Select Committee on European Union Written Evidence

Memorandum by 3i Group plc

  You have asked for written evidence in response to the following:

    "Members of the Sub-Committee visited Washington in early April and were struck by the role played by venture capital in the promotion and development of e-commerce in the US. It has been suggested that, although venture capital is readily available in the UK and Europe, it is less willing to become involved at an early stage. In short, it is less inclined to take the sort of risk that the Americans take in their stride. How true is this assertion? If it is true, how important a constraint on e-commerce start-ups is it? Is there anything which could be done to bring the situation more in line with that which obtains in the USA? Should we be concerned to follow the US model?"


  1.  3i was founded in 1945 and is Europe's leading venture capital company. Its shares are listed on the Official List of the London Stock Exchange and it is included in the FTSE 100 Index. At 31 March 2000, 3i had total investment assets of approximately £6 billion (including approximately £2.4 billion of "technology" investments) and investments in almost 3,000 businesses.

  2.  3i has 36 offices in Europe, two offices in the USA, and two offices in the Far East; and just under 900 employees.

  3.  Based on statistics for 1999 published by the British Venture Capital Association (BVCA), 3i is leading the UK high technology sector with a market share (as a proportion of the aggregate investment by BVCA members) of 42 per cent by number and 24 per cent by value of investments made.


  4.  For the purposes of this paper, we have defined "e-commerce" businesses relatively broadly so as to encompass businesses that are involved in transactions (the exchange of goods, services, and/or information) using the Internet as a medium; but also Internet Service Providers and providers of Internet-related hardware and software that facilitates e-commerce.


  5.  We believe the overall development of the e-commerce market is very largely driven by the following factors:

    —  the entrepreneurial culture prevailing within the economy and the extent to which the environment is "entrepreneur-friendly";

    —  the perception of risk and returns on the part of investors, including the importance of stock markets as the key "engine" driving returns; and

    —  the availability of investment funds.

    Our evidence is presented below in consideration of each of these three factors in turn. Whilst recognising that some economies within Europe (particularly the UK and Germany) are more advanced than others in terms of e-commerce development, in this paper (for simplicity and because the points we would wish to make would essentially be the same) we generally do not seek to differentiate between different countries within Europe.


  6.  The primary driver of business development, especially in "new" areas, is the identification by entrepreneurs of ideas and opportunities for wealth creation. This, we would propose, is largely a function of both the general culture of entrepreneurship within Europe and of the extent to which the environment is entrepreneur-friendly. We would like briefly to explore each of these in turn.

Culture of entrepreneurship

  7.  A recent report commissioned by 3i from Insead's 3i Venturelab titled The Climate for Growth Entrepreneurship in Europe provides an extensive review of the climate for "growth entrepreneurship" in Europe and contains useful comparisons with the USA.

  8.  In the context of the culture of entrepreneurship prevailing in Europe, the report explores such questions as:

    —  Does the basic underlying cultural attitude support the notion of individual initiative?

    —  Are young people led towards following the "normal path" or are they encouraged to find their own way?

    —  How are entrepreneurs, and more especially successful growth entrepreneurs, viewed by society?

    —  What is society's (and the investment community's) attitude to failure?

  9.  One overall conclusion in the report is that cultural attitudes in Europe have never been as favourable to entrepreneurs as those in the US.

Entrepreneurial environment

  10.  The 3i Venturelab report also explores environmental considerations, and reaches several conclusions about the European position when compared with that of the USA:

    —  Relatively unfavourable fiscal environments (VAT, corporate tax, capital gains tax, treatment of stock options);

    —  Administrative bureaucracy, for instance the length and complexity of new company formation procedures; and

    —  Some structural rigidities, for instance inflexible employment regulations.

    However, the report does note that most countries have started to recognise the importance of fostering an environment in which growth entrepreneurship can thrive, and are actively seeking ways of improving the situation.

  11.  In this context, whilst some recent changes in the UK in the areas of capital gains tax and employee incentivisation should have a positive impact, we believe that the overall complexity of the taxation provisions in these areas, relative to some other economies, is having a negative impact on entrepreneurs.

  12.  Clearly, the US market for technology (including e-commerce) investing by venture capitalists is more mature than that in Europe. US venture capitalists have been investing in technology for 15 to 20 years, in contrast to Europe, where technology investing has only become significant in the last five years or so. This is reflected in recently published figures comparing the USA and the UK in terms of high technology venture capital investment as a proportion of GDP—for 1999, the figures were 0.27 per cent for the USA and 0.08 per cent for the UK.

  13.  As a result of this greater maturity, the US market has "environmental" advantages across a wide range of factors, including:

    —  the existence of role models to inspire and guide would-be entrepreneurs;

    —  the availability of serial entrepreneurs and executives with managerial experience of building such businesses;

    —  the existence of a substantial pool of managerial talent represented by executives within large corporations such as Microsoft, Cisco Systems and Intel;

    —  a more "experienced" stock market for technology companies; and

    —  the existence of a highly-developed infrastructure of advisers, investment banks, incubators and business angels who are familiar with the screening and structuring of technology investment proposals.

    We believe that in Europe, these same "environmental" features will emerge as the e-commerce market grows and a virtuous circle develops.


  14.  It is well accepted that e-commerce represents a huge opportunity for value-creation, through cost savings, increased productivity and efficiency, greater transparency, etc. It is this opportunity which, in a free and entrepreneurial economy, is the engine that drives the creation of new businesses, by offering entrepreneurs and investors the prospect of sizeable returns.

  15.  Because e-commerce businesses tend to be highly cash-consumptive in their early stages, funds are often invested in them through several "funding rounds", with the cost (or price) of investing in a particular business generally increasing substantially as the business successfully reaches each of its development milestones. This increased cost of investment, of itself, acts as a strong incentive for venture capitalists and other investors to seek to invest at an early stage in a business's development.

  16.  From the perspective of a venture capitalist, whose primary focus is equity investment, the major part of the returns from an investment are constituted in the form of capital gains, as the investment is sold (for cash or shares in the acquiring company) or the investee company achieves a flotation on a stock exchange (at which point the venture capitalist could expect to realise cash for a proportion of his investment). The existence of buoyant mergers and acquisitions markets and receptive and liquid stock markets are, therefore, a more immediate engine driving venture capital investment.

  17.  In this connection, the establishment of high-growth technology-focused stock markets in Europe, the introduction of the Techmark index in late 1999 and the revision to the London Stock Exchange's listing rules for "innovative high growth companies" have been helpful developments. These changes essentially track the experience of the USA, where the primary stock market for technology companies (NASDAQ) is more developed and has been established for a longer time than the equivalent markets in Europe. The ability of companies to achieve a listing at a relatively early stage on a stock market (in terms of the listing criteria and quoted investor appetite) has been helpful to venture capitalists in assessing the risk/return profile of potential investments in early stage e-commerce businesses.

  18.  Whilst there is, as yet, little statistical information on the returns being made by venture capitalists from early-stage e-commerce investment, there is strong anecdotal evidence that the potential for substantial returns exists. High profile examples of listings achieved recently on the London Stock Exchange by venture capital-backed e-commerce companies include, Netstore and Bookham Technology. The high returns being made (we believe) on early-stage e-commerce investment are in contrast to the relatively low returns historically made by venture capitalists on early stage investments in conventional businesses. For example, the European Venture Capital Association ("EVCA"), in its 1998 Investment Benchmarks Report, notes that, for "mature" European private equity funds, net annual returns to investors were 10.9 per cent for "early stage" investments and 14.5 per cent for "buyouts". Within the UK, the difference in returns achieved is even greater—8.3 per cent for "early stage" investments, compared with 16.5 per cent for "mid MBO" investments and 19.2 per cent for "large MBO" investments (source: WM Performance Measurement Survey 1998).

  19.  In terms of assessing the risk/return criteria applied by venture capitalists in assessing potential investments in early-stage e-commerce businesses (which is the key focus of your assertion), it is important to recognise that there are relatively low barriers to entry into the European venture capital market and no major restrictions on the entry into Europe of capital from overseas, particularly from the USA. In addition, the Internet is creating global marketplaces, which means that the business models, strategies and potential of early-stage e-commerce proposals can be largely appraised on a global basis.

  20.  We should, however, recognise that the relative immaturity of the e-commerce market in Europe brings with it a number of "environmental disadvantages" (see paragraph 13 above)—such as the lack of a sizeable pool of managerial talent and a less developed adviser infrastructure—which directly impacts upon the assessment of risk.

  21.  That said, any significant disparity in the risk/return criteria applied in the USA as compared to Europe would be expected over time to result in a flow of venture capital into the market with the better risk/return trade-off. We would accept that there may be a short-term disparity but would assert that this would diminish as funds from institutions in the USA enter into the European markets. Throughout the 1990s, the US pension fund industry, in particular, has supplied substantial funding to European venture capitalists, and this has increased with the growth in technology opportunities.


  22.  It is clear that in Europe there is huge investment momentum toward investing in early stage technology (including e-commerce) opportunities, driven by the returns being earned on investments in such businesses. The BVCA's 1999 annual Report on Investment Activity notes, inter alia, that in 1999:

    —  investment in start-up and early-stage companies reached record levels;

    —  high technology companies received more venture capital (over £1 billion in 1999) to back more businesses than any other industry grouping;

    —  nearly four times the number of Internet-related companies were backed, receiving over seven times more investment than in 1998; and

    —  86 per cent of all the high technology companies backed were at a start-up, early or expanding stage of development.

    Whilst the EVCA has not yet published its statistics for 1999, we believe they will reveal a similar picture of increased investment levels and momentum toward early-stage technology investment.

  23.  There is also evidence of a shift in activity within venture capital, from buyout funds to technology investment. 3i itself has announced a strategic target of growing the proportion of its UK investment portfolio represented by technology investments from 9.5 per cent at 31 March 1998 to 30 per cent. As well, venture capital organisations which historically have been "big players" in the buyout market have recently launched substantial technology funds.

  24.  The availability of substantial funds for investment in early-stage technology (including e-commerce) opportunities is further illustrated by the variety and number of "players" now in this market. As well as venture capitalists, the last few years have seen a huge growth in the number of "business angels" (in the UK to around 18,000); the emergence of "Internet incubators"; and the growth in corporate venturing, where an established company takes venture capital-type stakes in a range of start-up and early-stage companies in order to gain access to technological developments.

  25.  Whilst we perceive no shortage of investment funds at the current time, we note two specific areas where, over the longer term, we might expect additional funds to enter the European venture capital market. These are: (i) the currently very low level of private sector pension provision in Europe as a whole; and (ii) even in the UK, the relatively low allocations to venture capital investment by pension funds (compared with the USA). However, given that there does not appear to be a shortage of funds at the current time, there is no reason to believe that the arrival of additional funds would necessarily lead to significant market development.


  26.  The key point we would like to emphasise is that, over recent years, US institutional capital has been entering the European market in pursuit of e-commerce opportunities. The logical outcome is that, over time, any differences in risk/return criteria for investment in Europe compared to the USA will erode.

  27.  We do acknowledge that the European markets are less mature than that of the USA, and that a number of cultural and environmental "disadvantages" do pertain in Europe. Nevertheless, we believe the European markets are developing fast and we would re-assert that the relative immaturity of the European markets is not due to a shortage of investment funds or a reluctance to invest on the part of venture capitalists. On the contrary, there is a huge amount of investment funds "looking for homes" with the e-commerce area (at all stages of a business's development) and the entry into Europe of US institutional funds ensures that there is no logical reason, except in the short-term, for the overall markets to apply significantly different risk/return thresholds.

25 May 2000

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