Europe today offers a real alternative to the US in private equity. The industry has at last gained status as a true asset class and, at only 0.383% of European GDP, private equity still has considerable room for further growth. However, with the technology sector mired in trouble and a general economic slowdown threatening to affect buy-out activity, manager selection is more challenging than ever.
Picking the right managers is made even more difficult by the relative absence of independent data on the asset class. This means that dedicated research is required to identify, among the 1,200 or so European private equity fund managers, the 15 to 20 names that will constitute a sufficiently diversified portfolio.

Returns compare favourably with US
Private equity is a mature asset class in Europe, consistently generating high returns over the past 10 years.
Buy-out, venture capital and overall private equity returns in Europe now compare very favourably to those recorded in the US. As shown by the table above:
o European buy-out returns outperform US returns very significantly, ie by a factor of 2.7X on a three-year basis.
o European balanced venture capital returns are very close to US returns, at 54.6% IRR for three-year returns, and even beat US returns at 45.4% IRR for five-year returns.
o Early-stage venture capital is the only area where the US maintains a significant performance lead.
During the relatively stable macro-economic cycle of the late 1990s, private equity firms in Europe provided their investors with very good returns, which were less influenced than in the US by the technology bubble of 1999-2000.

Which segment of the buy-out market should you favour ?
As 2002 gets off to a sluggish start, planning ahead for commitments to buy-out funds becomes more tricky. Indeed, since a lot of companies will not reach their revenue and EBIT targets over the first two quarters of 2002, sellers’ expectations may have to be revised downwards, and buy-out prices should drop accordingly. But this is not happening fast, and certainly not to the same extent for large deals compared with small to mid-sized deals.
What is the definition of small to mid-size deals?
Broadly speaking, this term refers to transactions on companies valued in the E20m to E200m bracket. These deals tend to be executed by domestic funds, forming the bulk of the ‘mid-market’ segment of the European buy-out industry.
Whereas prices may decrease in this segment of the market over the next 12 months, it is uncertain whether prices will drop significantly at the higher end of the market, where probably too much money has been raised. As the list of pan-European mega-funds between E1bn and E5bn grows, there might not be enough deals of the right size and quality to fuel the performance of as many large funds. In addition, the auction processes systematically used at this end of the market may prevent prices from coming down significantly.
Another major development in the European market is the dramatic increase in secondary buy-outs, where one buy-out fund acquires a company from another buy-out fund. Such transactions represented 12% of all divestments at cost in 2000-up from just 4% in 1999. This is further proof that the larger buy-out funds have difficulty in generating ‘new’ deal flow and must look to the portfolios of smaller funds, thereby out-bidding potential trade buyers.
Consequently, the European buy-out market may hit the same limits that triggered the declining returns in US buy-outs over the last 10 years (see table above). If that happens, some of the domestic teams who are part of a pan-European network may decide to spin-off in order to concentrate on more reasonably-sized deals, where deal flow is not such an issue.
So, for the moment, and until the economic horizon clears, the safest haven in European private equity is with mid-market funds.

How to pick technology fund managers?
Technology is a totally different matter since company valuations are already down. The problem is time to exit since the IPO and M&A markets are unlikely to pick up before the end of 2003 or even 2004. So should you rush to take advantage of the low entry prices available today, backing whoever is on the market raising funds? Or should you wait and deploy your money more progressively, with more established venture capital fund managers?
Indeed, the terms for investing in technology have seldom been better, and the sector presents attractive opportunities. But investors looking for new fund commitments should be highly selective.
Technology investing through venture capital funds requires a high level of diversification to counter-balance the higher risk and relative lack of maturity in this sector. It should cover a variety of sectors such as communications technologies, micro-electronics, software and life sciences. These are areas where Europe often has a leading edge in terms of both fundamental and applied research.
From a geographic perspective, technology opportunities in Europe tend to develop in clusters. They are currently concentrated in a core group of countries: Germany, France, the UK, Scandinavia, the Benelux and Ireland.
Even more than in the traditional buy-out area, manager selection is the key to superior returns in venture capital. This has been particularly true ever since the big shake-up that started in early 2000 and wiped out valuations of technology companies, whether quoted or unquoted. Fund managers who invested their funds too quickly, entering companies at inflated prices, will probably not raise another fund since their return on these investments will range from poor to negative.
Fortunately, there is a group of managers who raised their last funds at the peak of the technology hype in 1999-2000 but have so far been cautious about investing it. These managers share certain characteristics: 1) They stayed away from over-inflated company valuations. 2) They kept sufficient money to continue making new investments until 2003. 3) They were able to provide follow-on finance for their existing portfolio. This small group of 10 to 15 funds will lead the top-quarter of European private equity in the years to come, generating high returns to investors. Access to these managers will therefore become critical for their next generation funds that will hit the market in late 2002 or early 2003.

Choose the right route into private equity
For investors who lack access to the best funds or the dedicated in-house resources to carry out the necessary research, selecting the right mid-market buy-out funds and the more mature venture capital funds is going to prove difficult and time-consuming.
So how can they avoid missing the rising stars? Going through a fund of funds may be the best way, provided they choose funds of funds managers who focus on the mid-market and have relevant experience in European private equity. Unfortunately, this is rather uncommon these days, as most funds of funds managers took the easy route by focusing on large, pan-European buy-out funds in Europe and by allocating most of their venture capital commitments to US managers.
Access Capital Partners is a European funds of funds manager with E500m under management that focuses exclusively on European mid-market buy-out and venture capital funds

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