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Join the venture scouts

Investment guru Paul Myn ers&#39 report on institutional investment called for the abolition of the minimum funding requirement, which he claims discour ages investment by institutional investors in the UK.

The report has raised the temperature for UK pension funds by highlighting that they are too risk-averse and do not invest enough in small compan ies and venture capital.

The report is courageous and eminently sensible. In particular, I was encouraged that Myners resisted the temptation to recommend corrective regulatory measures. Nothing is more harmful to investment markets than hastily installed reactive measures.

In fact, the minimum funding requirement was just such an ill conceived measure and the result has been its unintended, but easily foreseeable, impact on venture capital inv estment by UK pension funds.

Levels of investment in venture capital are very low. In the US, funds aim to invest bet ween 5 and 10 per cent of their assets in venture capital compared with around 1 per cent in the UK. There is anecdotal evidence of how this affects the fund-raising ability of UK companies,many of which end up with prim ary funding from US and continental European inv es tors.

Here at Catalyst, we spent two-thirds of our time marketing our first fund to UK institutions and raised only 8 per cent of our money in the UK – and this was from a firm run by a really good friend.

In the absence of regulatory compulsion, the question is whether or not UK pension funds will change their attitude towards small companies and venture capital. The likeli hood is that they will – bec ause returns have been exc ellent, the Government is aggressively advocating change and the diversity of available funds has increased considerably.

The British Venture Capi tal Association reports on fund returns each year. Calcula tions in the latest BVCA/The WM Company Per for mance Measurement Survey indicate that the average private equity fund has returned 20 per cent to its investors over the past 10 years. Over three years, the average is 31 per cent.

Returns like these will certainly encourage trustees to increase venture capital exposure. UK pension funds have already demonstrated their willingness to accept risk by investing relatively heavily both in UK and foreign equities. Interestingly, UK pension funds will be investing at a very good point in the investment cycle by having waited until now. The massive falls in new economy shares mean the prices pay able for young businesses have tumbled.

There has been marked Government activity to stimulate interest and investment in small companies and venture capital and, while one might question the interference of Tony Blair and Gordon Brown, there can be no doubt about the clarity of their message.

In addition, the embarrassing success of Frankfurt&#39s Neuer Markt relative to the Alternative Investment Mar ket has engendered proposals to encourage investment in small companies and incentives have been put in place for individuals and corporations to participate in venture capital.

Over the past few years, dozens of new companies have emerged in the UK and Europe, off ering inv estors an array of choices in terms of style, approach and investment philosophy. This contrasts with five years ago when the market was dominated by buy outs and new compan ies were nearly all generalists. Such activity may have helped to foster economic res tructuring but did nothing for the growth companies of tomorrow.

The percentage of venture capital going into new businesses has soared over the last few years. Figures from the BVCA show that, in 1996, over £3bn was invested by the UK venture capital industry in new businesses. This figure rose to over £8bn by 1999.

Investment firms and adv isers need to develop strategies for dealing with the likely influx into venture capital funds. Historic returns may be high but there are correspon ding risks. The BVCA report cautions that the distribution of returns between funds is very wide – much more so than for other asset clas ses – so investors need to be ext remely careful in selecting the right venture capital fund and fund manager.

Track records are a useful consideration but trustees should bear in mind the difference between luck and skill in assessing past performance. Getting to know the people involved is essential but pot ential investors should remain aware of the high turnover in this booming industry.

Perhaps the easiest factor to assess is the res pective styles of different firms. Gen eralists have fared well in the past but investors are inc reasingly asking how they will perform in a more difficult market. Interest rates are no longer tum bling but share prices are. The economic out look is more uncertain, with bankruptcies on the rise.

As competition increases, more investors are asking what specific strengths a fund mana ger possesses, which will enable the fund to add value in the still inefficient private equity market.

Funds run by the growing number of specialists have been gaining in popularity. Some of these are sector-based and believe they can better identify tomorrow&#39s stars and then add value by leveraging their particular expertise.

We focus exclusi vely on the Euro pean financial services sector. This market is going through a fantastic per iod of change and growth, as readers of this paper will fully app reciate. This has enabled us to invest our first fund very quickly in some exciting businesses in Europe and the UK.

Other fund managers focus on a variety of different sectors, the most common being information technology and bio technology.

Apart from sector funds, there are firms concentrating on specific types of investment, such as distressed ass ets or especially complex deals. Other firms look at the rapidly growing secondaries market, where existing investments in funds are sold to other inv es tors bef ore the assets are reali sed.

There are also a host of country-specific funds but questions can be raised about their viabil ity in the increasingly pan-European market environment. But country-foc used funds in emer ging markets may add that specific knowledge base which is so vital in this inefficient market.

Above all, investors need to avoid the mission shifters – firms that try to change their tack in an attempt to catch every shift in the investment wind. They will never build deep expertise in any area and will inevitably be late in the investment cycle.

It is clear from the BVCA figures that potential returns on investment are high. The Government is backing change and there is an abundance of funds on the market for those willing to invest. The door is wide open for UK pension funds to reap the rewards of investing in venture capital. Only time will tell whether they do.


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