All is not rosy in the venture capital garden

BUSINESS OPINION/John McManus: It is very hard to get a handle on just how bad - or good for that matter - things really are in the economy. Take last week. Despite all the doom and gloom generated by the inadvertent release of the Department of Finance budget memo, trade figures out on Friday showed exports are on the rise, albeit a little slower than hoped.

One alternative barometer of the health of the economy is venture capital investment, which reflects, among other things, business sentiment. Last week also saw the publication of the third annual report of the Irish Venture Capital Association produced by law firm Matheson Ormsby Prentice.

Not surprisingly the association put the best possible gloss on the report which was based in figures supplied by its 18 members. It concluded that despite a fall in total investment from €208 million in 2000 to €124 million last year, investment in the high tech sector had held up pretty well.

It pointed out that over €100 million was put into the sector, some €68.6 million of which went into software companies. It goes on to say that "the proportion of money going into the high-tech sector was actually a little more in 2001 than in 2000".

There are, however, a number of figures in the report which indicate that perhaps things are not quite so rosy in the venture capital garden as you might think.

The first is the collapse in the number of investments made at the "seed stage" - from 30 in 2000 to just three last year. This means that the amount invested in what are essentially two-men-and-an-idea operations shrank from €22 million to €760,000.

Another table in the report breaks down investments by size. It shows that although the total number of investments by venture capital companies held up reasonably well, the size of the average investment made last year shrank dramatically. In 2000 there were five investments of between €6.3 million and €12.7 million. Last year there were no investments in this bracket. By comparison the number of investments of €317,000 or less jumped from 59 to 77.

There are also signs that the industry is shifting back to less risky investments. The number of investments in manufacturing companies grew from two to 10, while investments in medical instrument/devices companies went from zero to five. Investments in telecommunications companies slumped from 10 to five and the number of stakes taken in communications and media companies fell from 21 to seven.

The report also shows that venture capital houses are de-investing at a much higher rate than in previous years. There were some 51 exits in 2001 compared to 40 in 2002. It is however the nature of the exits that really tells the story. The number of investments written-off rose from two to 10, while the number of investment situations that ended with the company itself buying out the venture capital investors rose from six to 16.

The final bit of bad news is contained in a table that shows the source of venture capital funds. It indicates that Irish pension funds and insurance companies have effectively abandoned the market, while the banks have cut their contributions by half.

In 2000, pension funds committed €38.9 million while insurance companies put up €30.34 million for venture capital investment. Last year they put no money into venture capital funds. The banks' contribution halved from €63.7 million to €25.39 million, while the contribution from corporate investors collapsed from €30.5 million to €13.37 million.

The only sector to increase its investment levels was the Government, which through various state agencies increased its contribution from €33.7 million to €53.4 million.

TWO things should be borne in mind before drawing too many conclusions from the report. The first is that the figures involved are small and as a result relatively minor changes can have an exaggerated impact. The second is that we are now nine months into 2002, but that said there is no real reason to expect that the situation has improved. If anything it is probably worse.

Taking the above into account the picture that emerges is of a venture capital sector that got very badly burnt and has headed for the hills. The long-term consequences of this are obvious and clearly bad for the economy. If you were going to highlight just one issue it would have to be the failure of the industry to continue to provide seed funding. It would appear particularly short-sighted given that all bar the most pessimistic economic forecasters believe the worst is over on the economic front globally.

The funds will no doubt argue that they are not charitable organisations and are in the business of making returns for their investors. Incurring losses to incubate new business ideas is really the job of Enterprise Ireland and the like, they will say with some justification. A similar argument would probably be put forward by pension funds and insurance companies for abandoning the venture capital market - presumably in search of greener and safer pastures elsewhere. It is worth remembering that this was the position in the early 1980s and that banks, pension funds and insurance companies came under sustained pressure from the Government to make funds available for venture capital-type investment. Perhaps something similar may be needed again.

But by far the most worrying issue arising from the report is what it tells us about the state of indigenous Irish industry. It very much supports the view that the picture painted by commonly used indicators - such as exports - is a mirage, with strong performances from a number of multinational-dominated sectors such as pharmaceuticals flattering the figures and breeding complacency.

jmcmanus@irish-times.ie