Venture capital and private equity are currently popular and much discussed topics in the Swiss press. Venture Capital in this context refers to risk capital for the financing of young businesses, while private equity is the general expression for investments in non-quoted businesses (for simplification, "venture capital" will be used as a synonym for both concepts in this article). Up to now, however, this topic has primarily been dealt with in the press from a macroeconomic point of view. Venture capital seemed to be the answer to the difficult economic situation. One hoped for the long awaited period of economic recovery by supporting young businesses. The USA was pointed to as a successful example: in the last few years, new jobs were not primarily created by blue chip firms, but rather by young businesses. Seventy percent of the firms quoted on the NASDAQ were originally financed with venture capital.

Venture capital is being discussed more and more as an investment possibility. More and more institutional and even private investors are discovering this new investment category. What makes them so interesting are their high returns and, at the same time, relatively low risk (comparable to that of the Standard & Poor’s 500 Index) and low correlation with traditional investment categories. This means that adding venture capital can significantly improve the efficient frontier of a portfolio.

An American example teaches us a lesson

In the USA, venture capital is already an established branch with more than 2,000 limited partnerships, which invest in a wide spectrum of businesses - from young start-up businesses (seed or early stage venture) to leveraged and management buyouts. In 1995 the venture capital market reached record volume of a total of 43.5 billion US dollars in managed wealth. Some experts think that with these volumes, venture capital can only be described as an alternative investment category. The great enthusiasm for this category of investment can be explained above all by the high returns, which have been above 20% per year in the last five years. What may be surprising for many is the fact that 80% of the venture capital funds raised came from conservative investors like pension funds, banks, insurance companies and university endowment funds. /they now invest an average of 5.5% of their funds in this investment category. It is expected that this trend will become more pronounced in the coming years and that institutional investors will invest 10 -15% of their wealth in this investment category over the mid- and long-terms.

Europe is catching up

In Europe the market covers a managed wealth of 21.3 billion US dollars and therefore corresponds to half of the American market. Venture capital financing has so far been most common in Great Britain, where about 50% of the collected funds go. In comparison, France and Germany are still in the early stages and Switzerland is, in this respect, rather a "developing country". In all of Europe there are only 400 partnerships specialized in venture capital. Established players with a proven track record of several years like, for example, Doughty Hanson, 3i, Industri Kapital, Apax, Charterhouse, Münchner Technologie Holding and Candover are rare.

However Europe seems to be waking out of a deep sleep and is even viewed as the up-and-coming venture capital market by experts. There are many reasons for this:

Europe has many outstanding universities that hold a great deal of "idea potential" for start-up businesses that has not yet been commercially used. In America, the large venture capital centers have grown up around the well-known universities like Stanford in California or MIT and Harvard in Boston.

In Europe, more and more initiatives for the support of young businesses are been launched. There are also already a number in Switzerland, such as, for example, the "Swiss Venture Capital Screening Board" of the ETH and the University of St. Gallen.

The problems of succession over the next ten years in more than 700,000 small and medium sized businesses in Germany and Switzerland offer a number of attractive opportunities for management and leveraged buyouts.

Because of the record sums that have flowed into the venture capital industry in the last five years in America, as well as the fact that only a limited number of good investment possibilities exist, more and more American partnerships have been discovering the European market, including Advent International with offices in London, Frankfurt and Milan or HarborVest Partners (formerly Hancock) with an office in London, to mention just two examples.

The different initiatives of new stock markets such as, e.g. the AIM in London, the New Market in Frankfurt, the New Market in Paris, Easdaq in Brussels and the venture capital stock market in Basle are also advantageous for the development of venture capital. They offer venture capital investors exit possibilities that have only been available to an insufficient extent in Europe up until now.

 
Investment possibilities in venture capital

The investor essentially has the possible routes for investing in venture capital: first, direct investments can be made in individual young businesses. Second, one can take shares in limited partnerships or acquire shares in funds-of-funds.

Direct investment in young businesses is generally to be discouraged, because this involves high risk. On the one hand there is a large lump risk if only one firm has been invested in and on the other hand, the investor generally does not have the necessary know-how to properly evaluate and support the firm and its development potential. It is always essential that a firm is not just given financial means - active management by outstanding experts must also accompany the funds. The private investor generally lacks not only the time, but also the necessary knowledge.

It is better to invest in venture capital partnerships. Partnerships generally invest in between 10 and 25 individual firms. In regard to direct investment, risk is decreased considerably through this structure. Additionally, the general partners (the actual venture capitalists) make sure that in addition to the investment of funds, an active accompanying process takes place in the management sphere in that a general partner takes a seat on the board of directors and attends to the strategic direction of the firm. If the firm does not however develop according to plan, it is not uncommon that the entrepreneur is replaced and the general partner becomes operative until adequate management has been found. A prominent Swiss example of a venture capital partnership is Venturetech, which has specialized in investments in young technological firms.

Investments in partnerships are not possible for everyone however. They are characterized by high minimum investments (depending on the partnership, between one and ten million US dollars) and by long "lock-ups" - periods generally from ten years and up. So it’s not surprising that these categories of investment have remained closed to private investors up to now. But investments in partnerships are not entirely simple for institutional investors either. With more than 2’500 partnerships world-wide, it’s difficult to choose the best. This is, however, of fundamental importance because there are big differences in return between the industry average and those of the best partnerships. The net return of all industries in the US was 16.7% per year from 1980 to 1995. If we take the top 50% of the partnerships in the same time period, the achieved net return increases to over 20% and with the top 25% of the partnerships it is even over 30%! But the best partnerships won’t accept any new investors. Kleiner, Perkins, Caufield & Buyers, an early stage venture partnership based in California and specializing in "high-tech", is generally thought to be the "star-partnership" because they have managed a net return of over 45% per year consistently over the last 10 years. Kleiner Perkins doesn’t even need a week for a newly launched fund to be oversubscribed by "regulars".

A further investment possibility in venture capital is investment in the so-called funds-of-funds. These invest in a wide spectrum of partnerships. The lump risk that arises with an investment in individual, highly specialized partnerships is reduced by a targeted choice of different partnerships. Additionally, many funds-of-funds serve as "door-openers" to some of the best partnerships because they have built up close relationships to them over the years. However, with these funds one also generally has to deal with high minimum investment sums and long "lock up" periods.

 
Innovative products from Switzerland

The innovative firm Castle Private Equity AG, which was launched in March of this year by Liechtenstein Global Trust and Partners Group, Zug, offers an answer to the obstacles that have been linked with investments in this investment category. Castle Private Equity AG is the first Swiss investment company for venture capital and private equity funds quoted on the stock market. For the first time investors can take part in this interesting investment category through the acquisition of stocks quoted on the stock market. The stocks of Castle Private Equity are traded daily on the Luxembourg stock exchange. Problems like high minimum investment sums of a lack of liquidity because of long lock up periods do not come into play anymore because of the structure. The fund-of-funds principle guarantees wide diversification and a professional investment team that includes over 15 investment managers with more than 15 years experience in this industry provides access to the best partnerships in the world. Since the first issue, almost 90% of the entire wealth of Castle Private Equity has been placed with 26 first class partnerships. In this way, a very well diversified and balanced portfolio in regard to investment style, geographical regions and industry sectors. The capital-weighted net average return (IRR) of the chosen partnerships has been about 38.5% in the past.

Risk capital without risk

Although venture capital is still in the early stages in Europe, all signs indicate that this will change radically in the coming years. Venture capital is a complex market that is inherently inefficient. With investments in venture capital, it’s particularly important then to invest in the best partnerships or in the best "fund of funds", whose managers have many years of experience in venture capital and have, above all, a first class network of contacts. Only in this way can the best returns be obtained with low and diversified risk.

 Article by, Dr. Claudia Petersen
the director of LGT Private Equity Advisers AG, Vaduz, 
the investment manager of Castle Private Equity AG, 
a traded Swiss investment firm for private equity and 
venture capital investments.