3i pull-out reflects ill health of VC in Europe

Yesterday's revelation that 3i is abandoning early-stage investment in start-up companies reflects the poor state of European venture capital.

The underperformance of venture capital against other forms of private equity, such as growth capital and buy-outs, is underlined by the latest performance figures from the European Private Equity and Venture Capital Association.

The EVCA figures, compiled by Thomson Financial, showed early-stage VC investments in Europe, since inception, had fallen 0.1 per cent annually on average, while returns from late-stage VC stoodat 7.8 per cent.

Overall pooled VC returns of 4.5 per cent were dwarfed by the 16.1 per cent buy-outs achieved. This may explain why some of the biggest European VC investors, such as 3i and Apax Partners, have shifted to bigger deals.

Philip Yea, 3i's chief executive, says a big handicap for European venture capital is the lack of a centre of excellence or "ecosystem" of angel investors, corporate investors and VC firms.

"The UK has been relatively successful and we have made good money in the UK," Mr Yea says. "But there is no real ecosystem. There are just a whole number of factors. Having said that, there have been some successes, so it's not black and white."

3i's decision to abandon early-stage investing mirrors Apax's move, which last year raised a fund for the first time that will not invest in VC, the market for which the firm was founded under Sir Ronald Cohen, former chairman. The shift of big VC investors towards deals with bigger companies is also underlined by Index Ventures, a European venture capital firm best-known for investing in Skype, which this year raised a €400m ($624m) fund for late-stage investments.

Yet, Simon Cook, chief executive of Esprit Capital Partners, contends that the top quartile of venture capital managers perform as well as buy-out firms.

"You shouldn't tar the whole asset class with the same brush," he says. "Top managers can make money. Venture capital firms need to invest in management."

Some recent early-stage deals illustrate his point. Balderton Capital received a $140m windfall when AOL bought Bebo, the social networking site, this month. Balderton made $120m, and Index Ventures $60m, from the sale of MySQL, an open source software group, to Sun Microsystems in January for $1bn.

"The returns are as good as anything coming out of the US now," says Barry Maloney, managing director of Balderton. "But you've got to be in the game for the long term. We're in our sixth year but for the US guys, many of them are up to their 10th year."

Nevertheless, Mr Maloney concedes it could be difficult to secure profitable exits in the next 12-15 months.

"Firms moving up the scale doesn't mean the whole concept of venture capital is damaged," says John Polden, managing director of MTI, the venture capital group. "Venture capital is not so affected by econ-omic cycles."