Venture capitalists fear the bubble may burst after another record year

Britain's venture capitalists are on a roll. In the past 12 months, they have spent more than pounds 10bn taking companies private - a 33 per cent increase on the figure for 1996 and a new record. Peter Thal Larsen hears worries that the bubble might be about to burst.

Given the vast sums of cash venture capital firms still have available for investment - over pounds 8bn was raised by new funds during the year - 1998 is unlikely to be any different.

But some observers, including a number of senior venture capitalists, see signs of an unsustainable boom. "At this stage of the cycle, there is a growing worry that the next transaction may be a deal too far," says Tom Lamb, a senior director of BZW Private Equity.

He points to the increasing size of private equity deals. The pounds 900m CinVen is believed to have offered Reed Elsevier for IPC, its consumer magazine stable, is just the latest in a string of large transactions. Other deals include the pounds 700m buyout of bookmaker William Hill by Nomura, the Japanese bank, and the pounds 515m put up by Legal & General to acquire BTR's polymers business.

Venture capitalists are victims of their own success. Since the recession of the early 1990s, most have generated returns on their investments of 30 per cent or more a year - comfortably outperforming the stock market.

Money has also flowed in from the US, where the returns from venture capital have recently been lower. Of the funds raised in the past year, experts reckon as much as half has come from American investors.

The result is that funds are getting larger: In 1997 venture capital groups Schroders, Doughty Hanson, Charterhouse and Candover each raised buyout funds worth more than $1bn. To invest the cash they then have to concentrate on larger deals - usually with a value of pounds 50m or more.

But experts question whether there is an adequate of supply of deals of that size. "In the early 1990s companies had to sell because they were strapped for cash. Now they have strong balance sheets," says one venture capitalist.

The result is intense competition. "In the UK you now have a classic auction with four or five companies looking at each transaction," says Tim Wright, assistant director at Apax Partners.

Many venture capitalists are finding it hard to invest their funds sensibly. For example, Charterhouse Development Capital - best known for its buyout of the Porterbrook train leasing group - has been sitting on an pounds 800m fund since May, but has yet to invest a penny.

A frequent complaint is that funds like CinVen - which can draw on the huge British Coal, Railways and Barclays Bank pension funds - are pushing up prices by overpaying for deals.

But CinVen, which tops the UK buyout league for 1990-1997 with deals worth pounds 4.87bn, says its success is the result of its willingness to fund additional investment in the companies it backs.

But many venture capitalists are taking a more hands-on approach with groups are playing an active part in the running of the business. This can mean pursuing acquisitions in the same industry to generate economies of scale.

In March, Doughty Hanson, one of London's most aggressive private equity investors, spent more than pounds 400m buying packaging businesses from Pechiney of France and Germany's Schmalbach-Lubeca. By merging the two, Doughty created one of Europe's largest metal packaging companies.

"Financial buyers are becoming the conglomerates of the 1990s," says Mr McKenzie. "They are assembling companies, and can also put more debt into them than the stock market is comfortable with."

The lack of sophisticated equity markets may also make it harder for investors to float their businesses when they come to seek an exit.

With private equity deals growing in size and complexity, the risk is that any economic slowdown will leave venture capitalists with burned fingers. Many see alarming parallels with the late 1980s, when private equity funds launched ambitious buyouts of kitchens group Magnet and supermarket chain Gateway, only to watch them go spectacularly wrong when the recession hit.

Even if that can be avoided, one thing looks certain: venture capitalists will find it a lot harder to make money in the next few years than they have in the previous five.