findings, which will be reported in time for the Budget in 2001.

Why should institutional investors invest in venture capital?

The main reason sophisticated investors choose private equity funds for their portfolio is, simply, superior investment performance. Since 1987, cumulative private equity returns (measured net) have outperformed all principal UK comparator asset classes (measured gross). The London Business School report shows that mature UK private equity funds (those raised more than four years ago) have already returned to investors 131% of their investment, while still retaining a conservatively valued 44% within their portfolios. The report also shows that several young funds which have not yet reached maturity (those funds raised within the last four years) have already produced returns in excess of 15% per annum. The returns of these funds are likely to increase as they reach maturity and exit their investments.

Is private equity investment high risk?

One of the main concerns about private equity investment, is that it is perceived to be high risk. We make the case - and this is supported by the London Business School report - that the two do not necessarily go hand in hand. Putting all your eggs in one basket is high risk, as is putting all your available cash in one company. When you invest in a private equity portfolio, a loss of capital is extremely unlikely.

The maturing of the private equity industry

I believe we are dealing with perceptions. An out-of-date view is held about our industry which harks back to the early-to-mid 1980s. There is no getting away from the fact that some pension funds did not derive good returns during this period. In those days the industry was very young. We did not have the right exit markets. As I mentioned earlier, the relatively recent development of enterprise stock markets in Western European countries has improved the exit opportunities for the private equity industry, benefiting valuations, shortening the holding period for investments and thereby enhancing returns. We have more role models and better quality managers for our investee companies, be they academics in research laboratories commercializing their knowledge, or well-paid, well-pensioned managers jumping ship to a management buyout/ in or start-up. We have seen considerable improvements in the fiscal environment in the UK for entrepreneurs, although capital gains tax still needs to be simplified. Last, but by no means least, we have a much more experienced cadre of venture capitalists. Private equity firms are increasingly concentrating on industry sectors where they can employ real experience in depth.

Updating the perceptions

There are three other main misconceptions held about the venture capital and private equity industry:

1) We have been criticized for not investing enough money in start-up and early-stage companies, especially high-technology companies. As explained, this trend is clearly reversing. Companies that required finance for expansion and development accounted for nearly half the number of businesses backed by BVCA members in 1999.

2) The venture capital industry is perceived to invest only large sums of money. In 1999,over half the number of companies invested in, received sums of less than £1 million. Indeed, 19% received sums of less than £200,000.

3) Last year was the first year that funds invested exceeded funds raised. This should address the concerns of commentators who have suggested that perceived high levels of fund raising simply drives up prices.

The outlook

Some commentators may be uncertain about the future, and where best to put their money. Private equity and venture capital firms are not uncertain. We possess a combination of healthy optimism, patient money and a strong appetite for backing new ideas. Barring catastrophic unforeseen occurrences, we expect the UK private equity and venture capital industry to continue growing and flourishing.

British Venture Capital Association

Essex House
12-13 Essex Street

Tel: 44 20 7240 3846
Fax: 44 20 7240 3849