Investors left gasping as new deals dry up

When venture capitalists have money to spend, why are buyouts so thin on the ground?

Many investors felt the need for a large whisky after the 11 September terrorist atrocities. Plummeting stock markets, reduced consumer and business confidence, never mind the horror of the events themselves, made for a grim few weeks.

But the private equity industry got its smooth malt a few weeks ago when it unveiled the most significant deal to take place in the UK since the attacks – the sale of Whyte & Mackay and Invergordon Distillers to a management team for £208m, backed by WestLB and Rotch.

Sadly, it was just a brief return to normality in an industry that is gasping for deals. Statistics from the Centre for Management Buy-out Research show that only 12 deals took place in September, compared to 66 in the same month last year.

Exacerbated by the decline in the technology market – once a fertile ground for venture capital money – the private equity industry has endured a gloomy few months. Last week, 3i, the UK venture capital bellwether, shed 17 per cent of its workforce and posted a 23 per cent drop in its net asset value, blaming global economic "uncertainty".

Apax Partners, the early-stage venture capitalist, saw its plans for a €200m (£125m) deal with an unnamed "tourist" company stall in September. And Carlyle Group and Softbank scaled down the size of their European funds, because of the slump in deal flow.

"I don't think it's a reduction in the opportunities that are around. But as this year has got tougher, businesses have fared less well and the forecasts in selling memorandums have not been achieved, so deals are aborted in the due diligence stage," says Alastair Gibbons, head of UK investment at Bridgepoint Capital, a buyout house.

It is all very different from the heydays of the technology boom. During 1999 and in early 2000, venture capitalists became the pioneers of a new frontier. Entrepreneurship went beyond fashionable – everyone was doing it – and the rewards for those companies who helped budding Richard Bransons were phenomenal. Apax raked in around £1bn when it sold its stake in Autonomy Corporation. Its initial investment was just £1.7m.

By the end of last year, private equity funds were achieving annual rates of return of around 20 per cent. This success enabled private equity companies, which include venture capitalists, to raise billions from pension funds and wealthy individuals who wanted to achieve double-digit returns on their cash. European private equity companies increased the amount they raised last year by 89 per cent to €48bn but invested only €34.9bn.

This surplus cash is still swilling around, as even during the first half of this year, only €11.1bn was invested in Europe. And more money has been brought in, such as the €4.4bn fund raised by Apax in February.

But spending the cash isn't easy. First, new flotations are now as rare as flying pigs, while potential trade buyers are concentrating on their core businesses rather than searching for companies to acquire. This means that VCs can't cash in their investments. Even if they could, the poor market conditions mean they would get less for their money.

Second, fear of an economic downturn has made some venture capitalists think twice about investing in new companies – particularly in the technology and telecoms sectors – and led them to focus instead on the struggling young companies already in their portfolio. The prospect of their investments going bust is very real.

But some in the industry see opportunities in the current economic climate. The falling stock market might mean that a VC can't sell its wares but it also means it can buy up companies at much reduced prices.

Many companies, for example Apax Partners, have the money to do this. "We have an enormous amount of cash. But we think this is a phenomenal opportunity. There are an awful lot of distressed companies – particularly quoted technology companies," says Clive Sherling, a director at Apax Partners.

Despite last week's bad news, 3i could also be well-positioned. A cautious investor compared to some of its peers, it still trades at a slight premium to its net asset value. This relative strength is largely due to two factors: it has a diverse portfolio and so the downturn in the technology, telecoms and biotech sectors (which represent 37 per cent of its portfolio) hasn't hit quite as hard as it might have done. Also, since it floated in 1974, 3i has valued its non-quoted investments on an earnings basis, using the small company indices multiple (now at 7.9). This means that the valuations of its non-quoted investments did not ride on the coat-tails of the tech bubble quite as much as those of some other companies, and therefore had less far to fall.

For the smaller technology-focused VCs, life is more difficult. Many have seen their portfolio values fall dramatically and some have even returned money to investors. One example is Geocapital, which gave $200m (£139m) back to its original investors, citing a reduction in good quality opportunities in the current market.

"It's a market of two halves," says John Mackie, the chief executive of the British Venture Capital Association. "The long-established technology investors like 3i and Apax generally avoided the worst excesses of the hype, so they are saying it's business as usual. [But] the technology players who have come into the market in the past two years are saying, 'At the moment we are focused on our portfolio. The monies we have got available we want to hold back.'"

While many private equity firms have cash aplenty, for those that are trying to raise more, the downturn bites. Bridgepoint Capital, a specialist in medium-sized buyouts, is currently fund-raising to meet a target of €1.6bn. It's now just a cat's whisker away from this, but it hasn't been easy.

"It is not a fund-raising market," says Bridgepoint's Mr Gibbons.

This company has a better chance of succeeding than most, as it was barely tainted by the technology boom; it focuses on more traditional industries, such as the recently announced buyout of WT Foods. Mr Gibbons remains optimistic about the prospects, because the lower valuations of companies make for good buying opportunities.

"Activity did fall for a while," he says, "but the best time to invest is coming out of a recession. Remember, 1991 to 1994 were good years for investment activity."

For some private equity players, awash with cash and with few obvious investment opportunities, these are depressing times. For others – those who invested wisely last year – there are some bargains to pick up. The day of reckoning for the venture capital industry has arrived.