Recent Research: Ernst & Young Report Sees VC Globalizing

A significant increase in venture-backed exits is signaling a new phase in the evolution of the global venture capital industry, according to a report released May 3 by Ernst & Young. Venture-backed company exits grew in value and number in 2005, as the U.S. and Israel saw increasing merger and acquisition (M&A) valuations, while Europe experienced an increase in Initial Public Offerings (IPOs) - a trend that is set to continue this year and into 2007, according to Transition, the fourth annual Ernst & Young Venture Capital Insight Report. The following summary is from the Ernst & Young press release accompanying the report:

"Global consumer markets, increased international competition, investment opportunities in emerging markets, the higher cost of building a company in the mature markets and advancements in technology are all continuing to drive the globalization of both venture funds and their portfolio companies. "Private, venture-backed companies must increasingly act like multinationals earlier in their life cycles, taking advantage of the new global ecosystem that matches the increased demand for innovation with an international supply of talent, technologies, business models and capital," said Gil Forer, Global Director of Ernst & Young's Venture Capital Advisory Group.

"Collaboration among funds is also increasing as global investors seek out local funds in the emerging innovation hotbeds for help in making the right investments and penetrating large developing consumer markets. As cross-sector innovation increases, so will collaboration among funds to complement each other with the right skills and expertise when investing in the cross-sector deals that will likely characterize the next wave of disruptive technology or business models.

"This fourth annual report on the state of the venture capital industry indicates that while in the near term in the US there will probably be continued reliance on both M&A and exploration of more innovative exit opportunities, improving market conditions and investor demand for venture-backed offerings are likely to result in increased venture-backed IPO activity in both the US and Europe through 2006. In the emerging markets, the increasing number of China-focused venture capital funds being raised and invested suggests that there is a robust population of venture-backed Chinese companies in the IPO pipeline.

"Venture-backed company exits grew in value and number in 2005, setting the stage for continued investment in 2006:

• In the United States, 356 companies were acquired for an aggregate amount paid of US$27.3 billion, an increase of 17 percent as the median amount paid rose to US$23 million with more mature companies being acquired and increased competition among buyers.
• In Europe, venture-backed IPO activity surged last year with 60 offerings that raised EUR 2.03 billion (US$2.40 billion), a 71 percent increase in transactions and a 185 percent increase in capital raised.
• Private equity firms are increasingly buying-out venture-backed companies, providing an exit to venture capital investors - a trend that looks set to continue.
• Leading investment bankers and venture capital investors believe that the challenge of meeting Sarbanes-Oxley requirements in the United States and the increased bar to listing on NASDAQ are creating new interest among venture-backed companies in listing on global exchanges such as Hong Kong, Tokyo and AIM. AIM, in particular, has become a growing destination for growth-company listings.
• The number of companies in the pool of private venture-backed companies in the U.S., Europe and Israel continues to contract. The contraction is concentrated in segments such as information services, communications, consumer and business services and retailers, as positions taken during the tech boom are being traded for promising new opportunities in biopharmaceuticals, medical devices, semiconductors, electronics, and Web 2.0 offerings.
• The rebalancing of the venture capital portfolio is ultimately a positive sign for the future of the industry as it makes way for new start-ups to attract investors' attention. The contraction in the number of companies also increases the chances of the winners to achieve market leadership through strategic acquisitions, ability to penetrate new markets and innovation of customer need-based products and services.
• There is a potential exit backlog of 1,912 private venture-backed companies in the U.S., Europe and Israel. These companies, with a cumulative US$51 billion of venture capital invested in them, have not received financing in several years and are maturing from a venture capital perspective. Current rates of venture-backed exits call into question the possibility of this many companies finding a timely and successful liquidity event.
• The anticipated shakeout in the venture capital industry through a healthy consolidation in the number of funds is underway. Between 2000 and 2006, the overall number of firms making investments in U.S. companies declined by 49 percent. During the same period, the number of firms investing in European companies dropped by 52 percent, while the count of active investors in Israeli companies fell by 57 percent.
• 2005 was a milestone year for venture capital in China: Chinese venture-backed companies launched a second wave of successful IPOs on the NASDAQ; China-dedicated funds raised US$4 billion in committed capital; foreign venture capitalists advanced the deployment of various operating models in the country; and the government revised regulations that had temporarily restricted the ability of foreign venture capital investors to exit investments in Chinese companies, clearing the way for continued foreign investment.
• Indian early-stage investment is in comeback mode, with the formation of new India-dedicated venture capital funds and an increasing focus among foreign venture capitalists on defining their India strategies. A new emphasis on IP driven products among Indian entrepreneurs and investors, along with announcements by Intel, Cisco, and Microsoft of significant development plans in India, suggest that the country is poised for a new wave of innovation.

"Overall, the Limited Partner (LP) community is looking ahead to a stable investing environment and improved exit conditions. Key observations related to the LP outlook include:

• Succession management - the ability of venture capital firms to groom new partners to be as successful as their predecessors - remains a concern for LPs.
• First-time funds are finding little support in the current fundraising cycle, even those formed by individuals with strong track records, as LPs reduce the number of their manager relationships and focus on brand-name firms.
• LPs are taking a cautious approach to direct exposure to China and India, given the challenges and memory of losses in those markets. Intellectual property protection is seen as key differentiator between China and India, with India's more robust protections giving it the edge in IP-driven ventures."

Transitions is available at: http://www.ey.com/global/download.nsf/International/SGM_-_VC_-_Insight_-_May_2006/

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