Ivan Vercoutere of LGT Capital Management examines how venture capital has contributed to the growth of high-technology companies in the US and how Europe is now beginning to catch up
Technological invention and innovation has been a driving force behind the longest and most stable economic expansion in the US. In fact, the greatest bull market in US market history is often cited to have started in 1982, shortly after the introduction of the PC. Back then the technology sector was a small part of the economy, as it accounted for less than 20% of total investment spending. Today, technology spending amounts to over 50% of total investment spending and has led to significant increases in productivity and capacity creation.
Technology spending contributed approximately 17% of GDP growth in the US during the 1990s, compared to 5% in the 1980s, and has been a major contributor to low inflation in the overall economy. In fact, the overall rising wage pressures have been partly offset by technology deflation. The positive economic impact of technology has been recognised by the financial community, as the sector currently represents approximately 35% of the US stock market capitalisation compared to 10% in the early 1990s. Energy and consumer-oriented companies dominated the stock market in the 1970s and 1980s, but in the 1990s US investors have directed large amounts of capital into high-tech industries, including a total of $350bn (e350bn) raised in initial public offerings (IPOs).
The rapid ascent of today’s technology market leaders such as Cisco, Microsoft, Oracle and Sun Microsystems is even more formidable given that many of them were started in the 1980s and originally backed by venture capitalists, many of whom had started with a few million dollars of capital to invest in the 1970s. Venture capital has been the primary source of capital invested in young and rapidly growing companies with high growth potential. For many years, venture capitalists have been the catalyst for the creation and growth of America’s leading and most successful technology companies.
The dramatic improvement in the ability of young and emerging technology companies to raise capital reached a record in 1999 with $69bn raised in IPOs, eclipsing the previous record of $50bn achieved in 1996. This large inflow of IPO capital has directly benefited venture capitalists and is leading to a dramatic and unprecedented surge of the US venture capital industry. In fact 271 US venture-backed companies went public in 1999, or approximately 50% of all IPOs, raising an estimated $24bn. The market’s growing appetite for these issues is evidenced by the four years median age of these venture-backed companies, compared to 5.5 years in 1997. Some of these companies are even younger, like Sycamore Networks, a developer and marketer of software-based optical networking products that currently has a market value of $39bn and was formed in early 1998.
The 1999 IPO market has produced 15 companies with a market capitalisation in excess of $10bn, and the number of Internet IPOs surged to 288 from 44 in 1998 and only four in 1995. Internet IPOs in 1999 have gained an average of 274% and reached valuation levels not seen before. As the IPO market continues to sizzle, venture capital funds are reaping unprecedented rewards for having invested in cutting-edge technologies and ideas at an early stage in these companies’ development, and in many cases at their formation. According to Venture Economics, US early/seed stage venture capital funds average 91.2% one-year and 46.6% five-year annual compounded returns as of the third quarter of 1999. The average annual returns are 55.5% and 34.8%, respectively over the one- and five-year period for later stage venture capital funds. Investors should not forget when looking at these performance figures that in the early and mid 1990s, venture returns were poor as a very large number of start-ups failed.
The formidable performance of venture capital funds is leading to a surge in new funding. According to Asset Alternatives, the US venture capital industry raised $35.6bn from institutional and individual investors in 1999, an increase of 87% from 1998 fund raising levels. By contrast, US venture capitalists never raised more than $5bn in any year before 1996, when they raised approximately $8bn. The enthusiasm for venture capital is such that 2000 might be the first year since the early 1980s that venture funds raise more capital than buyout and related funds. The pace is similar on the investment side. VentureOne reports that $14.9bn poured into venture-backed companies in the fourth quarter of 1999, the highest amount ever recorded US venture capital history. At $36.5bn the 1999 total exceeded the combined annual totals of the previous three years.
What is driving such activity levels? Venture capitalists are searching for the next Yahoo!, eBay or Amazon.com, where returns to original investors have been 100–500 times initial cost. The fact of the matter is that most of the increase in venture investment activity has been allocated to the Internet, communications and networking technology sectors, which are capturing over 50% of all venture funding. In the meantime, biotech and life sciences investments have been largely ignored by the venture and stock market communities until recently in lieu of the quick and phenomenal returns of the information technology sector. Many well-established venture capital firms in 1999 significantly reduced and in some cases disbanded their life sciences and biotech teams to focus exclusively on the Internet. The 150% gain in the NASDAQ Biotech index since September 1999 has put biotech and life sciences venture investing back on its feet. Could it be that markets are recognising the profound impact that the capital invested in the 1990s is finally bringing about new drugs and discoveries that could positively impact people’s life in a way that the Internet cannot even hope for?
How to value value?
In today’s venture capital and private equity markets, all the old rules are being broken. The main driver for these changes is technology. The current dynamics of the US equities market is greatly influencing the global private equity market. In fact, without the performance of technology stocks, the S&P 500 would have had a negative return in 1999. To get a sense of the magnitude technology/media stocks have reached, the top 10 US technology companies have an aggregate market capitalisation of approximately $2.5trn, or 20% more than the combined market capitalisation of the German and French stock markets.
Now comes Internet company valuations. As a group, Internet companies have gone from a market capitalisation of $2bn in 1995, when only four of them were public, to approximately $1,000bn or 10% of the US stock market capitalisation. In fact, new valuation benchmarks have to be used. Price to sales have replaced P/E multiples. No sales, have you tried price per engineer? That is the methodology used for a number of US technology companies acquisitions by European telecom companies.
Buyout firms for their part have been watching their venture capital counterparts produce sizzling returns in the past five years, in some cases over 100% per year compared to the buyout funds’ average 15% to 20% annual returns. Many of the more traditional buyout firms are realising that they may well have to embrace technology and the Internet at the core of their investment strategies to sustain the types of returns they have become accustomed to during the corporate restructuring of the 1980s and the leveraged build-ups of the 1990s.
US buyout firms are currently working on initiatives for developing Internet strategies within existing portfolio companies and are increasingly focusing on e-commerce and business-to-business threats and opportunities when conducting due diligence. However, many of them have limited technology and Internet know-how and lack the Silicon Valley contacts, entrepreneurial spirit and speed of the venture capitalists.
In the meantime, venture capitalists are increasingly being courted by large corporations to establish Internet joint ventures but Silicon Valley entrepreneurship and ways of deal making have not always been a match for the culture and structure of large corporations. If you can’t beat them join them. The solution might then lie in the convergence or joint-venturing between venture capitalists and buyout firms and many of these discussions are currently taking place as technology and the Internet are forcing old or more traditional industries to rethink their business model.
Europe’s venture capital renaissance
It has become commonplace to compare Europe’s slow acceptance of technology and the Internet, its rigid labour markets and lack of entrepreneurial spirit with the US’ enthusiasm for innovative technologies, competition, large and nimble capital markets. Wall Street’s early recognition of technology’s potential and the rapid reallocation of capital to the most promising opportunities has given US technology companies a competitive advantage.
Europe is entering a similar phase where technology investing takes centre stage. In fact, the emergence of the euro, the prospects for lower taxes, an increasing entrepreneurial spirit spreading across Europe and the growth and success of Europe’s stock markets for young and emerging companies are creating a unique and attractive environment for venture capital and technology investing. The best thing that has happened to European venture capitalists in recent years is the emergence and success to date of the Neuer Markt and other exchanges for young and emerging companies. The development of these markets is a fundamental element of a successful and prosperous venture capital industry and the creation of high-growth companies.
In a matter of a couple of years, Europe has gone from being idea-rich and capital-poor to experiencing a rush of venture capital funds, many of them from the US. The implications are profound. At a time when large corporations no longer provide long-term employment security, a new breed of entrepreneurs is emerging across Europe accessing the capital and knowledge of experienced venture capitalists. These new companies will provide Europe’s future leadership and growth in employment.
Germany is currently Europe’s largest market for technology investment with an estimated $5bn–6bn of venture capital funding for early- and late-stage companies in 1999. The recently announced merger of Deutsche Bank and Dresdner Bank, which is expected to result in massive layoffs in Germany, only serves to reinforce the trend of new entrepreneurs seeking to strike out on their own. The large flow of venture capital funds to European start-ups and the success and gains registered in 1999 and so far this year by technology companies on the Neuer Markt are proving to be strong incentives for young and bright individuals to set up a start-up.
But Europe has a lot of catching up to do. In many respects, it lags the US market by approximately 12 to 24 months. No one can dispute the significant lead that US technology companies have captured in developing and providing the technology and services that will capture a disproportionately higher portion of the revenues and benefits that will accrue from the $1,300bn of worldwide e-commerce projected by Forrester in 2003 or the upgrade in European telecommunications networks. European companies are reacting as evidenced by the level of venture funding and M&A activity. The value of European technology-related M&A transactions reached $455bn in 1999 and exceeded the combined total of every other year of the 1990s.
To catch up, particularly in the Internet world, Europe has to lower the cost of local telephony/internet access to match the US and increase Internet penetration rates. To do that, Europe needs to foster a more open and competitive telecommunications industry and increase broadband access. Meanwhile, Europe’s high mobile phone penetration rate and uniform standard for digital mobile telecommunications provides it with the opportunity to lead in m-commerce as the Internet goes wireless.
Implication for private equity investors
Despite all the publicity that venture capital and technology is currently getting, investors should not forget that the technology sector was experiencing significant difficulties during the late 1980s and the early part of the 1990s. Don’t believe it? Just look at the numbers. European venture capital returns have been in the mid-single digits until very recently. US venture capital returns were marginally higher thanks to a more developed and professional market. The percentage of failures was significantly higher than it currently is and very few companies could complete IPOs.
The large inflows of capital into equity mutual funds both in the US and Europe is likely to continue providing liquidity for IPOs and the beneficiaries will likely be the venture-backed technology and Internet-related companies, particularly in Europe where the demand and supply imbalance is the most pronounced.
For investors starting an allocation to private equity, the main challenges are the ability to source, analyse and select the most promising venture capital funds in an inefficient market where information, performance comparison and benchmarks are not readily available. Many of the most attractive venture capital funds are primarily available to institutional investors that can subscribe to the large minimums (starting at $5m on up). In addition, the surge in venture capital funding in the US and Europe means that many of the best-performing venture capital fund opportunities are significantly oversubscribed and often mainly available to prior investors. An alternative for investors who want exposure to the returns generated by venture capital funds is to invest in professionally managed technology focused private equity fund of funds or publicly-listed vehicles that provide investors with access to a diversified portfolio of private equity funds and investments on a global basis.
Not only is the current technology and Internet wave big, it is a revolution. The microchip and the Internet are reshuffling the global economic cards and present Europe an incredible and unique opportunity to create value for itself and enhance living standards. This will only happen if politicians and investors recognise this revolutionary force and are prepared to embrace it. Investors should however not forget the notion of risk and manage their return expectations.
Ivan Vercoutere is head of private equity at LGT Capital Management in Vaduz, Liechtenstein
LGT Capital Management
LGT Capital Management (LGT) serves as an alternative investment manager on behalf of the Princely Family of Liechtenstein, clients of LGT Bank in Liechtenstein and selected third parties. LGT is one of Europe’s leading private equity investors and fund-of-funds managers, and currently manages over e900m in private equity assets on a worldwide basis. LGT’s dedicated team of private equity investment professionals is responsible for investments made for Castle Private Equity, a Swiss investment company that is listed on the Zürich stock exchange and on the Luxembourg stock exchange.
As a principal investor and investment manager, LGT’s primary objective is to access the most promising private equity investment opportunities available in the global private equity market. Over half of LGT’s overall private equity investment activities have been in the areas of venture capital and technology with a primary focus on the US and European marketplaces, and selectively in the emerging markets of Asia and Israel.