LEARNING CURVE

German venture capital firm Earlybird has just come off the fundraising trail for its fourth fund and has by no means had an easy time of it. It began marketing the fund in 2006 with a target of between €150 million and €200 million, and finally closed in August this year on €127 million. Commitments of €200 million would have allowed Earlybird to build a portfolio of between 25 and 30 investments. As it is, Fund IV is likely to end up with around 20, still perfectly adequate for a team of Earlybird's size. “We would have liked to have raised €200 million, but it is not too big a deal. We always have the option of raising more capital next year,” says co-founder and managing partner Rolf Mathies.

A number of factors contributed to the drawn-out nature of the fundraising, with perhaps the most significant being the evolution of the firm's investor base. Whereas the preceding fundraisings were dominated by commitments from individuals – 75 percent in Fund III – Fund IV comprises 90 percent institutional money. “We changed most of our investor base, which always takes longer than simply going back to the current investors. We had to spend a lot of time getting used to new LPs and allowing them to get used to us,” says Mathies. The reason for the move towards institutional money was because advisers began to steer their clients' money away from higher-risk single fund investments towards funds of funds.

“We realised that as a European fund, it was very difficult to access the best US deals. With hindsight the move was a bad idea; firms moving quickly to the US from Europe tended in most cases to fail, as did those moving the other way.”

The vast shadow cast by the buyout industry in the years leading up to the credit crunch also hindered venture capital fundraising efforts. “When we started fundraising, the buyout strategy was still all the rage. It was making huge returns over shorter periods than venture,” says Mathies. “The industry is cyclical, but despite this many asset managers were only looking in the rear-view mirror. To achieve outperformance, you have to look at the macro perspectives. Right now people are coming back to venture but last year it was extremely tough.”

SCARCITY VALUE
Despite drawing a line under the fundraising a little way off its initial target, Mathies is confident that if the firm seeks fresh capital in 2009, which is likely, new LP contacts will be keen to come in. This is driven in part by a simple question of supply. “Venture firms in Europe with three or more fund generations behind them are quite scarce in Europe. LPs looking to invest in venture may only find 20 or 30 firms raising funds at any point in time,” says Mathies. “Even then the funds are smaller so it is harder to get in.” According to funds of funds operator Capital Dynamics, in 2007 there were 70 European venture firms with three or more funds, so having a track record is vital.

And a track record is what Earlybird has. Funds I and II were raised in 1998 and ran in parallel (to allow German state bank kFW to invest alongside Earlybird's other investors in the same assets). The €60 million fund achieved an IRR of more than 20 percent and generated a multiple of more than 4x. One outstanding investment was the web-based mortgage broker Interhyp. When Earlybird floated the company it generated 70 times the initial investment: more than the entire €60 million fund. As a result, when the firm called on investors for Fund III in 2000 – technically speaking the firm's second fund – they raised $230 million. Investors were clamouring to get back in because it was, in Mathies' words, at the “peak of the venture capital hype”. Investing alongside the repeat investor base of high-net-worth individuals were several large US family offices and the Government of Singapore.

Fund III, however, proved a learning experience for Earlybird. The firm decided it would benefit from a hub in Silicon Valley that could tap into the vast pool of US institutional money and access the region's deal flow. It opened an office in the heart of Palo Alto with a full investment team. “At that point in time in 2000 it was in vogue, let's say,” comments Mathies. But 18 months after opening in Palo Alto, Earlybird closed down its US operation as the downturn took hold. “We realised that as a European fund, it was very difficult to access the best US deals. With hindsight the move was a bad idea; firms moving quickly to the US from Europe tended in most cases to fail, as did those moving the other way.”

“But on the other hand we built a great network in the US, learned a lot from the US investors and brought a lot of the Silicon Valley approach back to Europe,” says Mathies. “I would describe it as a lesson learned, and this is how our current investors see it.” Despite the unsuccessful US foray, Mathies is still hopeful that Fund III, when fully divested, will achieve a multiple between 2.5x and 3x.

FOCUS ON EUROPE
With the lessons of Fund III learnt, Earlybird's fourth fund is investing closer to home. It is mandated to put 90 percent of the €127 million to work in Europe, with 10 percent set aside for opportunities elsewhere if required. Mathies maintains that around two-thirds of the fund will be invested in Germany, Austria or Switzerland, simply because the relationship between investor and investee at venture level has to be ongoing. “If you are an early-stage investor you have to be close to the deal,” says Mathies. US-focussed activity for Fund IV will be limited to helping portfolio companies break into the market.

So far, Earlybird has drawn down around €30 million from Fund IV and made eight investments in companies such as Munich-based software company conject and Miracor, which makes medical devices to benefit patients recovering from heart attacks.

In terms of sector preferences, Earlybird has a tendency to focus on communications, technology and, as is the case with the lion's share of the fourth fund's investments, healthcare. Mathies maintains, however, that too much sector specialism is not the way forward. “Some people think venture funds should be dedicated to one area. In 2000 everybody wanted internet-only funds, in 2002 everybody wanted biotech funds and now everybody wants to have a cleantech fund. This is not a good idea for really early-stage investors. What you are looking for are great entrepreneurs and to find the best ideas: not the trendiest ideas.”

Mathies is very optimistic about the next few years for the European venture capital industry. The abundance of repeat entrepreneurs and strong technical innovation, combined with a relatively small number of venture firms ready to deploy capital, mean that entry valuations are half what they were in 2000, according to Mathies. “2008 should be one of the best vintages. We are at the optimal point in the cycle.”

With around a quarter of the latest fund already invested, and market prospects looking good, it is likely that Earlybird will return to the market to raise a fifth fund in mid-2009.