EUROPEAN COMMISSION

ENTERPRISE AND INDUSTRY DIRECTORATE-GENERAL SMEs and Entrepreneurship Financing Innovation and SMEs

Brussels, 30 November 2011 ENTR/E3/UH D(2011)

Workshop on Venture Capital Fund-of-Funds Brussels, 27 October 2011 SUMMARY REPORT 1

The role of the Commission staff was to facilitate discussions and contribute to put together this report. Consequently, the summary report should not be constructed as reflecting the position of the Commission and its services. Neither the Commission nor any person acting on behalf of the Commission is responsible for the use, which might be made of the information contained herein.

The workshop 2 was organised by the European Commission, Directorate-General for Enterprise and Industry, Unit Financing Innovation and SMEs. The purpose of the workshop was to discuss with industry representatives (venture capital funds and managers as well as fund-of-funds investors and managers) and with some national and institutional investors investing in venture capital about their views on structuring panEuropean venture capital fund-of-funds. Since any such structure is to be established jointly by the European Investment Fund (EIF) on behalf of the Commission, representatives of the EIF reported about their experience as fund-of-funds. Industry views were presented by EVCA and some fund managers. The European Commission stressed that it aims at attracting private investors, institutional investors and private managers through at least one fund-of-funds with EUwide operations to cover the whole VC spectrum from early- to later-stage. Such structures are proposed in two programmes that are to be implemented in 2014-2020: fund-of-funds covering the expansion and growth phase in the new Programme for the

As the workshop was held under thr Chatham House Rule, this summary is written accordingly and does not identify who said what. The purpose of these minutes is to briefly summarise presentations given and to reflect the main views stressed during the workshop discussion.

Context of the workshop: According to the European Council Conclusions of 4th February 2011, the Commission was, among others, invited to present a proposal for putting in place an EU-wide venture capital scheme building on the European Investment Fund and other relevant financial institutions and in cooperation with national operators. Against this background, the Commission proposed on 29 June 2011 a Budget for Europe 2020, listing among equity instruments also funds-of-funds (or European fund) investing across borders in VC funds. The Commissions budgetary proposal is still subject to a final approval by the European Parliament and the Council. Based on the June proposal, the Commission presented on 30 November 2011 its proposal for financial instruments under the new Programme for the Competitiveness of Enterprises and SME 2014-2020, including venture capital fund-of-funds investing across borders, which is planned to be established jointly by the European Investment Fund or other entities entrusted with the implementation on behalf of the Commission together with private investors and/or national public financial institutions (see below footnote 3). At the same time, the Commission presented its proposal for financial instruments under the new Horizon 2020 programme, also including funds-of-funds (see below footnote 4). The Commission will now work on structuring of these funds-of-funds to be implemented from 2014 on.

Commission europenne, B-1049 Bruxelles / Europese Commissie, B-1049 Brussel - Belgium. Tel: (32-2) 299 11 11. Office: BREY 6/215. Telephone: direct line (32-2) 2953864. E-mail: ulla.hudina@ec.europa.eu

Competitiveness of Enterprises and SME 3 and a structure in the new Horizon 2020 programme 4 . The Commission has been working on these proposals against the background of a difficult situation on the VC market in Europe (with levels that are now at those from 1996) and in parallel to the Commission forthcoming proposal 5 for a new European legislative regime for venture capital funds. Since existing market fragmentation with 27 divergent national environments hinders venture capital operations, the new European regime should enable easier cross-border fundraising and marketing of venture capital funds. It is in the interest of the European Commission and its implementing agency to attract more EU- and also non-EU private and institutional investors as well as to consider to increase the share of funds-of-funds investing in VC. In only 10-15 years, European venture has emerged through a constant learning process. European Investment Fund has been working as a fund-of-funds and has a good track record with some outstanding portfolio companies in the funds that the EIF has invested and that give a strong signal about developing European venture and should attract investors back to the European venture. Established and well known private investors could with their participation attract other European and non-European investors. Venture is in its concept a private sector business and European venture needs a proper ecosystem (incl. active exit markets). Europe needs more private money as well as more smart money for VC to back growth-stages and also for business angels to increasingly back early-stage firms. By leveraging the latter investors, substantial early-stage market needs could be covered. However, more sophisticated money is rather needed for financing of growth stages so that firms can become successful. Industry expressed the following views and recommendations for a model structure of a European fund-of-funds for the next 2014-2020 EU budget period: - Venture capital in Europe accounts for only approx. 5 billion on an annual basis and this is tiny compared to most asset classes. Europe lacks institutional investors base: institutional investors such as pension funds, insurance companies, asset managers and banks generally consider the market too small to allocate investment expertise or resources (in 2007, of investors investing in VC 12,2% were pension funds and 5,4% insurance companies, whereas in Q1 2011 these shares were only 2% and 1% respectively; in the same period share of government agencies investing in VC substantially increased from 9,9% to 56,9% according to EVCA statistics). In addition, university endowments and family offices are very limited in number and have limited venture programmes in the EU in comparison to very active and more numerous peers in the US. This structural challenge is compound by European venture not delivering competitive financial returns in comparison to other private equity investment stages. - Moreover, venture capital does not compete on a level playing field with other private equity stages or property investments. Venture capital fund managers cannot blend their equity investments with cheaper bank financing (later stage investors can actually get bank funding). The public sector in the shape of the European Commission, European Investment Fund and European Investment Bank is now critical for the European venture.

Press release (30 November 2011) Programme for the Competitiveness of Enterprises and SME:

http://europa.eu/rapid/pressReleasesAction.do?reference=IP/11/1476&format=HTML&aged=0&language=EN&guiLangua ge=en and the European Commission proposal (see p. 33): http://ec.europa.eu/cip/files/cosme/cosme-commissionproposal_en.pdf
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Press release (30 November 2011) Horizon 2020:

http://europa.eu/rapid/pressReleasesAction.do?reference=IP/11/1475&format=HTML&aged=0&language=EN&guiLangua ge=en and the European Commission proposal (see p. 54-57): http://ec.europa.eu/research/horizon2020/pdf/proposals/com(2011)_809_final.pdf#view=fit&pagemode=none
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The Commission will on 7 December 2011 propose its legislative regime for European venture capital funds (http://ec.europa.eu/internal_market/investment/venture_capital_en.htm)
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Therefore, the industry proposes a multi-annual programme for private sector managed funds-of-funds, leveraging public sector financing and attracting institutional investors to VC. The funds-of-funds can act as intermediaries to bridge the gap between large institutional investors and smaller venture capital funds. The funds-of-funds can level the playing field for VC funds if the public sector capital is deployed on a non-pari passu basis. Such structures could overtime reduce the requirement for public sector support to VC. The industry stresses that funds-of-funds need to be managed by private sector in order to enable large pension funds to access much smaller VC, provide instant access to VC without having to have knowledge of this specific market, to provide a learning opportunity for investors as they monitor the progress of their investments through the limited partnership structure, and to drive the fund-offund by making a commercial return and investing in the venture funds most likely to succeed. It is not only the size; it is also the expertise, skills and network of private managers. European venture is under capitalised, not inexperienced. Moreover, the proposed scheme should complement existing programmes and mandates run by the EIF that has been a cornerstone investor and known for very detailed due diligence. Furthermore, the industry advises that European funds-of-funds are to be based closely on existing private sector fund-of-funds models; they are to be based on incentives and reward success. Like all limited partnerships each fund-of-fund is a negotiated agreement and thus a one size fits all approach will not work. The scheme should be open to all fund-of-fund managers who want to enter the selection process. The funds-of-funds should be able to invest across all industry sectors: different sectors have different funding cycles; themed or sector based funds could distort the market, trying to pick winners. The funds-of-funds need to have the flexibility to develop a long-term investment strategy (flexibility is needed since within 10 years focus can change). A themed approach could suffer from feast or famine narrowing the ability to attract private sector investors. The funds-of-funds are pan-European. The venture funds in which they invest should have high target allocation to European companies. The industry proposes scheme as a multi-annual programme that will gradually build capacity in the market. 2-3 billion could be earmarked for the 2014-2020 budget period. Fund-of-funds should invest on a non pari-passu basis and with no downside protection. Industry's proposal for a non pari-passu approach builds upon ongoing underperformance of the VC industry in the EU and therefore private sector investors needs to be incentivised to invest more in the VC industry. The fund-of-funds' manager has the responsibility to develop an investment strategy that will attract both private sector investors and institutional investors.

Building upon recommendations of the VC industry, representative of a certain public financial institution commented that non pari-passu approach would not make a difference. Another national expert supported pari-passu approach and stressed that downside protection could be attractive only at funds level but not at fund-of-funds level. Certain private fund manager commented that institutional investors were not a homogeneous group and one model could not work for the whole Europe. Therefore, different concepts, with which managers of fund-of-funds could attract investors, would need to be taken into account. Some participating national operators presented another tool (rather than a concept) for a pan-European fund-of-funds model structure: - a joint initiative to pool capital and expertise of national VC market operators in a common pan-EU investment vehicle to tackle the market fragmentation and give portfolio funds critical mass to operate trans-nationally with mainly early- but also later-stage investments, to select best firms and increase their funding (bottomup approach);
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by combining national operators resources, value added of such a fund-of-funds lies in cost-efficiency, knowledge of national operators of their domestic market, quick start of operations and complementing the EIFs operations, access to new or emerging management teams, national operators acting as sponsors and their capacity to leverage capital invested by the private sector; expected size of this fund-of-funds project is 250 million, with first closing target date in 2013, investment period of 4 years and duration of 12-15 years this proposal could be implemented soon and serve as a pilot financial instrument for the EU financial structure planned for 2014-2020.

Some participating national operators stressed that their existing capabilities and expertise should be leveraged with additional public money and used for cross-border investments with a bottom-up approach. However, some other participants questioned building upon national operators only and thus favoured leveraging existing successful management teams with substantial knowledge about specific cross-border market needs and in cooperation with cornerstone investors. One financial operator urged the Commission to support cross-border investments with a pan-European structure and general partners operating in several countries. The Commission explained that EUwide approach targeting all 27 Member States has to be taken and that it would up to the fund-of-funds management team to find investment opportunities and have flexibility to operate where these opportunities are. Any such scheme would need to be balanced with national vehicles and also with other schemes that are backed by the EU Structural Funds. Further examples of national structures were given. For example, objectives of a certain national fund were not only in providing smart money to the industry but also in sending a signal about attractive location for portfolio high growth firms to be headquartered in this country; this fund backed venture capital funds with significant presence in the country along with enhanced support for entrepreneurs and thereby it has built up an appropriate ecosystem. One regional fund-of-funds with 100 million under management has since 2005 targeted in particular early-stage investments with a sectoral approach, intervention was structured as public-private with a separate governance and investment team from private sector; goal has been to leverage initial public money to raise capital on the market, institutional investors (80% private) invested 3x more than the respective region; this structure has downside protection with guarantees to cover 1/3 of possible losses at the end of funds life (this has been helpful for fundraising, however nowadays upside boost might be even more effective), 2/3 have been already invested with a significant leverage effect in 5 funds and 6 direct coinvestments; notion of SME-friendly environment and social aspect of supporting SMEs and creating jobs are also present; while regional focus has certain limitation, similar structure would be effective EU-wide. Another national venture capital initiative aims at boosting technological investments, attracting private specialised investors focused on different stages and creating technology-based firms, objective of the initiative is also to incentivise the investorsentrepreneurs ecosystem; this innovation initiative has so far backed 2 public venture capital funds (one fund-of-funds and one coinvestment structure) to cover the equity gap with participating industrial capital (of leading sectoral firms that have in addition to capital also knowledge and contacts) that has attracted private capital (without any limitations on the profile of private investors) and these private investors are leading the vehicle and have to be board members of portfolio companies; each investment round is of at least 1 million. A national fund was presented, namely a national revolving innovation fund, offering subordinated loans as well as stimulating venture capital; this approach was created based on a shift in the national financial approach and lessons learnt (speaker stressed the following: not to disturb the market, public intervention only in case of real market or
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system failure, market selects and is the lead investor, intervention requires an integrated approach, no subsidising of management fees, building in incentives and rewarding success, stimulating access to finance by improving the risk-return profile for early-stage VC funds, fund-of-fund approach with professional private VC funds has a better risk-return profile, broadening scope across borders and thereby limiting national constraints to operate only nationally). Moreover, equity gap has broadened, and the respective national authority has with its revolving innovation fund attracted business angels, stimulated new boutique early-stage VC funds as well as attracted back larger later-stage VC funds; the revolving component enables that returns from investments flow back directly to the fund (this offers a structural and constant comfort zone, environment is reliable even with a change of government). The same national authority will as of next year have another innovation fund for SMEs and this fund is to be based on three pillars (1) innovation credit scheme (direct project finance), (2) seed capital (enterprise finance via early-stage VC market), (3) fund-of-funds (enterprise finance via later-stage VC market; on a pari-passu basis because the local VC market is developed). Participating private fund managers reported about their equity operations: they are longstanding, globally based, well established firms with stable teams and track records; their investors are mostly from the US and Europe and only about 15% is selectively invested in Europe, they have consistently backed many US venture groups and over the last years they have increasingly moved into Asian venture (particularly Chinese and to a lesser extent Indian venture); venture is a global business and their investment activities are yet targeting mostly private equity since growth is key to investment success. These private fund managers emphasised that European venture capital sector was not attractive enough on a global stage and was not regarded as a priority sector among global LP investors given their rather negative perceptions about the European venture and because returns in Europe have lagged behind those in the US. However, the latter two reasons are not insurmountable and there is an urgent need to attract global private and institutional investors back to the European VC sector. While this will be difficult even with a non pari-passu approach, the industry proposal for a European fund-of-fund structure could significantly overcome one or both of the abovementioned reasons and could be a very good way of attracting interest in European venture again and to revitalise the VC market. The scheme should be flexible in enabling management teams to decide on investment opportunities and there is a room for 4-5 fund-of-funds with 300 million each. As a standalone concept, a fund-of-funds model would not solve the problem of the European VC. Hence, a broader ecosystem, reliance on established relationships with general partners, presence of global firms along with more attractive tax regime would also be required (i.e. in the US, proximity to universities is a crucial factor and portfolios of VC funds in the US are currently outperforming their European peers). However, it was stated that last years were difficult for both the EU and US and certain private fund manager also reported about similar performance levels of its US and EU portfolio. It was stressed that the US funds were taking advantage of good returns that they had had in the 1990s when the European venture only started to develop and that there was no reason that European venture markets would not perform as the US markets do. Representative of a certain private venture capital fund pointed out that comparisons should not be made only based on backward-looking data since venture firms are investing in high-tech forward-looking developing sectors (i.e. cleantech). It was also emphasised that while the US market was much bigger and thus enabled economies of scale and scope to both funds and firms, US venture capital funds were operating mostly locally (i.e. in the Boston area and Silicon Valley). Moreover, representatives of another leading public venture capital fund manager stressed after the workshop that previous EU efforts focused mainly on narrowing the VC industrys funding gap and not sufficiently on addressing the objectives of the
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European Single Market. Based on this, the biggest challenge now is to widen the European VC industry to all the Member States, thereby enable cross-border VC investments and fundraising and allow innovative and growth-oriented SMEs to take the full advantage of the potential of the Single Market. Therefore, smart and proper measures should be put in place to foster the activity of the top tier fund managers across the whole European market, operating together with local players. It is crucial that the European market scales up to achieve critical mass for funders (LPs), investors (VC GPs), but also corporate venture investors, and above all SMEs. Therefore, the level of incentives and the financial commitment through the EU-wide VC scheme should be proportional to the real additionalities and value added provided by each of the initiatives in order to develop the European VC market. Moreover, this top down push from the European Commission/EIF, duly aligned with the best interests of private investors, should be reinforced by collaborative initiatives among large public LP operators, together with national authorities that play a critical role in the development of their local ecosystems. To conclude, the Commission will reflect upon the views exchanged during the workshop discussion and it will based on its proposal from 30 November 2011 (see footnote number 3 and 4) continue to exchange views with the industry, national and private investors in order to establish an appropriate structure that would encompass both policy objectives and market needs.