Chapter 9
Looking for Investments Outside Silicon Valley

Although their experience has so far been mixed, American venture capital firms continue to look at Europe as a promising market. The challenge is to blend Silicon Valley style investing into the local culture, writes Paola Subacchi.

Over the last three to four years a growing number of American venture capital and private equity firms have set up shop in Europe and billions of dollars have been raised for venture capital funds. With their home market already mature and well exploited they looked to expand to new pastures. Advanced research in areas such as telecommunications and biotechnology, environments that are increasingly favorable to private equity as well as the success of new markets such as the Neuer Markt and techMARK are all factors that encouraged the Americans to take a close look at the European market. Over the last five years, there has been a transformation of Europe's business and corporate environment in which private equity firms have emerged as sources of new investment, higher employment and value creation. In particular, Europe's business community increasingly understands and appreciates the role that private equity investment has played in reshaping American business over the past 20 years.

"Europe offers interesting, albeit challenging, opportunities to build global companies outside Silicon Valley" says Eric Archambeau, general partner at Benchmark Capital in London. "People are becoming less risk-adverse and more inclined to leave big companies to start their own business" . Similarly, Tim Duffy, the managing director for Europe at Vennworks, believes European universities and research centers offer interesting opportunities. In particular, a number of government research institutes currently under budgetary constraints are keen to commercialize some of their research.

Given that Europe is an area with substantial political, institutional and regional differences, and different degrees of economic development, investors should not only focus on sectors, but also consider regional opportunities. Roeland Boonstoppel, head of Crescendos European operations, indicates the UK, Germany, France and Sweden as the most promising countries in terms of technological development. His opinion is largely shared by other American VCs. Jose Brena, co-managing director of TD Capital Communications Partners, includes Spain, which has a competitive telecommunications sector while financial instruments are more developed than in other countries such as, for instance, Italy. According to Brena, Scandinavia is a good place to stay in the loop, but it is difficult to make money there because of the strong competition and the wide gap between theory and practice.

Setting up in Europe

Setting up offices locally is paramount, especially for early stage investments, in order to help entrepreneurs build their businesses, stay in touch with local markets and develop a feeling for the local culture. Although in recent years business practices have become more homogenous, doing business in Europe still requires a deep understanding of cultures and habits of individual countries. "The only way to work successfully in Europe," says Boonstoppel, "is to acknowledge that each country in which we invest has a different culture and therefore we cannot push the US style in the European markets regardless of local practices and habits.

For a number of reasons including the special US-UK relationship, Anglo-Saxon practice and the fact that it is at no more than three hours by plane from most of the main research centers and technology clusters in France, Germany and Scandinavia, the American VCs look at London as the ideal location from where to explore the European market. Also, in London it is easier to recruit people with the right kind of skills, experience and entrepreneurship. In particular, American VCs look for people with analytical background, the experience of US investment style and a deep understanding of European cultures. As Crescendo's Boonstoppel puts it: "We need people who understand the cultural and business differences."

Most of the American VCs target the European market with a dedicated fund. For instance, Benchmark Capital, Silicon Valley venture capital firm, when it opened its doors in London last year launched a $750 million fund specifically dedicated to investment in European technology start-ups. Similarly, TD Capital Communications Partners, which was founded in 1995 as a spin-off of TD Capital, the global private equity arm of Toronto Dominion Bank, opened its London office in June 2000 with about 200 million euro earmarked for investment in Europe. Partners responsible for the European operations normally have full responsibility for approving investment in Europe. In the case of Benchmark, the four partners based in London are totally independent from the Menlo Park office and they're the only ones to evaluate and decide on investments in Europe.

A different and more unusual operational model is provided by Crescendo Ventures, a global venture capital firm founded in 1993, which opened in London in 1999 without a dedicated European fund. With over $1 .1 billion and more than 80 active portfolio companies, the firm works closely with several European affiliate venture capital firms including Innovacom in Paris, Wellington Partners in Munich and ADD Partners in London. Cresecendo's philosophy is to have a global fund with the aim of funding the best opportunities rather than meeting regional allocation requirements, ensuring that all portfolio companies receive equal attention from the firm. As a result, the London office draws from the same fund used for crescendo' s investment in the US.

Investment Activity in Europe

TD Capital communications Partners, which invests across the investment life cycle including early-stage growth, expansion stage, industry consolidations, management buyouts and balance sheet re-capitalization. The firm has recently invested ￡30 million in a co-led (Madison Dearborn recently invested ￡110 million equity financing of EON Communications, a new broadband communications company. EON Communications raised ￡265 million to build a state-of-the-art digital broadband communications network in South West Scotland and North West England, the largest remaining unbuilt service area in the UK. EON will be the first single source provider of bundled communications services including digital interactive television, fixed line voice telephony, Internet access and high speed data services in the region.

Semiconductors and microprocessors, IT and software, biotechnology and healthcare product, telecommunication and media are the main focus of US venture capital in Europe with a growing number of funds exclusively devoted to telecom, technology and life science investments. Benchmark Capital, for instance, invests mainly in application services, infrastructure services, Internet retail, Internet services- business, Internet services, mobile Internet, networking equipment, semiconductor and software. So far it has made only two investments, in Flutter, corn, the UK person- to-person betting site, and Keen Europe, the online advice service. Crescendo Ventures is interested only in communications and Internet infrastructure and services. Within these sectors, Crescendo invests evenly in five main markets: optical networking, wireless communications, communications software, and a group of encompassing servers, storage, and edge performance. Early this year Crescendo led the first round of a $13 million financing in Munich-based CoreOptics, a supplier of optical networking Solutions. This followed last year's investment in the $53 million second round financing of Optillion, a Swedish fibre optics transceiver company.

No Rush to Close, No Rush to Exit

Although the Americans do not easily admit it, when they arrived in Europe they presumed to be able to easily capitalize on the expertise they had accumulated over the years at home and to import the US, not to say Silicon Valley, model of investing. At that time some industry experts compared the arrival in Europe of US venture capital and private equity firms to "the decimation of UK banks in the l990s, when international investment banks were at first dismissed by their competitors" But the reality of putting US venture investing into practice has proved to be rather different. The strong stock market of the late 1990s and the subsequent fall made assessing potential investments rather complicated, while cultural, political and institutional differences made market penetration more difficult than originally expected.

Until the middle of last year, the combination of a rising stock market and a healthy appetite for new issues meant companies could offload their portfolio investments quickly at high prices. In that highly valued market the return on investment depended entirely on the right timing to enter and exit. As a consequence, even if American VCs claim to have always been selective in their investment decisions, several investors rushed into deals and focused on the wrong metrics in fear of missing the boat. When TD communications Partners set up shop in London and was forced to turn down several potentially good deals because the values were too high, they began to wonder if they had arrived too late. "Because capital was flooding into Europe from all sort of sources ", says Jose Brena, "values were going through the roof."

Coming to the party late can have its advantages, as new entrants to the market who have only new investments to consider and no legacy issues chewing up their time are quick to point out. It has been recently calculated by Venture Economics that in the first quarter of the year, US venture capital firms suffered losses of up to 30 percent, signaling that forecast average one-year returns in 2001 could be minus 35 percent to 40 percent. Compare that with the peak of the technology bubble when average funds showed triple-digit returns. However, it's a bad idea to place too much emphasis on quarterly performance returns on account of the fact that the average early-stage investment has a seven-year life cycle and at the other end of the maturity spectrum, i.e. buyouts the typical holding period is three to five years.

The current market downturn and the prospect of some years of extremely modest growth— not to talk about recession—have pushed investors in a more somber mood with the consequence that there is no pressure to rush into deals. Jose Brena notes that investors have switched back to correct metrics to assess a company' s potentials, such as good management teams, solid business plans, and cash flow. "Markets now penalize companies without cash flow to break even" he adds. Roeland Boonstoppel points out that the current market is attractive for investment, not for exit. Entrepreneurs therefore have to realize that they have to build companies rather than looking for quick money.

Finding a Niche

Although the European venture capital industry is still small compared to US, it is steadily growing, with plenty of money, a web of contacts and deep understanding of cultural, political and institutional issues. "The Americans should not underestimate their European colleagues", says Boonstoppel, "even if they are very good".

Early-stage investments in young companies in high growth sectors represent an area where US venture capitalists can fill a gap, given that European firms tend to focus on mid and late venture capital. As bank debt is expensive or difficult to obtain, US firms can quickly grow their business in Europe by providing young companies with equity finance to sustain rapid expansion.

Firms like Benchmark attempt to differentiate by exporting Silicon Valley style investing. In other words, they take a labor-intensive, team-oriented approach to venture investing and act as accelerator and incubator for their portfolio companies by facilitating synergy among them, creating strategic partnerships. "There is no point to reinvent the way to approach the start-ups", says Eric Archambeau. Jose Brena of TD Communications Partners stresses that on their arrival in London they could capitalize on their background with start-ups and their reputation and professional network as individual.

Expectations for the Long Run

Although Europe is on the right track to create the right culture for venture capital, there are still some obstacles that need to be removed. Entrepreneurship is becoming more widespread, but tolerance for risk taking is far lower than in the US as forming start-ups comes to a much greater personal and social cost. "There is no shortage of money or good ideas", says Tim Duffy, "the problem is to convince people to take risks." And regional differences mean Europe lacks a big domestic market such as the US, with the consequence that companies find it more difficult to become worldwide leaders in the global market. "Europe does not have yet the frame of reference to build worldwide leaders in the global market", concludes Archambeau.

There is optimism. "Ten years from now we will see a very impressive number of global companies to be born in Europe," says Archambeau. Brena thinks Europe's main advantage is to be a bit late in terms of deregulation. "Countries can use the forthcoming deregulation to deploy capital more efficiently." he says.

　Supplementary Reading