Stepping into the breach

European venture capital firms may not be as familiar with venture finance as their cousins in the US. Or even if they are, there is a strong chance they will not have used it. Venture finance is a niche area of lending which, while it has become part of the landscape in the US venture market, is still relatively under-deployed in Europe.

Put briefly, it allows fast-growth companies to access low-cost capital without going through the dilution of ownership that comes with another round of equity financing. “It's fantastic for bridging a gap before a revenue or profit milestone,” says Octopus Ventures' chief executive Alex Macpherson. Octopus is a UK-based venture capital firm which says it appreciates the benefits of venture finance, but has only rarely used it.

Venture finance tends to come in the form of either growth capital or equipment financing. In both cases, capital is provided and paid for by way of interest and principal payments – typically over a period of between 24 and 48 months – and stock warrants to give the lender access to the company's upside.

Venture finance exists for the simple reason that growth companies frequently need capital injections and traditional lenders generally stay away from early-stage – and hence high-risk – companies. Certainly businesses with a negative cash flow will not look like a good bet in the eyes of a traditional bank's credit committee.

UNCLE SAM'S LITTLE BROTHER
The venture finance market in Europe is a something of a minnow compared to its US counterpart. There is a dearth of aggregated data showing the scale of venture lending in Europe: which could be seen as an indication that this is a small marketplace dominated by a handful of players.

Market participants offer a number of reasons why venture finance has not taken off in Europe to the same extent as in the US. The first and most simple explanation would be that the region has a smaller and less developed venture capital industry. Simon Hirtzel, chief operating officer of European venture debt provider Kreos Capital, is confident that rather than being under-developed, the European venture finance market is proportionate to the size of the venture capital market across the continent.

Others suggest that it is hard to build up the critical mass required as a lender to deploy resources effectively across disparate European jurisdictions.

For those looking to raise venture finance funds – rather than lend from a balance sheet – there is also a suggestion that European limited partners are wary of venture debt as an asset class. It is more appealing to high-net – worth individuals – who more easily appreciate venture capital upside and capital protection – than institutional investors.

Before the credit freeze arrived in August 2007 and changed the entire lending landscape, the European venture market was growing under its own steam, according to lenders.

ETV Capital is a London-based venture finance provider which has been active in the market since 2000, and was bullish about demand for venture debt before the credit crunch hit last year. “Our market place was becoming increasingly aware of our product offering and understood its value as a source of capital,” says a spokesman for the firm.

Hirtzel of Kreos agrees: “Compared to 10 years ago, there has been tremendous growth in the popularity of venture debt among growth companies and their venture capital investors,” he says.

Such optimism about the growth of the European venture finance industry is echoed by the fact that Orix, a Japanese banking group which has for some years been active in the US venture finance market, recently saw fit to open in London. Orix targets slightly later-stage venturebacked businesses, typically with revenues of more than $10 million.

ICE AGE
The onset of the credit freeze was bound to affect specialist venture finance providers, but the exact nature of the effect is not clear.

Mark Taylor heads up Noble Venture Finance, which earlier this year closed its second venture finance fund on £100 million (€119 million; $150 million). For him the credit crunch started well. “The first 11 months of the credit crunch were helpful. VCs had realised that leverage was a good thing,” he says.

Taylor has been active in the European venture finance market for as long as anyone, having set up Europe's first venture debt fund – European Venture Partners, which now trades as Kreos Capital – on behalf of Dresdner Kleinwort Benson in 1998.

Did the first 11 months of credit crunch boost demand for ETV Capital's services? “Without doubt,” says a spokesman. “We saw a tremendous increase in activity especially from what we would view as the non-core market: i.e.more established, mature private and public companies.”

Rob Young, a principal at Orix in London, highlights the fact that a number of peripheral players which were active in the venture finance market a year ago have withdrawn.“Hedge funds were getting involved on both the equity and debt sides, often offering borrowers attractive terms. If there were 10 to 15 hedge funds operating in this space a year ago, there are now just two or three at the most.”

Young points to the fact that successful venture lending requires an infrastructure including elements like a proper credit committee and access to stable long-term capital.

Other players in the European venture debt market that have had to scale back their activity levels include US-based firms and many of the UK's high street bank lenders.

But the withdrawal of much of the competition and the resulting increase in demand for finance from the remaining players was just one of several effects of the credit crunch. ETV Capital says the real issue as far as it was concerned was ensuring consistent evaluation of credit risk as the outlook became less certain and investor support became less clear. At the same time Mark Taylor at Noble says that while the fund has been “overwhelmed”with opportunities since August last year, it is having to take more time on evaluation and apply increasingly vigorous tests to potential investees.

MIXED BLESSING
And while the first 11 months proved something of a blessing to those offering venture debt, the tumultuous September that followed was “difficult for everyone”, says Taylor. The difficulty, to state the obvious, arose because September tipped Europe and the US towards recession, meaning some VC-backed companies may not survive and exit horizons – very important to those in venture finance – are pushed back.

As with any group of investors, venture finance providers have a dichotomous view of the downturn: concern over the safety of the current portfolio on the one hand and excitement over the anticipated glut of well-priced opportunities next year on the other.

However, the lack of exit routes for VCs presents an additional boon for venture finance providers. As sponsors are forced to support their companies for longer periods of time and through deteriorating economic conditions, they will often have to inject more capital. The venture finance providers, who can provide this extra capital with minimal dilution to the equity base, may well be in even greater demand.