the double helix: entrepreneurship and private equity ... · page 3 executive summary page 4 the...

The double helix: Entrepreneurshipand private equity

Future trends in private equityinvestment worldwide

© 2002 Apax Partners Ltd/The Economist Intelligence Unit. All rights reserved.

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ENTREPRENEURSHIP

The entrepreneurial environment isimproving everywhere—andEuropean countries are, surprisingly,now leading the wayPage 6

TECHNOLOGY

Technology may be a tough sell atthe moment but the next wave ofinnovation, embracing the IT,telecoms and biotechnologyindustries, is already well under wayPage 12

PRIVATE EQUITY

Robust growth, superior returns andglobal scale will characterise theprivate equity industry over thecoming decade Page 20

CAPITAL MARKETS

The critical importance of growthstockmarkets to early-stageinvestment will drive consolidation atthe regional, and eventually global,levelPage 26

SOCIAL INVESTMENT

Spreading the benefits ofentrepreneurship—the momentumbehind social private equity isgrowing0

IN CONCLUSION

A personal view from Sir RonaldCohen, Chairman of Apax PartnersHoldingsPage 34

Contents

ACKNOWLEDGEMENTSPage 2

INTRODUCTIONPage 3

EXECUTIVE SUMMARYPage 4

The double helix: Entrepreneurship and private equity

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This report was prepared by Apax Partners with thehelp of the Economist Intelligence Unit. We wouldlike to thank Daniel Franklin, Andrew Palmer, AlisonRea and Mike Johnson at the Economist IntelligenceUnit. Thanks also go to David Cleevely of Analysys,Mike Ward of BioBusiness Associates and JohnHodgson of Haruspex Ltd.

Our international telecoms, information technologyand healthcare teams contributed significantly to thereport. Special contributions were made by JohnMcMonigall, Peter Englander, Mike Grabiner, JeremyReffin, Stephen Thompson, Richard Wilson, DavidFitzgerald, Michael Risman, Michael Chalfen, BorjaMartinez and Adam Frost.

Special thanks to Richard Lambert for his expertguidance.


ACKNOWLEDGEMENTS

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2002 marks our 30th anniversary. It istempting to look backwards. The growth ofthe private equity industry has beenextraordinary. Entrepreneurship hasblossomed. We have seen two cycles ofcreative destruction in information technologyand are experiencing the beginning of athird—advances in digital technology and thegenomics revolution will have far-reachingimplications.

It is our business to think ahead, and thisreport looks forward—to the environment inwhich entrepreneurs, our partners, willoperate; to the future of the private equityindustry itself; to the technology revolution,and where it will take us intelecommunications, information technologyand biotechnology; to growth stockmarkets;and to social investment.

Technology is driving the globalisation ofbusiness and information. It is not alwayspossible to predict which technologies willtriumph. We live in an age in which, in thedeveloped world at least, change is aconstant. Success lies in the ability to capturethe opportunities created by change.

INTRODUCTION

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Entrepreneurs create jobs and stimulate growth butthey cannot succeed in a vacuum. They need a hos-pitable environment in which to operate—a kind ofecosystem in which capital, universities, companieslarge and small, growth stock exchanges, competitionpolicy, laws and infrastructure all foster entrepreneur-ial ideas and bring them to commercial fruition.

Capital is the lifeblood of entrepreneurial innova-tion. That usually means private equity in the form ofventure capital. This intimate and fruitful relationshipbetween the private equity industry and the entrepre-neur forms the double helix of this report’s title.

The report has six sections. The first four sectionsbroadly follow the entrepreneur from the birth of aninnovative idea to the creation of a public company. Thefifth section, on social investment, shows how the pri-vate equity industry is using its skills for social as well asfinancial objectives. The sixth section presents the per-sonal conclusions of Sir Ronald Cohen, Chairman ofApax Partners Holdings. These are our main findings:

1ENTREPRENEURSHIP

The correlation between entrepreneurship, job creationand economic growth has been firmly established. Gov-ernments everywhere have absorbed this message andmany of them are now moving to encourage start-upsand new businesses. According to a forward-lookingindex produced by the Economist Intelligence Unit forthis report, north European countries will provide themost hospitable framework for entrepreneurs globally,with the Netherlands, Denmark and the United Kingdomfilling the top three positions. But around the world gov-ernment policy, the availability of finance and increasedentrepreneurial experience are all helping to make theprospects for entrepreneurs brighter than ever before.

2TECHNOLOGY

The technology achievements of the past 20 years willbe rivalled by those of the next 20. These are not theeasiest times to finance innovative technologies. Butthe role of innovation and the venture-backed entre-preneur is as important as ever. In IT, entrepreneurialactivity will focus on the trend towards mass customi-sation, from reprogrammable chips to the personalisa-tion of entertainment and educational experiences. Intelecoms, smaller innovative service companies willwork alongside large network operators. And inbiotechnology, the technological advantages of thebiotech firms will confirm their dominant role in deliv-ering the next generation of drugs for large pharma-ceutical companies.

3PRIVATE EQUITY

The private equity industry is set for rapid growth overthe next ten years, with pension funds in the UnitedStates and Europe likely to double their allocation tothe asset class. Growth will be driven by a narrowingin the perceived risk differential between private andpublic equity portfolios, easier access to private equityfunds for investors, better exit opportunities throughthe financial markets and continued outperformanceby private equity in terms of returns. Within the indus-try, scale will be increasingly important for funds inorder to spot trends and deliver value to companiesand investors.

EXECUTIVE SUMMARY

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EXECUTIVE SUMMARY1 ENTREPRENEURSHIP

2 TECHNOLOGY3 PRIVATE EQUITY

4 CAPITAL MARKETS5 SOCIAL INVESTMENT

6 IN CONCLUSION

4CAPITAL MARKETS

Growth stockmarkets, with their shorter reporting-history requirements, are critical in enabling new busi-nesses to expand. There is pressure on Europeannational exchanges to consolidate into regional andeven global exchanges, but politics and local interestsare delaying progress towards a pan-European capitalmarket. The costs of continued fragmentation inEurope are reflected in a lower level of early-stageinvestment than the United States, which is alreadythreatening Europe’s lead in mobile telecoms.

5SOCIAL INVESTMENT

Private equity and social investment—financial trans-actions intended both to achieve social objectives anddeliver financial returns to investors—make an odd-looking couple. But social private equity offers a sus-tainable and profitable model of capital allocation to“under-invested” communities, and is already creatingjobs and entrepreneurial role models in the UnitedStates. With the launch of the United Kingdom’s firstcommunity development venture fund in May 2002,social private equity is positioned to evolve into a newsegment of the venture capital industry.

6IN CONCLUSION

Despite its extraordinary success over the past 30years, private equity is still an industry in its infancy. Ifthe sector has grown tenfold over the past decade, it islikely to do the same again in the coming ten years.That growth will help drive greater dynamism in theeconomy as a whole—there is almost no limit to whatcan be achieved by new companies in new sectorswith high growth prospects. But with success comesresponsibility. We all have to be very conscious ofwidening disparities in wealth, and of the scope forcreative economic development in areas that have notattracted investment in the past.

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1ENTREPRENEURSHIP o

New research shows that northEuropean countries will competehead-on with the United States tobe the natural home of theentrepreneur

The environment for entrepreneursis improving globally


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6 IN CONCLUSION

Netherlands 1 8.44 4 8.32

Denmark 2 8.39 5 8.04

UK 3 8.39 1 8.34

US 4 8.34 3 8.32

Switzerland 5 8.34 2 8.34

Finland 6 8.21 7 7.89

Canada 7 8.01 6 7.96

Sweden 8 7.98 8 7.76

Israel 9 7.92 19 7.06

Germany 10 7.92 12 7.52

France 11 7.87 16 7.32

Singapore 12 7.76 14 7.41

New Zealand 13 7.75 9 7.73

Belgium 14 7.75 13 7.45

Ireland 15 7.74 18 7.28

Norway 16 7.73 11 7.52

Taiwan 17 7.56 20 6.96

Australia 18 7.54 15 7.38

Austria 19 7.54 17 7.31

Hong Kong 20 7.26 10 7.59

Japan 21 7.04 21 6.91

Chile 22 7.02 22 6.53

Spain 23 7.00 25 6.28

Italy 24 6.99 24 6.36

Portugal 25 6.89 27 5.96

South Korea 26 6.82 23 6.38

Hungary 27 6.40 26 6.03

Czech Republic 28 6.33 29 5.68

Poland 29 6.31 30 5.65

Greece 30 6.01 33 5.18

Slovakia 31 6.00 32 5.41

Malaysia 32 5.68 31 5.46

Mexico 33 5.39 40 4.64

Bulgaria 34 5.39 37 4.79

Saudi Arabia 35 5.38 42 4.57

Peru 36 5.37 38 4.79

Philippines 37 5.36 36 4.92

Argentina 38 5.31 28 5.74

Colombia 39 5.28 34 5.10

Sri Lanka 40 5.27 39 4.70

South Africa 41 5.10 46 4.38

Turkey 42 5.10 48 4.28

Thailand 43 5.09 35 5.01

Egypt 44 5.07 45 4.43

Brazil 45 5.06 41 4.62

India 46 5.05 49 4.27

Russia 47 5.04 50 4.17

Romania 48 4.84 43 4.46

Venezuela 49 4.62 44 4.44

China 50 4.41 54 3.64

Ecuador 51 4.40 51 4.12

Pakistan 52 4.38 53 3.64

Vietnam 53 4.36 52 3.79

Indonesia 54 4.35 47 4.31

Azerbaijan 55 4.35 58 3.23

Iran 56 4.28 60 2.81

Kazakhstan 57 4.28 56 3.40

Ukraine 58 4.15 57 3.33

Algeria 59 4.05 55 3.61

Nigeria 60 3.57 59 3.09

Entrepreneurial Framework Index (rankings out of 60 countries)

2002-06 1997-2001rank score rank score



Source: Economist Intelligence Unit

Schumpeter was saying it in the early 20thcentury. The epochal achievements of Alexan-der Graham Bell, Henry Ford, Bill Gates andothers attest to it. And research has proved it.

Entrepreneurship and innovation lead to job creation,which in turn produces economic activity, and togeth-er they serve as a catalyst for economic growth.

A 2001 study by Harvard Business School onbehalf of the National Commission on Entrepreneur-ship (NCOE) showed that of the 1997 Fortune 200,America’s 200 largest corporations in that year, themajority were directly founded by one or more entre-preneurs1. A secondary level of analysis into the ori-gins of the constituent parts of the remainingfirms—those whose origins rested in mergers, spin-offs and amalgamations—showed that almost all ofthem began with one or more entrepreneurs. In total,

197 of the 1997 Fortune 200, which in that yearaccounted for 1.3m jobs and over $400bn in rev-enues, could be traced back to entrepreneurial origins.

Other studies have found a direct correlationbetween entrepreneurial activity and economicgrowth. The 2000 and 2001 Global EntrepreneurshipMonitor (GEM)2 studies conclude that there is a strongassociation between entrepreneurship and GDPexpansion. According to the GEM 2000 report, abouthalf the difference in levels of economic growthbetween countries can be explained by the presence,or lack, of entrepreneurial activity. A study producedfor Indiana University’s Institute for DevelopmentStrategies3 corroborates the GEM reports’ conclusionsand finds that high economic growth rates in turnstimulate further entrepreneurship, creating a chainreaction of innovation and entrepreneurship.

1From the Garage to theBoardroom: TheEntrepreneurial Roots ofAmerica's LargestCorporations, NationalCommission onEntrepreneurship,August 2001.

2Global EntrepreneurshipMonitor 2000, Paul D.Reynolds, Michael Hay,William D. Bygrave,Erkko Autio and theKauffman Center forEntrepreneurialLeadership at the EwingMarion KauffmanFoundation, 2000;Global EntrepreneurshipMonitor 2001, Paul D.Reynolds, S. MichaelCamp, William D.Bygrave, Erkko Autio,Michael Hay, 2001.

3Entrepreneurship andEconomic Growth: AnObvious Conjunction?,Indiana University,Institute for DevelopmentStrategies, 2000.

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Until recently, the United States was the undisputedhome of the entrepreneur. Few European and Asiangovernments were attuned to entrepreneurs’ needs,local finance for new business ideas tended to be risk-averse, and tax and labour regimes often stymiedrather than stimulated start-ups. Faced with thisimbalance, frustrated entrepreneurs carried their ideasto Silicon Valley, Boston and other US centres for hightechnology and new business development. As aresult, says the NCOE, the United States controlssome 70% of venture capital worldwide.

But things have changed. A new global index pro-duced by the Economist Intelligence Unit specially forthis report ranks 60 countries worldwide by the quali-ty of the framework they offer entrepreneurs, andshows that Europe is increasingly competitive.

The Entrepreneurial Framework Index rewardscountries that are low on red tape, friendly to privateenterprise, have an equitable tax regime, an open andwell-developed financing system, flexible labour mar-kets and a modern, networked infrastructure. Therankings are both historical (covering 1997-2001)and forward-looking (covering expectations for 2002-06), allowing an assessment of trends over time. Theyproduce some striking results:

European excellence. The index shows three northEuropean countries—the Netherlands, Denmark andthe United Kingdom—clustering at the top of the globalladder over the next five years. In total, seven out of thetop ten places are filled by European countries, withFrance in 11th spot. That’s not unexpected in itself—ina global ranking, it would be surprising if Europe’s sta-ble and sophisticated business environment did not pro-pel it to the top. And a lead in the policy, institutionaland infrastructure framework for entrepreneurs does notalone guarantee greater entrepreneurial activity: other

factors—market size, demographics, tolerance ofincome differentials, culture—also play a part. But theindex results show that Europe’s top performers cannow compete head-on with the United States.

Europeans can excel at innovation too. A new Euro-pean Commission assessment, 2001 InnovationScoreboard, has found that the United Kingdom, Ire-land and France are now producing more science andengineering graduates per head than the United Statesor Japan, and that Finland, the Netherlands and Swe-den are world leaders in R&D investment as a per-centage of GDP4. Home Internet access in theNetherlands, Sweden and Denmark also outstrips theUnited States. According to a Boston ConsultingGroup study5, Europe’s most innovative new compa-nies are producing remarkable annual returns toshareholders—the top ten listed companies in theE500, an annual list of the continent’s most entrepre-neurial companies from the Growth Plus organisation,generated an annual average shareholder return ofmore than 100% between 1995 and 1999.

Europe’s entrepreneurial high-flyers cluster in Scan-dinavia and northern Europe. Countries such asFrance, Germany and Italy (which ranks a lowly 24thin the index) still tend to ascribe higher social status tomanagers of large, established companies, and as aresult, their finance, tax and legal systems are gearedto favour them over the upstart. According to a recentsurvey in Stern magazine6, more than 10% of Ger-mans want to set up their own firms but many saythey are prevented from doing so by government redtape. Moreover, as discussed in the fourth section ofthis report, continued fragmentation of Europe’s stock-markets is exacting a high price across the EU interms of efficiency and cost.

But the United States, powerhouse of the global ven-ture capital industry though it is, can no longer assumeit is the automatic choice of the entrepreneur. The US is

Europe's emerging strengths(2001)

Source: European Commission

Science and engineering graduates as % of population aged 20–29

Public research anddevelopment expenditureas % of GDP

Information, communications and technology (ICT) investment as % of GDP

EU US

10.4

8.1

EU US

0.66

0.56

EU US

6.0

5.9

New researchshows that

north Europeancountries will

compete head-on with the

United Statesto be the

natural homeof the

entrepreneur

4The European InnovationScoreboard, CommunityResearch andDevelopmentInformation Service,Enterprise Directorate-General, EuropeanCommission, October2001.

5What Goliath can Learnfrom David: The HiddenRole Models in ValueCreation andEntrepreneurship,Boston ConsultingGroup, April 2000.

6Stern, March 27th2002.

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6 IN CONCLUSION

This is how the EntrepreneurialFramework Index was calculated. Thestarting-point was the EconomistIntelligence Unit’s Business Environ-ment Rankings, which measure thequality and attractiveness of the busi-ness environment in 60 countriesover the periods 1997-2001 and2002-06. The index covers 70 quali-tative and quantitative indicatorsgrouped in ten separate categories.

The Business Environment Rank-ings are geared primarily to the con-cerns of foreign direct investors.Analysts from the Economist Intelli-gence Unit therefore adapted theindex to focus on the policy, institu-tional and infrastructure variablesthat foster domestic entrepreneur-ship. These variables were dividedinto a series of weighted categories,with the weightings being derivedfrom prior research in the GlobalEntrepreneurship Monitor reports, asfollows:● political effectiveness, comprisingmeasures assessing government poli-cy, government efficiency, red tape,

bureaucracy, the legal system, cor-ruption and crime;● policy towards private enterprise,comprising measures assessing pro-tection of private property, govern-ment regulation, freedom to compete,competition policy, protection of intel-lectual property, price controls, lobby-ing and state controls;● the tax regime, comprising meas-ures assessing corporate tax, margin-al tax, value-added tax, compulsorysocial security contributions, fiscalincentives for investment and the fair-ness of the tax system;● financing, comprising measuresassessing the openness of the bank-ing sector, the quality of the financialregulatory system and access tomedium-term finance for investment;● labour market and skills, compris-ing measures of industrial disputes,mean years of schooling, labour flexi-bility, restrictiveness of the labourlaws, extent of wage regulation andthe cost of living; and● infrastructure, measuring tele-phone density, phone faults, the dis-

tribution infrastructure, stocks of PCs,the share of expenditure on researchand development as a proportion ofGDP, and office rents.

To test the validity of the Entrepre-neurial Framework Index, the Econo-mist Intelligence Unit regressed itagainst three variables—the percent-age of people between the ages of 20and 40, an index of the macroeco-nomic environment and the medianhousehold income level—which helpexplain the GEM 2000 report’s TotalEntrepreneurial Activity (TEA) Index.This TEA Index measures the propor-tion of the adult population in eachcountry that was engaged in theprocess of creating a nascent busi-ness, and the proportion of adultsinvolved in operating a business thatis less than 42 months old.

The Economist Intelligence Unit’sEntrepreneurial Framework Index hada statistically significant positive cor-relation with the TEA Index—theoverall model explains 40% of thecross-country variations in the TEAIndex.

Methodology

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pushed off the top spot in the index because of a com-paratively weaker performance on tax, red tape andcrime. As Europe’s governments beat the entrepreneur-ial drum with increasing vigour, competition betweenthe two sides of the Atlantic will only intensify.

Asian underperformance. By contrast with Europe,Asia’s showing is relatively disappointing—Singaporeand New Zealand are the region’s top performers inthe index, sitting in 12th and 13th place respectively.Japan’s stagnant economy and rigid tax and labourregimes push it down to 21st. Regulatory burdens,labour-market pressures and shallow financing envi-ronments all contribute to Asia’s patchy performance.

But if the region’s governments can address theseissues, particularly in Asia’s most populous markets,the potential gains are immense. China ranks 45th inthe index because of bureaucratic and regulatory bur-dens, but the past two decades of powerful growthhave already proved what the country can achieve ifits creative energies are unfettered. China, and Indiatoo, remain markets for venture capitalists to keep avery careful eye on.

Israeli ambitions. If there’s one stand-out country in thetop ten, it’s Israel. Israeli early-stage entrepreneurs havefound fertile ground in a society with unique conditions.Israel may yet become Europe’s Silicon Valley if politi-cal tensions in the Middle East (a variable excludedfrom the index) can be contained. An immigrant cul-ture, an inflow of Russians highly educated in the lifesciences and electronics, a strong defence industry, andgovernment support for innovation and new businesseshave all enabled entrepreneurship to flourish in Israel.About 25 active private equity and venture capitalfunds put some $2bn into start-ups last year.

The index results underline the fact that favourableentrepreneurial environments are no longer confined toone or two time zones—from the Netherlands to NewZealand, from Canada to Chile, countries around theworld offer entrepreneurially-minded people a frame-work which helps them to start and run new business-es. Compare the scores for 2002-06 with those for1997-2001: 57 out of the 60 countries show animprovement. The culture of entrepreneurship is blos-soming almost everywhere, thanks to a vector of con-verging forces:

Government support. Governments everywhere arerecognising the vital role of nascent businesses in theirefforts to achieve economic growth and create new

jobs. The entrepreneur is in favour in most of themajor economies. In parallel, a broad consensus hasemerged in Eastern Europe and Asia championing theopen market over the command economy and cuttingback the role of the state.

Vigorous pro-entrepreneurship actions in the pastthree years have brought tax breaks in Australia, apackage of small-business incentives in Brazil, a newloan-guarantee fund for entrepreneurs in Denmark, an“Enterprise 2010” programme for entrepreneurs inIreland, tax incentives in Japan, and actions in favourof better business education, easier regulation andlower taxation for entrepreneurs in Singapore. The lat-est UK budget, unveiled in April 2002, announcedcuts in corporate tax and a simplification of the VATregime for small businesses. And in emerging mar-kets, a new economic orthodoxy based around thesmall and medium-sized enterprise is increasinglyembraced by multilateral organisations such as theWorld Bank.

Of course, governments don’t get everything right.Sometimes policy takes two steps forward and onestep back. In Germany, for example, the capital-gainstax was reduced in 2002 from 56% to 25% and thegovernment has created an American-style “GreenCard” to make it easier for foreigners, including entre-preneurs, to work there—yet at the same time venturecapital funds are being scrutinised by the Ministry ofFinance for heavier taxation. Looking ahead, there is arisk that the European Union’s proposed PensionsDirective will impose quantitative limits on invest-ments by pension funds in private equity, potentiallyjeopardising the flow of capital to new businesses insome member states. But in general, governmentsaround the world are doing more to foster entrepre-neurship than ever before.

Availability of finance. Investors worldwide are allo-cating more money to entrepreneurial ventures. Thelatest data compiled by the European Venture CapitalAssociation (EVCA) indicate a leap in the number ofprivate equity and venture capital houses operating inEurope from 831 to 1,320 in just four years, with2001 investments (including buyouts) totalling$23bn. The dotcom bust may have punctured someof the euphoria surrounding entrepreneurship but itwill not slow the momentum built up over the pastdecade. As this report argues later in section three,venture capital and private equity are poised for signif-icant growth over the coming decade.

The expansion of private equity and venture capitalinvestment is happening in tandem with the consoli-dation of stockmarkets and a gradual liberalisation of

Theenvironment

forentrepreneurs

is improvingglobally

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6 IN CONCLUSION

7Local and GlobalNetworks of ImmigrantProfessionals in SiliconValley, Public PolicyInstitute of California,April 2002.

8http://www.usnews.com/usnews/edu/college/rankings/business/entrep.htm,US News and WorldReport website.

banking regimes. The flow of investment capitalacross borders, notably in Europe, is increasing as aresult. EVCA has found that the majority of privateequity and venture capital firms operating in Europeinvest in more than one European country. The intro-duction of the euro is accelerating this trend.

And as the size of the private equity asset classgrows, so does its political influence. For example, pri-vate equity groups are pressing their governments forever more favourable tax treatment of capital gains oninvestments in unquoted growth companies.

Education and experience. The dotcom era taughtmany people some salutary lessons, but its most last-ing legacy may be the fact that, in its aftermath, morepeople have been exposed to entrepreneurialism andentrepreneurs than ever before. Many employees oflarge companies who left to join start-ups havereturned to the fold, but they have learned skills andgained experience they may draw on again.

There is increasing evidence of a reverse braindrain, or so-called brain circulation, from the devel-oped to the developing world as immigrants to entre-preneurial centres in the West transfer capital andexpertise back to their countries of origin. An April2002 survey, commissioned by the Public PolicyInstitute of California7, of 2,300 skilled immigrants toSilicon Valley—most of them Chinese and Indian—found that 18% of those surveyed had invested instart-ups or venture funds in their native countries.According to the survey, 76% of Indian immigrantsand 73% of Chinese immigrants would consider start-ing ventures back home.

Furthermore, there has been a general rise in pub-

lic awareness of entrepreneurs—from Bill Gates toMichael Dell, leading entrepreneurs regularly featureon the covers of business magazines. More than 30countries now offer a local version of “Entrepreneur ofthe Year” awards, casting the winners as heroes andheroines of the local economy. A “World Entrepreneurof the Year” is then voted as the “best of the best”.

The addition of stock options to executive remuner-ation has also underlined the rewards of ownershipand entrepreneurship. And although some entrepre-neurs believe their skills cannot be taught, entrepre-neurship is becoming a core component of businesseducation courses in the United States, the UnitedKingdom, France, Switzerland and Spain. US Newsand World Report magazine makes much of its annu-al ranking of US undergraduate programmes in entre-preneurship, this year citing Babson College as No. 1,followed by the University of Pennsylvania and theMassachusetts Institute of Technology 8.

Age of the entrepreneurBusiness cultures everywhere are opening up and taxand regulatory regimes are restructuring to release thepower of private initiative. Apax expects entrepreneur-ial activity to recover quickly from the 2001–02 dip,as successful new enterprises in Europe and to a less-er extent, Asia replicate the drive and spirit that havelong helped sustain US innovation.

The question is not so much whether entrepreneurshave a bright future—they do. Rather it is where theirenergies will be concentrated (the topic of the nextsection), and how the private equity industry willevolve in response to these opportunities, a subjecttackled in the third section of this report. ■

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2iTECHNOLOGY o

IT innovation will cluster aroundmass customisation, technologythat allows companies to respond tocustomers’ needs much moreeffectively

The telecoms industry will divideinto large network operators andcustomer-focused smaller players

Biotechnology companies willdominate the introduction of newdrugs over the coming decade

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6 IN CONCLUSION

Entrepreneurship is nothing without innovativeideas. And innovative ideas are nothing with-out a route to market. To have a commercialfuture, innovation must above all be market-

driven. The key to this linkage is the “innovationecosystem”, of which private equity and venture capi-tal are major components.

Of course technology-driven research should not beunderestimated. Important innovations have famous-ly emerged from the lab, as in the case of AlexanderFleming’s discovery of penicillin. And enabling tech-nologies such as the telegraph, telephone, radio andcomputer set the stage for the Internet, an unprece-dented integration of capabilities.

However, in terms of market acceptance and prof-its, technology-driven innovation has traditionallyfailed to deliver. McKenna Group research indicatesthat only 8% of R&D from corporate research labs isever commercialised. And studies by Professor Ericvon Hippel of MIT’s Sloan School of Managementshow that 67% of innovations on semiconductor andprinted circuit board processes were developed by oraround users, as opposed to only 23% from the man-ufacturers’ R&D centres and 10% from suppliers.

The innovation ecosystemA creative idea becomes a market-driven innovationonly when it is supported by the fundamental con-stituencies of the innovation ecosystem—entrepre-neurs themselves; capital, of which venture capitaland IPOs are an important part; competition, whichincreases the incentives to innovate; research institu-tions, including academia, corporate labs and govern-ment-funded research; and a pro-entrepreneurshipbusiness environment, be it the national regulatoryframework or a local technology cluster such as ahigh-tech business park.

Although public markets are often best suited to

financing innovation in large listed companies, privateequity in the form of venture capital is usually moreappropriate to entrepreneurs. The decisive role of ven-ture capitalists is often to identify the best ideas, andthen to help create and support the managementteam needed to develop them into real products orservices. Ideas may flow freely from laboratories butthose with market potential will survive only with afine balance of commercial judgment, adequate capi-tal and rigorous management. Venture capitalistshave been and will remain a strong catalyst to innova-tion. No industries prove these points better thaninformation technology (IT), telecommunications andbiotechnology.

Information technology

Information technology started as just that: technologyto manage the burgeoning quantities of data that gov-ernments and companies gathered and therefore hadto sort, file and analyse. The electro-mechanicalpunchcard emerged in the 1880s and the phenome-non that is now called IT began to build. From 1880to the 1940s the proportion of the US workforce in theinformation sector rose from one-tenth to one-quarter.

Following its concentration on military applicationsin the aftermath of World War II, commercial R&Dtook off, and IT came to market with greatly simplifiedsystems. The 1970s saw Intel’s microprocessors,Apple’s computers and Compaq’s innovations in IBM-compatible hardware standards reach businesses andhomes. In the marketing and manufacturing of desk-top PCs for business, there were Microsoft’s operatingsystems, Oracle’s databases and SAP’s enterpriseresource planning software.

IT innovationwill clusteraround masscustomisation

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Ventured, gainedAll but SAP and Microsoft were venture-backed. Ven-ture capital learned to provide the catalyst that clustersof engineers and companies had lacked. It becameclear that each major innovation (mainframe, micro-processor, PC) triggered a further cycle of innovation.As each cycle began, its emergence was recognisedfaster, standards were set earlier and innovation basedon them was accelerated. Venture capital fuelled thisdizzying process, and entrepreneurs swiftly createdcompanies to compete with entrenched IT vendors.

This accelerating momentum helps explain why ina remarkably short period of time, the Internet haschanged the way companies operate and people com-municate. The near-universal ability to collaborate andinform via the Internet took place on the back of inno-vators such as early networking companies Synopticsand Wellfleet; core Internet hardware platforms fromCisco, 3Com, Juniper Networks and Ciena; and theefforts of marketeers such as AOL, Yahoo! and eBay,which created mass markets for networked communi-ties. The marriage of IT innovation and the Internetreached a logical conclusion with the Open Sourcemovement, which required innovators to stabilise andmarket Linux. Again, all of these companies wereventure-backed.

The news has not been all good, of course. Over-optimism led directly to the high-tech bubble of thelate 1990s. Business failures soared and enterprisebuyers bought solutions that have either not deliveredor not even been implemented. Since then, sellinginnovative products has become a tough proposition.

Data gold-miningBut IT innovation has not yet run its course—not by along shot. It is still very much needed as companiesstrive to compete in today’s tight markets. A commontheme in IT innovation today is cost-efficient solutionsto the complex problem of accessing data across dif-ferent devices and technologies: ● Large enterprises need to integrate the many soft-

ware applications they have deployed to harnessthe business intelligence in their systems, staff andpartners. Integration software will reduce theskilled human intervention required to make best-of-breed products work together. Process automa-tion software companies continue to emerge indata-intensive areas, for processes common acrossall industries (Streamserve in output manage-ment), or for vertical industry-specific processes(Retek in retail supply-chain management).

● Data management is increasingly required acrossand outside the organisation and therefore across

sites, networks and hardware platforms. Access istypically needed in real time, from multiple loca-tions, and from multiple devices. Managing thiscomplex and distributed architecture with spe-cialised IT staff is expensive and unwieldy. Tech-nologies that enable centralised management nowoffer solutions —such as BlueArc’s for storage net-works, Micromuse’s for enterprise networks andRed-M’s for wireless networks.

● The “design gap” generated by the increasing com-plexity of integrated circuits, and pressure to short-en time-to-market, needs to be bridged bytechnologies that can deliver complex solutionsfast. Hence the value of companies such as ARM,ARC or Parthus, which produce re-usable intellec-tual property (IP) cores that can be bundledtogether to deliver systems-on-a-chip applications.Further, the increased complexity in design createsopportunities for companies such as Cadence orSynopsis, which develop tools that help design,simulate and test processes of complex integratedcircuits.

Mass serviceLooking ahead, the main trend is towards mass cus-tomisation. This is already happening on the hardwarelevel with Dell, where during the order process thepurchaser configures PCs and servers as required,down to component specifications. It is starting tohappen with software too. Standards-based web serv-ices will manage the interface between multiple appli-cations that interact via the Internet. This will radicallylower the costs of integration projects in an enterprise,efficiently utilise legacy applications and data, andmultiply the effective applications available for a busi-ness user.

On the components side, reconfigurable and repro-grammable chips, and the systems-on-a-chip intellec-tual property (IP) model, will enable companies toreduce design cycles and increase their ability to adapttheir offerings to customer needs cheaply. Similar flex-ibility will evolve as the areas of entertainment, educa-tion and technology merge. Users will selectcombinations of scenarios, merge games, tailor cours-es and interact with films via broadband networks.

Promising developments that have yet to make animpact on the market include nanotechnology, fuelcells, biometrics and robotics. New human-computerinterface models (using speech, vision and touch intandem with new voice and eye recognition, screenand plastics technologies) could in turn allow us toembed computing anywhere—in clothes, in paper,and so forth. But the nature of these potentially dis-

15




6 IN CONCLUSION

viding network equipment to newcomers. At onepoint, the city of Berlin had 40 network serviceproviders, but market pressures have reduced thatnumber by half today.

In this new world, customer acquisition became theprimary business objective, setting the stage for a longperiod of tension, which continues still, between thebig engineering-driven incumbent operators and theirnew customer-facing rivals.

Telephonic turmoilCounting incumbents, equipment suppliers and newentrants, more than 500,000 jobs have gone in tele-coms worldwide since January 2001. This secondshake-out in the telecoms industry has been costly foreveryone. The industry still lives with the conse-quences. Many of the big mergers and joint ventureshave soured, including Sprint’s deal with France Télé-com and Deutsche Telekom, and British Telecom’sConcert combination with AT&T. Others that survivedhave performed poorly as they struggle under debtburdens.

The highest-profile problem is that of third-genera-tion (3G) debt and potential technical delays of 3Gservice rollout well into 2004. Over $100bn in licencefees has been paid out against expected future rev-enues. But 3G is only part of the story: companieshave also heavily overinvested as a result of unrealisticexpectations for the volume of fixed as well as mobilecommunications.

The moral of the industry’s current predicament isthat telecoms strategy should be based on two simpletruths: access to customers and concentration of traf-fic. Access to customers requires brand-building,understanding of users’ requirements and the ability todeliver services to the customers themselves. Concen-tration of traffic is the driver of all telecoms investmentbecause of economies of scale: the more traffic youhave, the cheaper the cost per bit carried.

Lumbering or nimbleThe evidence suggests that the big operators run goodnetworks but have been slow to grasp customers’needs. Smaller companies with no telecoms back-ground have meanwhile proven they can clean up, asin the creative business of ringtone downloading, nowa billion-dollar-plus industry. And private users andadvertisers have surprised telcos with their heavyusage of the short message service (SMS) in themobile phone business. Worldwide, an estimated400bn text messages were sent in 2001.

Large companies have also created telecoms busi-nesses to capitalise on the new opportunity to attract

ruptive technologies is such that it is difficult to predictwhether they will deliver innovation cycles that drivemarket adoption.

Telecommunications

The frenzy over global communications was intense.Millions of pounds of investment were gambled onwiring the world. Entrepreneurs and their bankerscame forward with innovations and financing butsceptics worried that instant communications wouldbenefit criminals more than anyone else.

It sounds familiar, but this was the unstable worldof telecommunications in 1870. The great trans-Atlantic market was at stake and the telephone wasemerging in the laboratory. By 1875, Alexander Gra-ham Bell had shouted into his mouthpiece, “Watson,come here. I want you!” to his assistant in the nextroom. The patent for the telephone was his reward,and the revolution on which we continue to build waswell and truly under way.

Dial C for competitionWe can look back and laugh today at the Victoriannetwork, the data speeds of the Morse Code and Gra-ham Bell’s seemingly ambitious hope one day to see atelephone in every major American city. But the prim-itive systems of the 19th and early 20th centurieswere actually the industry’s biggest breakthroughs,and they found their market. In 1930 users withurgent needs were willing to pay $300 (at today’sprices) for a three-minute London-New York phonecall. Perhaps the best indication of the progress wehave made through digitisation and deregulation oftelecommunications is that today the same call costsunder 10 cents.

Costs to consumers edged downward for decadesbut they plunged more dramatically after a wave ofprivatisation began in the 1980s, breaking up statemonopolies and introducing long-overdue competitionin most of the major markets. Combined with techno-logical progress in digital switching, productivity peremployee soared. Thousands of staff trained to main-tain and operate the old Strowger electromechanicalequipment had to go, along with the equipment.

Competition spawned a generation of serviceproviders that quickly learned to use the infrastructureof the former monopolies. Content entrepreneurs,makers of new network and user equipment sprang upover Europe, Asia and the United States. Ericsson,Cisco, Nokia and others had bursts of success in pro-

The telecomsindustry willdivide intolarge networkoperators andcustomer-focused smallerplayers

16


Ringing tillsEuropean communications private equity investment (€,000)

1989 90 91 92 93 94 95 96 97 98 99 2000

Source:EVCA

129,

841

110,

603

72,7

9318

3,50

1

51,0

7813

0,49

726

3,35

2

299,

505

552,

979

1,23

7,98

0

2,91

5,03

5

4,81

8,12

6

customers via better service. Centrica, formerly BritishGas, acquired One.tel in the United Kingdom, forexample, to bring customer-focused telephone servic-es to private homes via the BT network.

In response, private equity and venture capital haveflooded into telecoms start-ups and buyouts. Privateequity funding of communications in Europe in 2000reached a record total of €4.8bn before dropping backlast year. Beneficiaries included firms such as the for-mer Ericsson Enterprise Solutions firm Damovo, themobile location-based platform Webraska MobileTechnology and Germany’s CLEC Tropolys.

It will be 2003 before the telecoms sector getsback on course and demand and supply come backinto balance. Further consolidation lies ahead. Re-emergence of the basic rules and economics oftelecommunications will be the most significant fea-ture of the next two years or so.

Some specific predictions:● In fixed networks, margins will come under less

pressure. Telecoms traffic, now mainly data, will stillbe expanding at double-digit rates, and so growth indemand will eventually soak up capacity and con-solidation will reduce competition. However in themobile market competition will intensify as 3G iseventually launched, and regulators will increasepressure to reduce charges for some services.

● Overall, turnover will grow and start to return tothe long-term trend of 5-6% growth per year.

● Debt will continue to be reduced. In the shortterm, telcos will focus on consolidating their posi-tion in their domestic market, before turning againto international expansion.

● Employment will continue to fall. Part of this willbe due to the reverberations from 2001, part willbe because the initial investment phase for many

new entrants is over, and part will be becausethere will not be enough growth in demand to off-set gains from productivity and economies ofscale. Direct employment in telecoms will also fallbecause of outsourcing: many telcos will begin tofollow this route. Overall, this downward trend islikely to persist for some time.Ultimately, success for telecoms firms will lie in

defining markets and market segments and ensuringthat costs are low, channels are efficient and brand isstrong. Picking the right platform—the mixture oftechnology, services and operations, and support sys-tems—will be critical.

Netcos v ServcosThe implications for the future development of theindustry are immense. Purveyors of services will splitinto Netcos and Servcos, with the large operators (theNetcos) providing the network, and service-orientatedcompanies (the Servcos) finding and serving their cus-tomers over the network. Some of the more innovativeoperators, including BT, may be setting the directionfor the future with their internal reorganisations to splitthe functions.

Content-specific networks, such as voice or video,may exist for a long time yet, but their ultimate demiseis certain: the days are gone when economies of scalecould best be achieved by having specific networks forspecific services. A platform such as Internet Protocolover Ethernet can cope with most services and appli-cations, even if it is not optimised for any one of them.This potentially opens up a new industry structure.

Over such a platform many service and applicationproviders could flourish. The provision of that platformwould lead to (and ultimately require) huge economiesof scale. One implication of this could be the emer-

17




6 IN CONCLUSION

Biotechnologycompanies willdominate theintroduction ofnew drugs overthe comingdecade

responsible for 25-30% of new drug applications tothe US Food and Drug Administration (FDA), a figurethat could rise to 50% by the end of 2002. Sales ofthe leading 25 biotech drugs topped $21bn in 2001.Over the coming decade, biotechnology companieswill continue to dominate the introduction of newdrugs by providing the technical advances that accel-erate the efficiency of pharmaceutical development.

Clinical efficiencyOne of the key outcomes of the genomics revolution isthe huge increase in the number of potential drug tar-gets. Biotechnology companies are providing the noveltechnologies for identifying and validating these newtargets. They, not the pharmaceutical companies, willtake the lead in the next five years in discovering anddeveloping the drug molecules that interact with thesetargets.

Furthermore, the high-throughput screeningapproach pioneered within the biotechnology sector isgenerating most of the compounds heading forapproval in the next five years as well as the vastmajority of new small-molecule drugs entering clinicaltrials. Combinatorial biochemistry and chemistry com-panies are generating libraries of millions of new com-pounds that have drug-like characteristics. A highproportion of compounds still fail in early clinical trialsbecause the early laboratory and preclinical studies donot predict how they will behave in patients. The waya compound is absorbed, distributed, metabolised andexcreted by the body, and the extent to which it hasside-effects, are precisely those properties that make achemical a drug. Innovative companies are now devel-oping advanced in silico and in vitro methods to pre-dict those effects. This will eliminate inappropriatecompounds well before expensive clinical trials and, in

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Drug deliveryBiotechnology products as % of total drugs coming to market each year worldwide

4.0

13.0

23.0

10.7

14.0 14

.2

5.0

17.0

16.0

26.0

Source: EFPIA/CMR International

gence of “dumb” networks, operated independently ofany services or applications. An interim step will betechnology and applications providing intelligence andhigh-speed broadband connectivity to the end-user.

Biotechnology

When James Watson and Francis Crick unravelled thedouble helix structure of DNA in 1953, the seeds ofthe biotechnology revolution were sown. But it wasthe discovery of restriction endonucleases, DNA ligas-es and the other basic tools of recombinant DNA tech-nology around 30 years ago that made a newrevolution in industrial biology a reality.

Herb Boyer at UCSF and Stanley Cohen at StanfordUniversity in California created recombinantEscherichia coli in 1973, a genetic engineering break-through that had immediate practical implications.Stanford patented the technology and a Silicon Valleyventure capitalist, Bob Swanson, spotted the businesspotential. Negotiating an exclusive licence from Stan-ford, Swanson and Boyer founded Genentech, the firstrecombinant DNA company, in 1976.

Genentech’s model for the development of biotech-nology remains wholly valid: patented technical devel-opments and products are the key tangible assets thatbiotechnology businesses use to develop breakthroughbusiness, typically backed by investment from venturecapital and public capital markets.

This and other innovations have totally transformedthe drug industry. The biotechnology industry has nowgrown to approximately 4,000 firms worldwide,employing more than 250,000 people and generatingmore than $30bn in revenues. These young firms are

18


Top biotechnology drugs (2001 sales, $m)

Drug Company SalesErythropoeitin Amgen/J&J 5,540 Insulin Novo/Eli Lilly 2,458 Beta interferon Biogen/Schering/Serono 1,958 Alpha interferon Schering-Plough 1,447 GCSF Amgen 1,347 Leuprotein Abbott/TAP 987 Rituximab Genentech 819 Etanercept Immunex 755 Inflixmab J&J 721 Algucerase Genzyme 570 Palivizumab Abbott/MedImmune 543 Abciximab Eli Lilly/Centocor 431

Source: Various, Apax Partners

many cases, even before a compound is synthesised.The integration of information technology with

biotechnology will be pivotal. Computers are beingextensively used in drug discovery to garner, store andanalyse terabytes of data emerging from academic andindustrial research. Bioinformatics companies are con-verging with major IT providers to develop integrateddata management and decision-support systems fordrug companies, a move that is expected to cut thedrug discovery and development bill significantly overthe coming years.

The genomics-driven rise in peptide and proteindrugs will intensify the need to find ways of deliveringsuch compounds efficiently to the disease target site.Slow release formulations—where drugs are encasedin degradable polymers—are already available, andwe expect to see considerable innovation in this areaover the coming decade.

Drug delivery is just one of the areas where weexpect to see some benefit from the fusion of drugdevelopment, biological materials science and elec-tronics. A new generation of drug delivery systems, forexample, could be based on biologically responsiveimplantable microchips that not only serve as medi-cine repositories but also dispense the drugs in a man-ner that mimics the body’s natural production ofchemicals.

Outsourcing is inThe evolving shape of the pharmaceuticals industrywill only serve to reinforce the importance of biotech-nology companies. Rising regulatory standards andthe increasing leverage of healthcare payers are forc-ing the drug industry to cut costs and seek more inno-vative, efficacious and cheaper new pharmaceuticals.

This has been one driving force behind a decade ofpharmaceutical mergers that have consolidated andglobalised the industry. The behemoths find them-selves trapped by the logic of their massive R&D budg-ets, now starting to exceed 25% of sales, which canonly be justified if they launch between two and fiveblockbuster products per year to maintain theirgrowth. This creates major opportunities for innovativeand fast-moving biotechnology firms.

A substantial share of those R&D budgets—asmuch as 40% in the case of discovery research budg-ets—are now being spent on outsourced R&D; that is,on services provided by new biotechnology compa-nies. Products licensed from outside firms nowaccount for more than 40% of the pipelines of nine ofthe world’s ten largest pharmaceutical companies. Weexpect this trend to continue.

1970 1975 1980 1985 1990 1995 2001

Research surgeGlobal R&D spending on new drugs,1970–2001, $m

Source: Pharmaceutical Research & Manufacturers of America membership survey

618.

51,

061.

5

1,97

6.7

4,07

7.6 8,

420.

3

15,2

07.4

30,3

42.7

19




6 IN CONCLUSION

But biotechnology companies are no longer finan-cially dependent on large pharmaceutical companies.Continuous technological and commercial successeshave kept investor enthusiasm buoyant for a decade.The sector has been able to raise $100bn over thepast ten years, around $50bn of it in 2000 and 2001,according to data from BioCentury.

This influx of capital has allowed biotechnologyfirms to take their innovative compounds much furtherinto clinical development and to retain much broaderrights. Armed now both with valuable intellectualproperty and substantial independent developmentbudgets, companies such as Millennium, Vertex andImClone have been able to negotiate as equals withpharmaceutical partners, striking very large develop-ment deals.

Attention to prevention The advances in biological understanding and techni-cal capability open new vistas for future healthcare.Given the right technology—and the approval of soci-ety—problems could be identified and treated preven-tively through medicinal and lifestyle interventionsyears in advance of any overt disease. For example,monitoring technologies might be used to track keyindicators of an individual’s biological status andimmediate health prospects.

The move towards full understanding of the molec-ular pathobiology of diseases could also mean thatmedical indications would be subdivided, almost to aninfinite degree, with direct implications for treatment.Rather than treating the palpable physical symptomsof, say, rheumatoid arthritis, future therapies mightcomprise a customised cocktail of pharmacologicalcomponents designed to restore a patient’s normal

metabolism. Healthcare based on predisposition and risk avoid-

ance, or on intensive monitoring and pharmacologicaladjustment, would require very different institutions,modes of administration and payment systems thanthe present practice of crisis remediation. What is cer-tain is that as more knowledge moves into the handsof patients and primary care providers, healthcare sys-tems will evolve focusing more on the prevention ofdisease. Any company hoping to supply future healthneeds will have to evolve with them.

Current economic pressures on healthcare systemshighlight concerns about inequality of provision. Hightechnology solutions may widen the gap betweenthose who can afford the best care and those whocannot. In Apax’s view, however, much of the funda-mental importance of biotechnology resides in its dualability to give individuals information about their ownhealth and to allow them to avoid or substantiallydelay the onset of the kind of severe health problemsthat require expensive interventions. It will be increas-ingly apparent to payers, including governments, thatbiotechnology is a route not only to better healthcarebut also to cost-effective prevention.

Investing successfully in biotechnology requires along-range vision that brings understanding of howhealthcare must and will change. But it also requires anunderstanding of the short-term drivers—resource con-straints, competing scientific and technologicalapproaches, the regulatory environment, and the powerand phases of the market—of any investment opportu-nity. Biotechnology will change healthcare practices inan increasingly radical manner, but a high premiumwill be placed on market-driven insight and scientificknowledge in making investment decisions. ■

20


3PRIVATE EQUITYio

Private equity is primed for rapidgrowth

Top-quartile private equity firms willkeep producing superior returns

Scale is essential to success andwill change the shape of theindustry

21




6 IN CONCLUSION

It is a central theme of this report that entrepre-neurs are an integral part of innovation, but thatcapital is also vital. Venture capital and otherforms of angel investing are essential to entrepre-

neurs and small companies. For established compa-nies too, capital in the form of buyouts is often the keyto unlocking creative potential that is otherwise stifled.

In the United Kingdom, the most developed marketoutside the United States, some 87% of managersbacked by private equity say their firms would havegrown more slowly or would not have existed at allwithout the stimulus of such funding. And the BritishVenture Capital Association (BVCA) calculates thatfirms backed by private equity account for 2.7m jobs,or 15% of the UK workforce.

Despite the gloom spread by the bursting dotcom bub-ble, private equity is well placed for brisk growth overthe next decade. The global entrepreneurial environ-ment has never looked more receptive, and theprospects for market-driven innovation are similarlyfavourable. True, many investors were badly burned bythe correction in 2000-01, and there is a substantialoverhang of money raised before equity markets headedsouth. But most investors will be quick to put the pastbehind them and position themselves for the attractivereturns that the next IPO boom will bring. That couldcome in 2003, 2004 or 2005, assuming a sustainedglobal economic recovery (see box on next page).

Many pension funds, insurance companies,endowments, corporations, high-net-worth individualsand funds of funds will raise allocations to privateequity funds as they reach for higher returns and asthey become more familiar with the sector’s risk pro-file. Even large banks will provide a growing source ofcapital for private equity by investing more of theirasset-management clients’ money.

Pension funds especially are going to need highreturns if they are to pay for the growing retirementneeds of fast-ageing populations. Apax expects publicand private pension funds, the largest contributors toprivate equity, to double their average allocation toabout 15% of total funds in the United States andabout 7% in Europe over the next ten years.

This would add an extra $75bn or so to US com-mitments and $22bn (€25bn) to European commit-ments over ten years, were the amount of pensionfunds under management to remain stable. The effectwould be even greater if pension funds under man-agement grow. These numbers compare with an esti-mated $150bn raised globally by all investor types in2001 and a record $250bn haul the year before.

Even with that sharp drop last year, private equityretains the energy of the last decade, in which com-mitments rose fifteenfold in the United States andninefold in Europe, because the underlying drivers ofgrowth not only remain in place but are gainingmomentum. These drivers include an improved per-ception of the risk of owning private equity; the emer-gence of new vehicles for participation; and betterentry and exit opportunities:

Risk differentiation is blurring. For many biginvestors, risk distinctions between public and privateequity are starting to blur especially given privateequity’s rising diversification, increasing transparency,and strong focus on due diligence and performance.Moreover, the use of sophisticated risk modelling willpush allocations higher, particularly for top-quartileperformers, as investors realise that adding a chunk ofprivate equity to a stock portfolio can reduce overallvolatility while increasing returns.

Private equity is becoming easier to buy and sell.Funds of funds will multiply, giving a more appealing

Private equityis primed forrapid growth

22


The global economy is recoveringmore quickly than many expected fol-lowing its sharp slowdown in 2001.Driven by a strong rebound in theUnited States, the Economist Intelli-gence Unit expects global growth toaverage 3.1% in 2002, comparedwith an increase of 2.4% last year.The world economy will improve fur-ther during 2003, expanding by4.2%, and growth of this order willbe maintained over the medium term.

The US economy is now well intoa recovery. Data revisions show thatoutput was expanding at arespectable pace even in the final

quarter of 2001. Growth in the firstthree months of 2002 was extremelystrong, as firms started to ramp upproduction in order to stem the con-tinued decline in their inventory lev-els. In addition, consumer spendinglooks to have been fairly strong andeven investment spending appears tohave reached a low point. The headypace of growth in the first quarter willnot be maintained during the rest ofthe year, however; some special fac-tors pushed growth up and it isalready clear that the second quarterwill be significantly weaker. But evensofter growth during the summer sets

the stage for reasonable GDP growthin 2002 as a whole, and graduallyaccelerating consumption and invest-ment will support strong growth in2003.

The United States may be in thelead, but other key drivers of theworld economy are also showingsigns of life. The euro zone seems tobe improving, with business surveyssuggesting greater confidence andthat weak growth has alreadyresumed. Even in Japan, there aresigns that the economy is picking up,on the back of a turn in the inventorycycle and stronger export growth.

Bouncy

Real GDP growth forecasts (% real change)

2000 2001 2002 2003 2004 2005 2006United States 4.1 1.2 3.0 3.5 3.4 3.2 3.0Japan 2.2 -0.4 -0.7 1.5 1.2 0.9 0.9Euro zone 3.4 1.5 1.6 2.7 2.5 2.5 2.4Worlda 4.7 2.4 3.1 4.2 4.2 4.2 4.2

a At purchasing power exchange rates. Source: Economist Intelligence Unit

entrée into the asset class for smaller institutionalinvestors and high-net-worth individuals. These fundsallow more modest investments in diversified portfo-lios. Expansion of this market will further pry open theclass to wealthy individuals and others, who willincreasingly be able to trade the instruments as theywould any security.

Entry and exit opportunities are improving. As out-lined in the first section, the prognosis for global entre-preneurial activity is excellent, thanks to a number offactors such as government support, rising researchand development activity, and the high public profileof entrepreneurs. Investment in early-stage venturecapital and later-stage buyouts will continue to varywith the IPO cycle and debt availability, but venturecapital is expected to increase in Europe, which is cur-rently buyout-biased. Exiting private equity invest-

ments should also become simpler, thanks to theaccelerating development and integration of national,regional and global growth exchanges especially inEurope and Asia. More robust small-company marketssuch as AIM should also provide greater liquidity.

Clouds on the horizonThis rosy picture should not obscure the fact that thereare obstacles to growth which the private equityindustry must strive to overcome. In the short term,there is reluctance on the part of some investors, whowere burned in 1999-2001, to reinvest. Similarly,investment could slow while the overhang of moneyraised before the stockmarket correction but not yetinvested is absorbed and as adjustments are made totemporary over-allocations caused by the drop in valueof public equities in many institutional portfolios.

More worrisome over the long run are several

23




6 IN CONCLUSION

retirement-related trends. The spectre of more peopleretiring sooner could limit appetite for illiquid invest-ments, despite the compensating impact on the needsof pension funds to achieve higher returns which hasalready been discussed.

In Europe there are also fears that the EU’s pro-posed Pensions Directive, which EU leaders want tosee agreed by the end of 2002, will impose quantita-tive limits on the investment allocation that pensionfunds can make to private equity in order to reducerisk. EVCA has warned the EU that this could lead to“massive divestments from private equity and venturecapital” in countries such as the United Kingdomwhere no quantitative limits currently apply9. On theupside, however, limits would enable pension funds tostart making such allocations in EU countries whereinvestment in private equity is currently not permitted.

Of greater concern is the fact that defined benefitplans, the mainstay of private equity, are losingground to defined contribution plans around the world,led by the United States. There, from 1985 to 2001,defined benefit plans shrank from 65% to 44% oftotal pension assets, according to the Federal Reserve.Defined contribution plans are managed by each indi-

vidual rather than being pooled; this makes it moredifficult to meet the minimum amounts most privateequity funds require before anyone can invest. Trans-parency and ease-of-access concerns also make it lesslikely that individuals will turn to private equity in avery significant way.

But none of these challenges is insurmountable.The forces favouring growth are simply too strong.From 1996 to the end of 2001, over $600bn in pri-vate equity was raised in the United States and anoth-er $145bn in Europe. Asia, since 1999, has addedsome $30bn more. A decade from now, those num-bers could well look modest.

Underlying the growth in allocations to private equityby investors, of course, is the asset class’s superior per-formance, particularly on the part of the top perform-ers. Private equity returned 17.4% on an annualisedbasis over the past ten years in the United States, com-pared with 16.3% in Europe, according to ThomsonFinancial Venture Economics and the National VentureCapital Association (NVCA). Early-stage returns led thefield in the United States for the ten-year period, gar-nering returns of 32.5%, while in Europe, buyouts out-

Momentum maintainedPrivate equity* funds raised and invested(US$bn)

* Includes all private equity – both venture capital and management buyouts. Sources: NVCA, EVCA, IVA, Initiative Europe, Thomson Financial, AVCI and Economist Intelligence Unit estimates

US Europe Asia US Europe Asia US Europe Asia US Europe Asia US Europe Asia US Europe Asia

1996 1997 1998 1999 2000 2001

51.2

77.4

103.

6

137.

2

191.

8

162.

5

42.6

98.0

66.0

37.1

22.6

15.0

8.0

31.1

17.9

12.3

100.

2

22.622

.3

16.6

9.1

46.1

18.1

12.8

29.3

17.8

8.6

23.1

7.1

6.0

na na na na na na

Funds raised

Funds invested

Number of funds

297

297

na na 393 49 na 473 61 na 616 88 1,068 792 112 1,406 426 92 na

Top-quartileprivate equityfirms will keepproducingsuperiorreturns

9Proposal for a Directiveon the Activities ofInstitutions forOccupation RetirementProvision (PensionFunds): EVCA commentson discussions regardinga “Prudent Person RulePlus”, EVCA, April 10th2002.

24


Changing places% of total US pension fund financial assets

Sources: Federal Reserve Flow of Funds Accounts (revised)

30

35

40

45

50

55

60

65

1985 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 01

Defined benefitDefined contribution

performed other stages, delivering returns of 18.2%.Picking the top quartile of performers made a huge

difference in good years and bad. Take the 2000 vin-tage. So far, the top quartile in the United States haslost 1.5% on average versus the bottom quartile’s lossof 31.4%, while in Europe the best earned 0.1% andthe worst lost 18.4%, according to Thomson Finan-cial Venture Economics and NVCA. The gap is equal-ly obvious in a good year. For this take the 1994vintage. In the United States the top quartile has sofar gained 19.7% on average versus the bottom’s lossof 12%, while in Europe the best earned 16.4% andthe worst lost 1.3%.

In the short term, returns and valuations could behurt by the $231bn overhang of money raised from1996-2001 that is waiting to be invested in Europeand the United States. More important, the growingsize of private equity funds increases the challenge ofoutperforming the industry. It is harder to earn thesame high returns off a larger base, and more playerscan bid up prices to unrealistic heights.

Even so, returns will still outperform the publicmarket. Venture capital funds invest in smaller com-panies that, if well picked, should grow faster andreturn more than a larger public company. On thebuyout side, returns should also be higher since, opti-mally, assets are bought in a downturn, managementhave value-driven incentives and the company is thenfloated or sold at a higher price. Top-quartile firms inparticular should find it possible to return the 5-8%premium above public equity returns over the longterm that investors have come to expect for taking ongreater illiquidity or risk.

Scale will be an inevitable and essential component ofsuccess in the private equity industry. A growing pref-erence by large investors for bigger stakes in fewerdiversified funds along with rising allocations is driv-ing the evolution of larger funds. Entrepreneurs arealso attracted to larger branded funds because theyknow they can expect more support and better accessto the capital markets.

Scale, by supporting greater diversity by industry,geography and stage, will also enable private equity todeliver the consistent returns demanded by investors.Broad, global networks will give private equity housesthe reach to seek and analyse opportunities world-wide—as the Economist Intelligence Unit’s Entrepre-neurial Framework Index showed in the first section ofthis report, many countries around the world nowoffer go-getters a developed framework for innovation.A wide network will improve the quality of advice toportfolio companies and give them easier access tocustomers, suppliers and overseas markets.

Huge amounts of money are needed to launchtechnologies quickly onto global markets. Witness thegrowth in the amount of US venture capital investedover the past decade, which has mushroomed from$2.3bn in 1991 to a peak of $99.6bn in 2000, anda lower, but still sizeable, $36.5bn last year, accord-ing to Thomson Financial Venture Economics andNVCA. Buyout investments can require even moredaunting sums.

Scale brings its own problems, of course. Largefirms will have to be managed more professionally—how to control without quashing entrepreneurial spirit

Scale isessential to

success andwill change the

shape of theindustry

25




6 IN CONCLUSION

will be a central challenge, and resolving this tensionwill determine who succeeds. A decentralisedapproach that allows a firm to “think globally but actlocally” is likely to be most effective. Companies thatsucceed are set to maintain discipline, not loweringIRR expectations in the face of competition.

The crystal ballThe importance of scale also implies a shake-out in thestructure of the industry over the next decade. Manyfunds that arose during the Internet boom will be casu-alties of the bust—exiting as poor performance andshort histories make it tough to raise additional funds.New entrants will find higher barriers in their path.

The result will be a highly competitive bipolar globallandscape, with less than a dozen global private equityfirms at one end of the market and hundreds of small,

entrepreneurial boutiques with a specialised venturecapital focus at the other. A median tier of mid-sizedand national firms will come under pressure to evolve asthey find it increasingly hard to raise funds, offering nei-ther global coverage nor fleet-footed specialisation.

In an industry where culture is all important andmergers offer little in the way of synergies or cost sav-ings, organic growth will be the most cost-effectivemeans to achieve global reach and to access sectoralexpertise. As the industry draws closer to the main-stream, there will also be more publicly listed funds offunds and a small number of quoted private equityfirms. Private firms will continue to dominate, giventhe industry’s long-term investment horizons, thecyclicality of returns, the judgment involved in valuingportfolio companies and its compensation structures,with pay powerfully linked to fund performance. ■

26


4iCAPITAL MARKETSio

A pan-European stockmarket islikely but is threatened by severedelay

After losing out to the United Stateson the PC and Internet booms,Europe’s wireless lead may be atrisk

27




6 IN CONCLUSION

A pan-Europeanstockmarket islikely but isthreatened bysevere delay

Growth stockmarkets, which allow new com-panies with short histories to raise money,are critical in enabling new businesses toexpand. At the point that growth companies

need more capital than private equity firms can pro-vide, they go public. This drives a cycle of privateequity firms exiting old investments and reinvesting innew companies. The deeper and more liquid the mar-ket, the greater the opportunities to exit, and the moremoney is allocated to private equity investment inearly-stage entrepreneurial companies.

Europe’s fragmented stockmarkets remain a stum-bling block to economic expansion and job creation,placing the region at a competitive disadvantage inthis respect to the United States. Without change,European private equity growth will continue to fallshort of its potential.

The pressures on European stockmarkets to consoli-date are immense. First, there are the demands of aEuropean investing public which, recent stockmarketcorrections notwithstanding, is on a trend towardsgreater share ownership. A combination of privatisa-tion and restructuring, demographic pressures, taxincentives and low interest rates is increasing theamount of European capital seeking equity opportuni-ties.

Second, the arrival of the euro, by removing cur-rency risk and increasing transparency in trading costsand share prices across borders, has removed a hugebarrier to capital-market integration. Investment alongnational, rather than sectoral lines, is increasinglyanachronistic.

Third, competition has intensified. Even beforereports surfaced about its possible interest in biddingfor the London Stock Exchange (LSE), Nasdaq hasbeen positioning itself to be the lowest-cost global

exchange of choice for the next IPO uptick by expand-ing operations in Europe and Japan. Hence NasdaqEurope’s plan to offer a single trans-Atlantic IPO, asingle trading platform, rule book, and settlement andclearing system across the euro zone. Its systems aimto make the cost of clearing a stock across borders thesame as that of national trading on a local market.This means that if a British investor wanted to buy aGerman stock, clearing costs on the deal would be85% less on Nasdaq Europe than on the GermanExchange.

Faced with these pressures to consolidate, Euro-pean exchanges, including the LSE, have so farresponded with a series of largely abortive efforts tomerge. Only the Paris, Amsterdam, Brussels and Lis-bon bourses, which recently merged to create cross-border Euronext, have made real progress. Turf warshave previously scuppered more ambitious plans tolink up the Frankfurt exchange and the LSE. It doesn’thelp that the recent downturn in the IPO market hasmuted the urgency of the case for greater efficiency, orthat investment banks have not so far been particular-ly forceful in pushing for regional markets, whichthreaten to change the dynamics of competition fortheir business.

The European Commission’s so-called group ofwise men, led by Alexandre Lamfalussy, a Belgiancentral banker, has proposed ways to speed the adop-tion of a pan-European market. The group hasstressed the need for the region to develop a deeperpool of liquidity, a common prospectus to help incrossborder capital raising and common listing andaccounting standards. But once again, national inter-ests are proving obdurate, Germany’s rejection of asingle EU takeover code being the outstanding recentexample. As a result of such episodes, the wise men’sinitial target date for a single capital market of 2003has been put off until 2005 at the earliest.

28


A pan-European capital market will arrive eventual-ly. The exchanges know it—that’s why they’ve all beentalking. Forces are converging to produce pan-Euro-pean growth and large-cap exchanges, say, by 2010 atthe latest. By then, national exchanges will almost cer-tainly have disappeared. But that day is still a long wayoff, and in the meantime vested interests keep prolong-ing Europe’s disadvantage relative to the United States.

Does it matter if growth stockmarkets remain frag-mented? It’s a reasonable question. Europe’s stock-markets are clearly strong enough to support a biggerproportion of the world’s largest listed companies.

But problems start when a smaller company, whichcannot achieve a large-cap European exchange or USlisting, decides it wants access to a broader pool ofcapital, particularly in Europe. It then must approachmany listing departments, rule-setting authorities, andclearing, settlement and depository institutions andcounterparties—each with its own requirements andtechnology platforms. These overlapping proceduresand IT systems send time and costs rocketing.

Market participants too find the current situationcumbersome. Traders trying to buy and sell growthstocks across Europe would find it simpler to interactwith one exchange with one engine room. Forinvestors, allocating and reallocating portfolios acrossEurope is hard to do systematically. A US pensionfund wanting to own pan-European growth shares in aparticular industry sector has to buy into more thanone regulatory regime. It might invest more if it waseasier and cheaper.

Quantifying the potential gains from a fully integrat-ed European stockmarket isn’t easy, but in theory, a

pan-European growth stockmarket could be as big asthat of the United States. That would represent hugegrowth in market capitalisation. At the end of 2001,the 1,168 companies listed on Europe's main growthmarkets—AIM, the Nouveau Marché, the Neuer Marktand Nasdaq Europe—were dwarfed by the 4,109 com-panies listed on Nasdaq. The European exchanges’$84bn combined market capitalisation represented apaltry 3% of Nasdaq’s $2.9trn.

More importantly, a single securities market wouldmean a significant reduction in trading costs. ANovember 2001 report for the European Commissionon crossborder clearing and settlement by the Giovan-nini Group10 concludes that barriers between nationalexchanges add enormously to transaction costs forinvestors. Crossborder settlement, even via interna-tional depositories such as Clearstream and Euroclear,costs around ten times more than domestic settle-ment, according to some estimates.

The London Stock Exchange recently estimatedthat such inefficiencies add 20 to 30 basis points tothe cost of capital for a European company over USlevels, and that users in Europe pay on averagearound six times per transaction more for clearing andsettlement services than in the United States. Accord-ing to the LSE11, these differences arise from twosources: higher operating costs per transaction—around two-thirds of the total additional cost; andhigher margins—in Europe currently an average of29% compared with 0% on the part of the not-for-profit Depository Trust & Clearing Corporation (DTCC)in the United States.

One pan-European central counterparty, by cuttingthe number of settlements through netting and by

Are Europe's growth markets falling short?(2001)

*AIM, Nouveau Marché, Neuer Markt, Nasdaq Europe in Europe, Nasdaq in the US. Source: The Economist Intelligence Unit

GDP at market exchange rates ($bn)

Number of listedcompanies*

Market capitalisation ($bn)*

EU US EU US EU US

7,91

0 10,2

08

1,16

8

4,10

9

84

2,90

0

After losing outto the UnitedStates on the

PC andInternetbooms,

Europe’swireless lead

may be at risk

10Cross-Border Clearingand SettlementArrangements in theEuropean Union, TheGiovannini Group,November 2001.

11Response to the FirstReport of the GiovanniniGroup, London StockExchange, February 7th2002.

29




6 IN CONCLUSION

Westward hoWireless venture capitalby geography ($bn)

Source: Rutberg and Company

EU US

2.64

1.35

3.35

8.76

2000

2001

2000

2001

merging settlement systems, would save market par-ticipants €1bn a year, according to the LSE. What’smore, eliminating the duplication of IT systems ateach of the national exchanges would result in furthercost reductions for investors, as would lower head-counts across the exchanges.

A pan-European growth capital market with consid-erably lower costs and greater liquidity would in turnmean more investment in more entrepreneurial enter-prises. Vibrant growth stock exchanges like Nasdaqimprove the risk profits of early-stage investment forventure capitalists by increasing the chances of raisingsubstantial capital through an IPO. In this sense theventure capital market is driven by the public equitymarket. According to Thomson Financial Venture Eco-nomics and NVCA, US investors invested a record$99.6bn in venture capital in 2000, representing61% of total US private equity. By contrast, EVCA putEuropean seed and start-ups at €6.7bn, or just 19%of the European private equity total, which slows thecontinent’s ability to create as many successful inno-vative companies.

A well-developed growth market gave the UnitedStates most of the spoils from the personal computer

and Internet revolutions. Now wireless telecommuni-cations is the prize at stake. So far, Europe has thelead in developing mobile technology. But if innovativewireless companies can’t raise adequate funding tosupport growth in Europe, once the industry recoversits equilibrium it will migrate to the United Statesalong with potentially huge job creation and capitalformation. Europe may already have dithered too long.Since the start of 2000, private equity investments inNorth American wireless start-ups have been threetimes higher than in the equivalent European compa-nies, according to calculations by Rutberg & Companyin San Francisco.

The message to regulators and exchanges is clear.A European growth stockmarket will be a huge driverof growth for private equity and new businesses inEurope. This in turn will boost the number of newcompanies funded by venture capitalists and otherscoming to market, stimulating economic growth andjob creation. The PC and Internet revolutions wereboth US-centred not least because Nasdaq is a larger,integrated growth stockmarket. Without a pan-Euro-pean growth stock exchange, Europe risks losing outto the United States again on the mobile revolution. ■

30


5i SOCIAL INVESTMENTo

A sustainable model of investmentin disadvantaged communities isneeded

Social private equity investment ismore relevant than ever before

31




6 IN CONCLUSION

A sustainablemodel ofinvestment indisadvantagedcommunities isneeded

For richer, for poorerIncome distribution, selected countries (%)

Source: World Bank

Share of household income, lowest 10%

Share of household income, highest 10%

France Germany Italy Spain UK US

2.8 3.

3 3.5

2.8

2.6

1.8

30.5

27.3

25.2

21.823

.725.1

This report has argued that the environment forentrepreneurs and for private equity will beextremely positive over the next decade. Thereare still areas of concern, of course—among

them the fragmentation of European stockmarkets andan overhang of money raised before the dotcomcrash—but the prognosis for growth and returns isexcellent. Proponents of social private equity invest-ment, the subject of this section, believe that the ben-efits of this coming prosperity can be spread morewidely than they now are.

Private equity and social investment—financialtransactions intended both to achieve social objectivesand deliver financial returns to investors—make anodd-looking couple. After all, how can an industryprized for its superior returns be harnessed successful-ly to investment in depressed areas with scant historyof generating growth and little access to funding?

Yet many investors were similarly sceptical aboutmainstream private equity when it began 30 yearsago. That business is now huge. There is no reason for

social private equity not to develop into a similarlyvibrant, profitable and sustainable sector over the nextdecade or two.

A dose of realism is in order. Social private equitymay never post returns as high as its mainstreamcousin. But its returns can still be attractive to manyinvestors, especially as the asset class matures. It maytake a bit more time to find the right business modelsand companies, to groom less experienced entrepre-neurs, and to help steer smaller, less high-tech busi-nesses to success. But it can—and should—be done.

The roaring 1990s created tremendous wealth formany executives, entrepreneurs, venture capitalistsand investors. Corporations became more powerfulthan ever with the top six companies on the FortuneGlobal 500 list posting revenues in 2000 of a thump-ing $1.1trn. At the same time, governments the worldover have reduced personal and corporate tax rates inorder to boost entrepreneurship.

32


As companies and their teams have becomewealthier and taxes have fallen, however, the gapbetween rich and poor has grown. In the United Statesbetween 1979 and 1997 the average income of therichest fifth of the population jumped from nine timesthe income of the poorest fifth to around 15 times. In1999 British income inequality reached its widestlevel in 40 years. The poorest communities remainshackled by elevated mortality rates, unemploymentand crime. The cost is enormous: lower productivity,slower economic expansion and a growing number ofdisenfranchised communities liable to turn to violence.

It is in the interests of all for these problems to beresolved. But how? Philanthropy isn’t very effective—it does not encourage self-reliance. Government pro-grammes mean higher taxes, and often createattitudes of dependence on welfare, undermining thevery entrepreneurs they are designed to help. What isneeded is a sustainable model of capital allocation,which benefits both the recipients and the investors.Social private equity offers just this model.

Increasingly firms are reporting their impact on the com-munity, the environment and employees. At the sametime, socially responsible investment (SRI) in publiclytraded stocks has taken off. At the end of 2001, SRIfunds totalled $2.34trn or 12% of all funds under man-agement in the United States, while 5% of UK funds fellin this category, according to Oxford Analytica. SeveralSRI indices have been established to track returns.

Social private equity, however, is not just about try-ing to avoid harmful investments. It takes the processa step further by actively generating healthy business-es in distressed areas.

Already banks, state and federal governments, cor-porations, foundations, high-net-worth individuals andeven some pension funds have begun placing bets onsocial private equity. This includes the United States’sbiggest public pension fund, the California PublicEmployees’ Retirement System (CalPERS). A year agoit set up an initiative to invest $475m over time atattractive risk-adjusted returns in social private equityfunds with a California focus.

CalPERS is not alone. At the end of 2001 therewere over 60 community-development private equityfunds and funds in formation which had raised over$400m in assets in the United States, with 15 fundsoutside the United States managing at least $250mmore, according to the Community Development Ven-ture Capital Alliance (CDVCA). In the United States,the asset class has received a boost from the federalCommunity Reinvestment Act, which mandates targetsfor commercial banks’ community investment. Indeed,at the end of 2000, banks had provided 58% of thetotal capital invested in US community-developmentprivate equity funds, according to CDVCA.

In the United Kingdom, community investment,including private equity, will be spurred by the imple-mentation in the April 2002 Budget of recommenda-tions by the UK Social Investment Task Force. Theseinclude a tax credit to support private investment in

Social investment has explicit socialobjectives. Foreign direct investment(FDI) does not. But to the extent thatmuch FDI represents the flow of pri-vate money from developedeconomies to developing ones, thereis value in asking what benefits thisflow brings to investor and host.

This isn’t the place for a propersurvey on globalisation, its benefitsand its ills. But historic assessmentsof FDI projects12 in emerging marketshave found that a majority of theprojects have had a positive impact

on the host country’s nationalincome through increased competi-tiveness, job creation and the trans-fer of technology and know-how.Sceptics argue that this income ben-efit comes at the cost of exploitedlabour, but again the evidence showsthat workers employed by foreigninvestors in developing countriestend to be paid high wages relative toworkers employed by domesticinvestors in those countries13. As forthe foreign investors themselves, thecorrelation between the FDI stock

and the output of foreign-controlledenterprises in a country—so if theformer doubles, the latter does too—is a strong one.

There is a precedent therefore forthe market-driven flow of private cap-ital—which now accounts for morethan four-fifths of the total inflows ofcapital to developing economies—torelatively disadvantaged areas, withbenefits to investor and host alike. Itis just this precedent that social pri-vate equity investors are trying toreplicate within borders.

Can social investment work?

12Foreign DirectInvestment andDevelopment, TheodoreH Moran, Institute forInternational Economics.

13Fighting the WrongEnemy, Edward MGraham, Institute forInternational Economics.

Social privateequity

investment ismore relevant

than everbefore

33




6 IN CONCLUSION

community development, increased backing for com-munity development financial institutions and matchedgovernment funding for community-developmentventure funds.

The first UK initiative, the £40m ($60m) BridgesCommunity Development Venture Funds, waslaunched in May 2002. Half of the funds’ capital isfrom the UK government with the rest from entrepre-neurs, venture capitalists, banks, pension funds andcompanies. Government participation will help attaina targeted 10-15% IRR over the ten-year life of thefunds, although the hope is that they do so well thatanother, private-sector-only fund can be raised inthree to four years.

While $60m might seem small, compared with the$142m that Venture Economics and the NVCA cite asthe average mainstream venture capital fund size in2001, CDVCA reckons that most social investmentfunds are under $20m. Bridges is big enough to investbetween $150,000 and $3m in companies acrossEngland and reach sufficient diversification to achievedesired returns. The concept is to see what works, cre-ate a best-practice model and then scale up.

Challenges will abound for Bridges, and othersocial private equity funds, since community-development private equity has its own distinct profileand needs. Management takes more time and requiresspecial skills. Operational costs are higher than the1.5–2.5% norm for mainstream funds. It can alsotake longer to pick winners among companies thatusually lack history, track records and establishedprocesses. Bridges plans to take up to five years tomake investments, compared with regular privateequity funds’ three-year timescale.

Sceptics are likely to remain vocal until social pri-vate equity can prove that it is a solid investmentproposition. Some pension funds will have fiduciaryhurdles to consider. But perceptible progress is nowbeing made. By 2000, 25 US community-develop-ment venture capital funds had made investments inbusinesses that had created nearly 12,000 new jobs.Private equity is already beginning to create jobs andspark economic growth in distressed areas, just as ithas in the economy at large. For investors, venturecapitalists and entrepreneurs alike, the reasons to takeup the challenge are compelling. ■

34


Agreat deal has changed in the private equityindustry since we started 30 years ago. Itsscale has expanded dramatically. Startingfrom privately financed funds in the United

States, we now have an institutionally backed indus-try, which has already moved beyond the national tothe regional and now the global level. And yet I thinkwe are still only seeing an industry in its infancy.

The distinction between private and public equityhas begun to narrow. The best private equity firmshave delivered consistently high returns over manyyears. Investors are beginning to ask themselves: whyshould we view this asset class as a higher risk thanpublic equities? If you have a diversified portfolio, sec-tor expertise and a director on the board of a businessin which you have a significant stake, why shouldn’tyou capture a much better return by buying a privatecompany on a long-term basis than by buying largepublic company stocks?

Given the long track records of the private equityindustry leaders there is no reason why institutionalinvestors should not substantially increase their allo-cation to private equity in the future. It may seem far-fetched after the downward slide in the last couple ofyears, but over time they could easily be putting 15%or 20% of their assets into private equity—more thantwice the proportion that they do today in the UnitedStates.

What are the constraints? One is illiquidity. Anothercould be the number of attractive opportunities thatwill be available for private equity funds. But what wehave seen over the years is that as the industry hasincreased its size of funds, so the range of investmentsit can make has also increased hugely. Only a coupleof years ago it would have been unthinkable that a pri-vate equity group could acquire a company worth over€3bn. And institutions with long-term liabilities will notfind the longer time frame of private equity worrying.

Looking forward, private equity will be establishedin many more countries than it is now—certainlyIndia, China, Japan and South Korea. If peace comesto the Middle East, Israel could well develop its posi-tion as the Silicon Valley of Europe. The sector hasgrown tenfold over the past decade; it is likely to dothe same again in the coming ten years.

Entrepreneurship is at the heart of everything wedo. What the United States has shown in comparisonwith Europe over the last quarter of a century is themassive power of entrepreneurship as a growthengine. Vast numbers of new jobs have been createdin new areas of technology like the semiconductor, thePC and biotech industries, and the competitive posi-tion of whole countries has been greatly enhanced.

Politicians across Europe have noticed this. Themessage is that if you break down monopolies,encourage the entrepreneurial sector and reduce therole of the state in the economy, you will creategreater wealth all round. But more needs to be done—you can’t develop a really dynamic economy just bycutting tax rates. You also need to develop pools ofcapital, you need centres of excellence in research anddevelopment, big companies and universities that areready to invest in new ideas, and technology clusterswhich bring all these different elements together.

Most important, you need capital markets. Thinkabout the PC revolution. In the mid-1980s, Microsoft,Oracle, Sun and Cisco all went public in the UnitedStates, and all raised around $50m each. In thosedays in the United Kingdom you would have beenlucky to raise £3m on the stockmarket for anunproven company.

Growth stockmarkets are crucial to early-stageinvesting. This is still a major challenge for Europe.Unless we are able to develop a much more efficientstockmarket for growth companies across the wholeregion, we will be rather like a racing car with a tiny

6i IN CONCLUSION

A personal view from Sir Ronald Cohen, Chairman of Apax Partners Holdings

35

fuel pump trying to compete with a Formula Onemachine in the shape of the United States. Things arebetter than they were, thanks to the development ofEASDAQ, the Neuer Markt, the Nouveau Marché, andnow the arrival of Nasdaq Europe—their creation hasbeen one of the main reasons that early-stage invest-ment in Europe has risen in recent years. But if wedon’t want to lose out in the technology race with theUnited States, we have got to get these markets intothe right shape.

Early-stage investment in Europe takes a muchsmaller share of private equity investment than it doesin the United States. With a deeper and more liquidcapital market for growth companies, the proportioncould double and help to make the whole Europeaneconomy more dynamic. There is almost no limit towhat can be achieved by new companies in new sec-tors with high growth prospects. Intel, Oracle, Ciscoand Sun have all made it into the top 100 companiesin the world within the space of 25 years. That’s ourdouble helix at work—the coming together of entre-preneurs and private equity to produce wealth, jobsand growth.

Of course, the technology sector has turned downrecently, but I am sure that there are great opportuni-ties still to come. Another revolution has taken place

in telecommunications—wireless mobility has enabledus to transform the way we stay in touch and haveaccess to information. There will also be enormousprogress in biotech, allowing us to screen genes to dis-cover the propensity to certain illnesses and to act inorder to avoid them. One result will be even greaterdifferences in life expectancy that will add to thestresses between poorer nations and the developedworld.

The power of entrepreneurship is also a potentialforce for change within disadvantaged communities.We all have to be very conscious of widening dispari-ties in wealth, and of the scope for creative economicdevelopment in areas which are not attracting invest-ment. Unless we as entrepreneurs, companies,bankers and venture capitalists act responsibly in thisregard, then sooner rather than later governmentsmust resort once again to redistributing income andwealth through the tax system.

Over the past 30 years much effort has been madeto achieve the growth and success of the private equityindustry. In the future, the global economy as a wholewill be shaped by entrepreneurship, innovation and pri-vate equity to an even greater extent than it is today.With success comes responsibility. We will need toensure that our efforts address the risks of our age. ■




6 IN CONCLUSION

36


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