Institutional investors around the globe have committed more than $2.5 billion to leading European development capital funds in the past year.
The fund-raising exercise, while not yet complete, represents the largest commitment of capital to the industry since 1989-1990, when $2.33 billion was raised by the major development capital pools.
The appetite of U.S. institutions in particular has increased. Investors in these pools include the pension funds of Aluminum Co. of America; BellSouth Corp., General Electric Co., NYNEX Corp., Shell Oil Co., Utah State Retirement Systems and the State of Wisconsin Investment Board.
Non-U.S. institutions range from the British Unilever pension fund to the Bahrain Middle East Bank to the Long-Term Credit Bank of Japan.
The attraction of venture capital-type returns of 15% to 30% a year as Europe is recovering from recession is luring investors from the United States, Europe, the Middle East and the Far East.
The question is why investors think they can get such strong returns in Europe, which is beset with aging demographics, high unemployment, expensive labor costs, restrictive social policies and soaring state debts.
The answer lies in finding the right companies. "In Europe, you're chasing return at the company level," said Karl Van Horn, chairman of Arlington Capital Management, London, which is seeking to raise more than 150 million European Currency Units ($185 million) for taking large minority stakes in small, quoted companies.
Many large European companies are restructuring, shedding non-strategic divisions that are good investments. Many smaller companies are family owned and ready to sell out, or they need development capital to expand their operations as Europe adopts more standardized products as a result of the single market. Only seven years ago, there was 25% overlap between German and French standards. Now, there is 75% uniformity, Mr. Van Horn said.
Development capital funds - which include venture capital and buy-out funds - typically take large minority positions or majority stakes in portfolio companies, as well as usually a board seat. Deals are done on a friendly basis, with the development capital fund being able to provide strategic advice for portfolio companies.
Dealmaking is growing. While the U.K. buy-out market declined in 1993 from 1992, it has picked up sharply in the first half of 1994, increasing 16% from the second half of 1993 to 278 companies with a total value of 1.6 billion, according to the Centre for Management Buy-Out Research at the University of Nottingham.
On the Continent, 374 buy-outs with a total value of 3.12 billion occurred in 1993, the latest available data, according to London-based Initiative Europe Ltd.'s 1994 Europe Buyout Review. That compares with 383 deals valued at 2.96 billion in 1992, showing the average deal size is growing.
France, though down sharply from 1992, still was the strongest market, followed by Sweden, Italy, Germany and the Netherlands.
The attraction is clearly there for U.S. institutional investors, who have boosted both their overseas and private investments in recent years. They have become bigger players in the latest round of fund raising, increasing their investments or, as in the case of the Harvard Endowment fund, dipping their toes into the water for the first time, sources said.
In contrast, Japanese institutions - buffeted by the recession in Japan and falls in Japanese securities and property prices - have decreased their investments from the last major round of fund raising in 1989.
U.K. pension funds have tended to lower their investments, although commitments by some British life insurance companies have swelled somewhat. Meanwhile, investments by Middle Eastern investors appear to have increased slightly.
While many fund managers were apprehensive when announcing their latest funds, the speed with which investors committed assets has some fund managers ready to pop the corks.
"The new big boast is how quickly they've done it," said Antonia Millen, managing director of Initiative Europe.
For institutional investors, development capital remains a very small proportion of the total portfolio, usually 1% to 2% of assets for large pension funds.
John Suckling, secretary to the board of the 2.1 billion ($3.26 billion) Rover Group Ltd. pension fund, Birmingham, England, said, "Venture capital investments can provide superior returns while at the same time they diversify risk." The fund recently committed about 3 million each to pools run by Charterhouse and Candover PLC in an effort to enhance returns on its core investments.
For smaller British pension funds, venture capital is less attractive. With funds becoming increasingly mature, trustees are less patient with illiquid investments, said Nick Fitzpatrick, partner at the consulting firm of Bacon & Woodrow, London. Also, trustees are put off by the high-risk nature of the investments, hefty fee schedules and mixed track records, he said.
Nor are all large institutions convinced that returns are as good as expected. Some investors in previous pools have declined to sign up for the latest offerings.
"We are not convinced of the performance," said Frank Smulders, financial manager for the 12 billion Belgian franc ($376 million) AGFA-Gevaert AG pension fund, Mortsel, Belgium.
"We want to see whether returns will meet our expectations," echoed Graham Allen, managing director of ICI Investment Management Ltd., London, which invests 6 billion ($9.3 billion) in pension assets.
Some investors also worry that perhaps too much money is flowing into development capital funds, especially given sputtering stock markets. These funds may not remain "so attractive any more," said Winfried Kruger, chief investment officer for Hannover Ruckversicherungs-AG and Eisen und Stahl Ruckversicherungs-AG, Hanover, Germany. The sister reinsurance companies have invested in Charterhouse Capital Partners V, and are considering committing to Baring Capital Partners.
But others said while the size of some individual funds exceeded their initial targets, the total is less than in the previous major fund-raising round five years ago.
In addition, the notable absence of Electra Investment Trust PLC from the fund-raising process shrinks the overall amount of funds being raised. Some experts predict a consolidation in the industry.