The credit crunch since mid-2007 has shown the importance of the financial services sector to the economy and the health and wealth of nations.
The threat of bank failures leading to a repeat of the Great Depression of the 1930s has been enough for developed-country regulators, central banks and politicians to take unprecedented measures to maintain lending and capital flows to companies and people.
This had led to a number of initiatives, such as last month’s launch of a £1.5bn ($2.4bn) fund by six UK banks to invest equity for minority stakes in smaller companies, and state backing for venture capital (VC) firms (see Simon Witney’s comment).
Public money accounted for between a third and a half of all commitments to VC funds last year, according to research by the European Investment Fund, a state-sponsored asset manager that alone commits about €300m ($416m) per year to VC funds, while, in the US, initiatives such as Department of Energy grants have tried to pick companies in strategically important sectors, such as clean-tech.
However, research by Global Corporate Venturing into the 100 largest financial services companies, based on the Fortune 500 list, indicates there has been a steep fall in the commitment to VC by many of the world’s largest banks and insurers over the past decade, although the situation is reversed in many emerging markets as regulations have been liberalised and local stock markets have boomed alongside their economies.
The reasons behind the waxing and waning of support for VC has followed success or failure in the primary reasons for investment – to make money directly from fastgrowing companies, to gain an advantage when other related parts of the business want to make money from nascent businesses, to find innovative products to sell or out of social obligation.
Financial services companies have been some of the earliest and largest supporters of VCs. Credit card company American Express provided the initial $5m for its former employee, Reid Dennis, as he launched the first fund in 1974 for what became Institutional Venture Partners in 1980.
This was about half of the amount raised in the US VC industry that year, while banks, such as Wells Fargo, had been investing for more than 35 years by 2001.
In Europe, VC funds developed from the 1970s mainly from banks and financial institutions because outside the UK there were few pools of institutional pension fund or entrepreneurial wealth to provide investment commitments.
But unlike the majority of top buyout firms, such as Blackstone Group, CVC Capital Partners, and Apollo Management, which have often spun out from banks or had bankers as founding partners, the top 10 global VCs have been primarily originated from other ranks, such as serial entrepreneurs.
The top 10 firms managing the most successful VC funds, as judged by a forthcoming analysis of performance by Harvard University and the UK’s National Endowment for Science, Technology and the Arts, includes Matrix Partners, Sequoia and Mayfield Fund (see table and biographies).
Although it is hard to generalise about the performance of bankers as venture capitalists, as there are plenty of examples of VCs that have spun out and perform well, the institutions have underperformed as investors. Even during the height of the VC boom, in the 1990s, banks lost an average of 14% per year from their selection of early stage VC funds, according to the academic research (see box).
David Walker, senior adviser and former chairman of Morgan Stanley International, said: "VC’s lacklustre performance or failure substantially reflects the agency gap problem in that providers of initial funding (banks, pension funds and so on) have not engaged effectively, includingpractical support and guidance, with management of individual VCs, including identification and recruitment of suitable people to manage through to development."
US VC returns have this year fallen negative over a 10-year view for the first time as the dot.com flotation boom results drop out of the numbers. This has led at least some investors to pull back from the asset class.
For financial services sector investors with potentially strategic as well as financial goals from investing in VC, there has been a double impact from the poor relative results and lack of listings.
A string of successful VC-backed initial public offerings on the Nasdaq andother developed market stock exchanges fuelled the returns of venture investors.
Credit card company Visa said it started investing in 1994 after buying half of Intelidata, a home-banking software company that later went public, and realised about $200m over the next four years having backed internet group Yahoo and credit checking company VeriSign. Rather than invest via funds, Visa co-invested alongside established VCs.
These 1990s successes encouraged a wave of other financial services investors, including Germany-based insurer Allianz, which acquired a stake in European incubator Antfactory in 2000.
The fast-growing businesses also provided ancillary work to investment banks through earning an average of 7% in fees from taking companies public, or advising on takeovers by public companies.
For insurers and other investors there were other benefits from keeping close to fast-growing companies, such as public equity fund managers gaining access to so-called hot stocks before the first day stock price pop, or price rise, and to ancillary services.
The subsequent dot.com downturn primarily affected the technology, media and telecoms sectors, but large financial services firms had to write off billions in paper gains on their venture investments. Wells Fargo in June 2001 said it would take nearly $1.1bn post-tax charges "from impairment writedowns of publicly traded and private equity securities, primarily in the venture capital portfolio" it had written up in 1999 and 2000 as stock markets soared.
When taking the financial charge, Wells added: "Venture capital investing is a volatile business, but over the long-term it has earned very attractive returns.
"We have been in the venture capital business for more than 35 years. Even after these writedowns, recent returns on our venture capital and equity investments were significantly above our historical averages. We expect returns to be above our minimum hurdle rate of 20% in the years ahead."
The dot.com rise and fall also affected the longer-term market for venture-backed listings in developed economies.
In a recent paper – Is the venture capital model broken? – Steven Kaplan, Neubauer family professor ofentrepreneurship and finance and faculty director of the Polsky Entrepreneurship Center at the University of Chicago’s Booth School of Business, and Josh Lerner, Jacob H Schiff professor of investment banking at Harvard Business School, found that even after the US economy recovered between 2004 and 2007, there was a lower-than-expected number of IPOs compared with the 1990s.
In a guest comment for Global Corporate Venturing in July, Lerner and Kaplan said: "The small number of IPOs from 2004 to 2007 [only slightly more than 50 a year] came despite the robust stock marketover that period and despite the large number of companies that received VC funding over the previous five to 10 years.
"By comparison, in all but one year during the 1990s, there were more than 100 VC-backed IPOs. In five of the 10 years, there were more than 150. Then, in the recession and bear market of 2001 to 2003, the number of VC-backed IPOs dropped below 50 each year. But this was not unusual for a down-market – a similar pattern had occurred in the bear market from 1989 to 1991."
US-based law firm DLA Piper said its survey of technology company executives showed the lack of VC-backed company flotations, with just 14 in the third quarter of the year, meant the industry was "permanently altered".
Nearly 72% of respondents to the DLA survey said an IPO of a portfolio company was no longer the optimal exit strategy. As a result, more than 59% said the traditional VC model had been "permanently altered" and would lead to both fewer VC firms and fewer funded technology companies in the future.
Kaplan and Lerner added: "It is not yet clear why there were so few IPOs [between 2004 and 2007].
"Some blame the increased costs imposed on companies by legislation. Some blame increased litigation risk and the concomitant increase in directors’ and officers’ and other insurance. Some blame inattention from investment banks that were able to make more money from other activities. And some blame the scarcity on the fact that too many similar companies were funded during the dot.com boom, competing so fiercely that consumers received most of the benefits."
Lerner and Kaplan said the VC model was not broken and was potentially on the cusp of better returns as the cash flowing into the industry fell as a proportion of gross domestic product (GDP) and strong portfolio companies were waiting to be sold or floated in the wake of gambling group Betfair, which had a market capitalisation of more than £1.5bn after its IPO in London last month.
But with a reduced source of additional revenues to offset poor returns from investing in third-party funds, banks and other financial services investors were drawn to other asset classes promising greater returns built on debt or opacity, such as derivatives.
Between 2000 and 2008 the compound annual growth rate rise in UK debt increased by 10.2% per year, according to research by Will Hutton, vice-chairman of the Work Foundation. Bank assets as a proportion of GDP went from a third to five times in the UK between the lifting of credit controls in the 1970s to 2008, while in Iceland it increased to nine times.
John Taysom, an angel investor, said: "When the dollar was strong and dollar interest rates were low, US bank-driven costs of capital were very low and they could outbid for leveraged buyouts."
The tax advantages of debt over equity with the deductibility of interest payments also became more apparent as interest rates fell in the era of moderation from the early 1990s to accentuate the returns from a steadily growing global economy and boost overall asset prices, such as property.
These issues of falling returns, lack of IPOs and relative growth in other asset classes built on debt led to a number of bank VC operations being spun out over the past decade, including Toronto Dominion’s to form Fairhaven Capital Partners; US Bancorp Piper Jaffray investment bank, which had raised a $150m fund of VC funds in 2000 and is now spinning this operation off to form North Sky Capital; part of Morgan Stanley Venture Partners to form Crossmark after nearly 20 years of operation and six funds managing $1.2bn; Scale Partners from Bank of America; and Apposite Capital from Japan’s Mizuho, although the bank retained Mizuho Capital.
Others were closed, such as Belgium-based Dexia, which in 2002 shut its captive VC unit Dexia Ventures after six years to concentrate on growth equity and buyouts.
And a steady stream of changes has continued. Last month, Canada-based GMP Securities’ EdgeStone Capital Partners transferred its venture business VC Bridgescale Partners, according to local news provider Financial Post.
In May, Japan-based financial conglomerate Sumitomo Mitsui split with its VC joint venture partner Daiwa Securities Group after five years. The two sides said the joint venture, Daiwa SMBC Capital Company (DSCap), was being unwound "because the recent business environment surrounding the market for new listings has been extremely difficult" and "the business performance of DSCap is expected to continue to remain unfavourable".
As a result, Sumitomo Mitsui set up its SMBC Venture Capital Company using 40% of the assets from DSCap, which changed its name to Daiwa Corporate Investment Company to manage the remaining assets for Daiwa.
Others also cut back their commitments while most of the top-100 survey by Global Corporate Venturing make no reference to VC on their websites or said they were not investing in the sector.
Germany-based DZ Bank said "venture capital is not a focus" while John Danielsen, managing partner at Denmark-based Danske Private Equity, said: "We only invest in buyouts."
Danske’s first fund of funds raised in 2000 invested 29% of its €500m in venture, while the proportion shrank to 11% for its next fund in 2002 and 3% in its 2005-vintage third fund.
UK insurer Legal & General’s (L&G) spokesman said its private equity manager, LGV, was "a very small part of the insurance business, less than £200m out of a £320bn portfolio" and less than the near-£500m it managed a few years before. He said LGV was providing "effectively mezzanine capital to companies where L&G has some value to add, but not startups, just ones with strong cashflows".
Those that do still invest in VC are often reluctant to reveal their operation. France-based insurer Axa said its private equity operations included the gamut of investments, including VC, but it could not disclose the assets under management in VC.
However, it did say its recent activity to boost assets, such as its acquisitions of Bank of America’s and Natixis’s private equity funds, were not for its venture operation and "venture capital remains marginal in our fund of funds activity".
Other insurers were as candid. David Currie, chief executive at SL Capital, the private equity manager of Standard Life that the UK insurer part spun out to its managers, said: "Go back 20 years and most banks and insurers had VC operations, but over time the balance of third-party money coming in meant teams migrated to being independent as investor sentiment was negative about captives for fear of their being an agenda by the parent banks or insurers.
"Especially with continental [Europe-based] banks, there was a problem of [the parents] levering out problem cases into the private equity operation to sort out.
"We manage less than £500m in VC, or about 1% of Standard Life’s assets under management. The reality is SL does not have a private equity or VC policy but seeded a fund of funds [what is now SL Capital] some time ago and so most of our money comes from third parties.
"Standard Life is limited as when it was a mutual insurer it invested from its main members’ fund, but post-demutualisation it is now a closed life fund and in run-off, so its capacity to commit to something with long-term obligations does not make sense. Other money it manages is defined contribution pensions and again that does not necessarily fit with being a limited partner [investor] in private equity."
The double whammy of lower returns and lack of ancillary business or changes to investors’ products has come at the same time as greater regulatory scrutiny of the trading and investment activities of financial services firms.
These rules are set by international standards bodies in Switzerland – Basel III for banks and Solvency II for insurers – while there are also local regulations, such as the requirement in the US for banks to spin off proprietary trading divisions – called the Volcker rule after former Federal Reserve chairman Paul Volcker – or maintain a higher equity cushion against the amount they invest or lend, as is the case in Switzerland.
Currie added: "For banks, there is less commitment to venture capital as Basel III makes it expensive to hold capital, while insurers have Solvency II, which under a narrow point of view would argue the rules disallow capital allocation to the asset class."
Jim Hale, founding partner at VC firm FTV Capital, which
specialises in financial services, said: " p.MsoNormal, li.MsoNormal, div.MsoNormal { margin: 0cm 0cm 0.0001pt; font-size: 12pt; font-family: "Times New Roman"; }div.Section1 { page: SectionNew regulations such as Solvency II and Basle III are huge issues for financial services companies. For example rules to manage capital adequacy, liquidity and risk will all alter today’s delicate balance of profitability for industry participants.
"For financial institutions investing in venture capital, capital and risk management both apply. So, during the time that FTV has made dozens of growth capital investments (over the past 13 years), our LPs have done a turnabout; in the 90’s nearly half of our 38 institutional financial services LPs operated full venture investment functions. Today it is down to two. The twin pressures of capital and risk management dictated that the economics of those functions were sub par, and they were shuttered."
Hans Morris, managing director of growth equity firm General Atlantic and former president of Visa and chief financial officer at Citigroup, said: "As more risk is captured in the system, either through regulation or market forces, capital requirements are going up for almost all financial services businesses.
"A second trend is the increasing presence of financial services in emerging markets – a direct function of the emergence of a large middle class of consumers and savers.
"Third, there is a dynamic shift in the source of competitive advantage. All financial services companies are effectively information intermediaries, and any advantage in information is not enduring given the continuous disruption caused by declining costs of technology and communications.
"Incumbents have historically sought to take advantage of these trends. The financial crisis has taken a lot of the money and stamina for innovation investment – in terms of capital, executive talent and technology development resources – and made them a luxury they could not afford.
"I think this is equally true whether it was investment in internal activities or corporate ventures. The development cycle in a large company is vastly more complex and could take years, rather than the months it takes for a start-up.
"With the hurricane [of the credit crisis] over, chief executives are now looking at many of their businesses and trying to figure out where they will place their bets for future revenue.
"This means it might be better for some executives to partner a private equity firm with expertise specific to the business in question, and chief executives are more receptive now to this idea."
These issues have meant that whereas 62 bank and insurance companies had more than $16bn in VC funds in 2001, when the three academics mentioned earlier carried out their survey on performance, the total among the 100 largest firms now is estimated to be less than $10bn, according to a survey by Global Corporate Venturing.
However, Preqin, a data provider, in its Venture Report published last month, said a fifth of the 2,167 limited partners it tracks still came from banks, insurers and investment companies, including family offices, such as eBay founder Pierre Omidyar and hedge fund manager George Soros.
Both Omidyar and Soros are in the top 10 most recent investors in VC funds, according to Preqin, in a list otherwise dominated by large defined benefit pension or state funds.
co-founders Paul Allen (Vulcan) and Bill Gates (CascadeThe re-emergence of families and corporate investors in VC has often sprung from entrepreneurs who led the last wave of exciting technology companies, such as AOL co-founder Steve Case with his Revolution fund, Microsoft co-founders Paul Allen (Vulcan) and Bill Gates (Cascade Investments), and SAP co-founders Dietmar Hopp (Dievini Hopp) and Klaus Tschira (Aeris Capital).
Their emergence, either directly as angel investors or indirectly through thirdparty managed funds, as important investors relative to financial services investors has been seen as a positive development for VC, often as they retain close ties with their former businesses and bring corporate venturingstyle attributes in terms of strategic connections.
Walker said: "I would tend to the optimistic view that corporates and families are more likely to be effectively and closely involved. [This] equals a narrower agency gap [than banks or pension funds] which should imply better outcomes."
Yannis Pierrakis, head of investments research at the UK-based Nesta, said: "University endowments make the best returns from VC (Harvard, for example). In theory, I would expect families and corporates would do better than banks, which I think has been the case anyway as pension funds and banks have less risk appetite."
Taysom said: "Now the leverage game is discredited, if not quite over, we are back to growth from real businesses, not from shaving percentage points off borrowing costs and extending leverage to the edge of the risk-reward cliff.
"[This should mean] domain knowledge and sector contacts should show through and while many VCs view a deal as a single- point event, with the entrepreneur and shareholders, family businesses and the good VCs expect to deal with the same entrepreneurs and final acquirer maybe several times. This is a different attitude [more relationship and less transactional]."
Many of the most successful VC firms had close ties with family offices, such as the Bass or Rockefeller families, or the universities and technology firms that formed the early pioneers in the digital revolution, such as Stanford University and Hewlett-Packard.
Of the remaining developed economies’ banks and insurers in VC, some have become more focused or expanded their programmes, while other are taking greater heed of social considerations in supporting nascent businesses or looking for innovative products they can sell using technology as the agent of change.
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In addition to providing growth capital to leading software and services firms (including outsourcing and payments) Hale said FTV sought to create new products, such as on-line financial planning (financialengines.com) and exchange-traded funds (Powershares and ETF Securities). "Our most recent investment totaled $50m, providing capital for expansion to Financial Transaction Services", a US-based provider of electronic transaction processing services, he added.
Although a number of firms, such as mutual fund manager Fidelity, said their VC operations were purely looking for financial returns, others, such as Hartford, US bank Citigroup through its ventures and innovation team (see profile as Citigroup as this month’s most influential corporate venturing unit) and Royal Bank of Canada (RBC), said the minority investments were also about bringing strategic priorities to bear in their investments for future products or services.
While still currently part of the bank, RBC Venture Partners said it made equity investments in companies specialising in technology for the financial services industry and financial services enabled by technology, such as network infrastructure and products and services for the "underbanked" – people or businesses with poor access to mainstream financial services.
Although Morgan Stanley spun off what became Crossmark in 2005, three years later it bought a minority stake in clean-tech VC firm NGen, which has strong corporate limited partner backing, and built up one of the most successful franchises for green IPOs, including flotations of Tesla Motors and Amyris Biotechnologies this year, and the incipient listing of Brightsource Energy, in which it is also a minority shareholder.
Goldman Sachs said it no longer made VC investments from its principal investments area team but has sponsored specialist private equity firm Core Capital as it helps socially-responsible businesses or provides access to minorities or disadvantaged people.
This is similar situation to that of Bank of America, which spun off Scale but maintains a $150m Community Development Venture fund of funds for women, people from ethnic minorities or on low incomes.
In June, Switzerland-based bank Credit Suisse set up its SFr100m ($101m) fund SVC-Ltd for Risk Capital for SMEs to offer equity to growing businesses with the first criterion being those that could create or preserve jobs sustainably.
In the UK, as previously mentioned, the six main clearing banks have promised to invest up to £1.5bn in small and medium-sized enterprises after government pressure to be seen to be helping more nascent businesses after state bailout of the sector.
Italy’s Banca Intesa, meanwhile, set up Atlante Ventures and Atlante Ventures Mezzogiorno as regional VC funds and a training programme for entrepreneurs and collaboration with US-based angel investment group Maverick Angels.
For others, the withdrawal of some of the largest banks has provided a boutique opportunity, with merchant banks, including Burrill & Co and Allen & Co, increasing their role and influence.
Allen & Co, a legendary investment bank for media companies, is a backer of sFund – focusing on social media innovation – which is managed by VC Kleiner Perkins Caufield & Byers.
The cornerstoning of the sFund by a group of large companies, such as social gaming group Zynga, cable company Comcast and e-commerce group Amazon, has offered business access to corporate venturing often for the first time.
Other large financial institutions unwilling to create a separate management team for what is often a relatively small part of their portfolio includes New York state pension fund TIAA-Cref, which last month committed $50m to Good Energies, a Switzerland-based quasi-corporate venturing unit for clean-tech investment managed on behalf of the Brenninkmeijer family that founded the C&A clothing chain.
Burrill & Co has built one of the largest and most successful life sciences merchant banks and has set up a joint venture with Infinity Group in Israel and China to run VC funds.
It is in the emerging markets that there has been most growth in financial services’ involvement in venture capital. Josh Lerner at Harvard said: "There has been a clear pattern of [western] banks as venture capital [firms] proliferating in the late 1990s, but they have largely gotten out now.
At a financial services round table for corporate funds last year, there was only RBC [which also manages third-party money through the Blackberry Partners Fund] whereas in 2000 and 2001 banks dominated. It is similar with insurers, although in other markets, such as China, they are becoming more important."
China is removing restrictions on life assurers’ investments in private equity, including VC. In September, the China Insurance Regulatory Commission said it would allow insurers to invest in private equity and real estate, with an estimated $100bn awaiting the move, according to newswire Reuters.
Dominant China Life has already teamed up with China Development Bank, the country’s social security fund and a Chinese VC fund to set up a RMB15bn ($2.2bn) VC fund in Suzhou, a manufacturing hub close to Shanghai.
Joe Morgan, chief innovation officer, and James Anderson, head of corporate finance sales, at Silicon Valley Bank, said: "Our forecast is for 50% of the global VC dollars to be invested outsde the US over the next six to seven years and we have added people in India and China. These are big changes in our business. Every region is asking where Chinese and Indian banks have also been active sponsors of VC funds. ICICI Venture is raising $1bn for its latest fund.
State Bank of India, the country’s central bank, has a joint venture with Japan’s Softbank’s VC, SBI Ven Capital, and last month bought a fifth of A Little World, a technology services providing company with a strong rural focus.
Meanwhile, Agricultural Bank of China is marketing to its private banking clients a clean-tech VC fund being raised by Merchant bank New York Pacific Capital.