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?"
BACKGROUND ON
3I
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.
DEFINITION OF
E-COMMERCE
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.
OVERVIEW
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.
ENTREPRENEURIAL CULTURE
AND ENVIRONMENT
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.
PERCEPTION OF
RISK AND
RETURNS AND
THE IMPORTANCE
OF STOCK
MARKETS
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 QXL.com,
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.
AVAILABILITY OF
INVESTMENT FUNDS
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.
CONCLUSION
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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