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The politics of early stage investment

Boasting one of the largest institutional venture capital fund portfolios in Europe, the European Investment Fund is having to permanently balance commercial investment considerations with its political mandate. Not an easy task, finds Ricky Morton.

With €2bn committed to European early-stage venture capital investment, the European Investment Fund virtually stands alone as the patron saint of European venture capital funds. With the exception of 3i, which has recently sought to limit its exposure to the early-stage and high-tech sectors, no private equity institution has so much at stake in these segments of the European market.

“Our portfolio is risky but we have a responsibility,” says Marc Schublin, Head of Division, Policy and Institutional Coordination at the European Investment Fund. “We have a portfolio of 185 funds, of which around 75 per cent is invested in high-tech early stage funds. There may be a possibility of big returns one day, but we realise we cannot expect profits in the current climate.”

Although it is difficult, our strategy is viable. We are able to find good funds that operate within our constraints

In its own words, the EIF is a European institution whose main objective is “to support the creation, growth and development of small and medium-sized enterprises (SMEs).” It was established by the European Investment Bank (EIB), the European Union and a group of private banks in 1994 with a mandate to invest in venture capital. It intervenes by means of providing risk capital, using either its own funds or those available within the framework of mandates entrusted to it by the European Investment Bank or the European Union.

In addition to backing venture capitalists, where it effectively operates like a fund of funds, the EIF also gives portfolio guarantees to a wide range of financial institutions to enable them to develop SME-related activities. EIF guarantees comprise three products: credit enhancement, credit insurance and structured transactions. “We guarantee part of the SME portfolio of financial institutions across Europe. A lot of banks in continental Europe want to externalise their portfolios by selling bonds. We guarantee some of the bonds, taking advantage of our triple-A status, and this can enable them to commit further funds to SMEs in the region”, explains Schublin.

In 2000, the EIF realigned itself as the EIB's specialist risk capital arm, while the EIB raised its stake from 40 per cent to 60 per cent, giving several of the fund's private backers the opportunity to withdraw.

The EIF's €2bn of capital is divided into 2000 shares of €1m each. At the end of 2002, the European Investment Bank held just over 60 per cent of the EIF's share capital, with the European Union holding a further 30 per cent. The remaining 9.75 per cent is divided between 28 private financial institutions across the European Union, including German banks such as Kreditanstalt für Wiederaufbau (KfW) and Bayerische Landesanstalt für Aufbaufinanzierung; Italian banks including Banca Monte dei Paschi di Siena and Banca Intesa; French institutions like Caisse des Dép^ts et Consignations; and Dexia Public Finance Bank. (The UK is noticeably underrepresented, with Barclays Bank the sole UK representative.)

In total, banks from eleven of the EU's fifteen member states are shareholders of the EIF

Two main objectives
Discussing the fund's mission, Schublin says: “One of the key aims of the EIF is to enable Europe to compete with the US as a knowledge-based economy. As a result, we follow the political goals of the European Union, whilst always ensuring that we behave commercially.”

To elaborate on the EIF's political objectives, Schublin discusses the considerations that may precede its decision to commit to a regional fund. “If we were planning to invest in a regional fund based, say, in Milan and the North of Italy, we might request that 20 per cent of the fund's capital was invested in the poorer areas of Southern Italy.” The EIF also requests that backed funds commit no more than ten per cent of their total capital in overseas markets.

The EIF's political motives sometimes provoke criticism among European general partners. “They have a huge political agenda,” says one UK-based GP who declined to be named. “All of their decisions are politically motivated and seek to create jobs as the first priority. It is hard to see how they will achieve higher returns with an investment approach that sees them back Italian olive groves.”

However, the view that the EIF is weighed down by a political mandate is by no means a universally held one. “Politics does not tend to impinge on the EIF's strategy,” says Chris Kennedy, a partner at Go Equity, a mid-market investment firm based in Austria. “They're smart enough to know that they can't be missionaries and that they cannot be solely a job-creating vehicle. They clearly seem to have a financial motivation.”

Marc Schublin says: “Although it is difficult, our strategy is viable. We are able to find good funds that operate within our constraints.”

Major investor
Despite the market downturn, which saw many investors beat a hasty retreat from the venture capital scene in 2002, the European Investment Fund continued to pursue opportunities in the sector, investing a total of €471.5m across 36 new funds. Nonetheless, investment activity in 2002 was at a slower pace than in 2001, when a total of €800m was invested in 57 funds.

One of the key aims of the EIF is to enable Europe to compete with the US as a knowledge-based economy

To put this in perspective: across the whole of Europe, venture capital funds raised €8.5bn in 2002, according to data published by the European Private Equity & Venture Capital Association. In 2001, the fundraising total was €15bn. While other investors scaled back, the EIF effectively upped its contribution to Europe's venture capital market in 2002, accounting for 5.5 per cent of total funds raised against 5.3 per cent in 2001.

It is this persistence perhaps more than anything that distinguishes the European Investment Fund from its limited partner peers across the continent. Amid the adverse fundraising climate of 2002, it enabled many funds to overcome what might have otherwise been insurmountable fundraising difficulties.

“The EIF is one of the largest investors in the [Go Equity II LP] fund,” says Kennedy, whose fund closed on €54m earlier this year. “The EIF was a significant, although not cornerstone, investor in the fund, and their presence helped expedite the process, creating a level of comfort for other LPs.”

Late in 2002 the EIF agreed a €10m investment with the Prague-based Genesis Private Equity Fund, extended its geographical coverage to the Czech Republic and Slovakia. “The EIF has been very positive for our fundraising,” says Radim Tasek, investment manager at Genesis Capital. “It served as a reference to attract other LPs and also assisted us with advice and contacts for other potential investors at a difficult time in the fundraising cycle.” The €10m commitment to Genesis came with some conditions: “They were keen to ensure that our exposure to larger transactions was limited, but that suited us anyway”, says Tasek.

Like other investors we have to take a risk, but we expect good returns

With EU enlargement approaching, the EIF's remit now incorporates the group of ten Central and Eastern Europe nations that will join the EU in May 2004. Since 2001, EIF has committed a total of €75m into six funds across Central and Eastern Europe, although Schublin says that the fund's biggest contribution to the region has been via its guarantees product.

Schublin believes that the EIF's engagement in Eastern Europe proves that it is more flexible than some give it credit for. “We had some activity in [the Accession states] last year, but the market is difficult,” he says. “It is not really feasible to focus entirely on early-stage investment there, and so we play a role in more conventional equity support.”

Nor is it solely in the countries of the former Eastern Bloc where the EIF has broadened its range of activities. Schublin says that there is a possibility that the fund's focus will broaden to include more development capital situations, where the “burn rate of equity is less high and the risk is more manageable.”

Despite its prominent role in European venture capital, Schublin describes the EIF as “a small shop”. It has 65 employees, headed by Francis Carpenter, former secretary general of the European Investment Bank. “We are split across three main departments. We have around 17 people working on identifying venture capital investments, seven or eight people work in the guarantees department, while the bulk of the team works on risk monitoring, ensuring that our investee funds are being well-managed. We're a big investor [in individual funds], sometimes taking up to 20 per cent of a fund's capital. We have to be involved to oversee what happens.”

No carried interest
One of the recurring themes practitioners tend to bring up when talking about the EIF is remuneration. Outsiders speculate whether EIF employees are sufficiently incentivised to generate as high returns from their investments, given that their compensation is not linked to the fund's performance.

When questioned on the issue of carry, and whether it exists for EIF professionals, Schublin's answer is “unfortunately not. In terms of remuneration, EIF employees are paid on a commercial basis. The other issue making any prospect of carried interest difficult is that people don't always stay at the fund for a long time and are often seconded from the European Investment Bank.”

Does the market think this an issue? A limited partner interviewed for this article, who in the past has invested alongside the EIF, thinks it is: “The EIF consists of quite a young team of professionals who do not have a great deal of experience and aren't particularly well paid. There is a lot of turnover in the team which makes it difficult to achieve consistency.”

However, others take a more benign view. “Although not remunerated in the same way as other private equity professionals, I honestly don't believe they behave in a different way,” says a general partner.

Commercially viable?
Either way, as an investor in 185 venture capital funds across Europe, the EIF has good reason to consider itself, as Schublin puts it, a “leader in terms of European early-stage investment.” As venture capitalists have struggled to recover from the market crisis, the EIF has been playing an increasingly solitary and arguably therefore all the more important role in backing Europe's early-stage industries in the hope of an eventual pick-up in the market.

What it needs to demonstrate is that it can do this on a basis that is commercially successful in the long-term. “Like other investors we have to take a risk, but we expect good returns,” says Schublin. “We try to reduce the level of risk by getting involved at board level.”

At this point of its evolution, the EIF appears to have something of an image problem. Those that view the institution as one that prioritises the European Union's developmental objectives above generating competitive returns will remain reluctant to recognise the EIF as a benchmark investor. As one LP puts it: “We don't take a view on a manager either way if the EIF is involved in a fund, but obviously we will still invest if we think the fund is a good one.”

The real value and longevity of the EIF's contribution to the industry will be determined once it is possible to gauge the impact and performance of the investments it made during this difficult period for European venture capital. This assessment is still some way off.