Venture capital market slows

(November 2006) The Canadian venture capital industry has become more conservative with its funding disbursement, focusing its relatively scarce capital on later stage financings, according to the industry association.

In its quarterly study, the Canadian Venture Capital & Private Equity Association reported a continued decline in venture capital investment in Q3, with emerging companies seeing a 32% drop in funding, to $331 million. That’s just 13% above the “low-water mark” of $292 million in capital deployment, set in Q3 2005.

On a year-to-date basis, venture capital investment fell 8%, from $1.3 billion in the first nine months of 2005, to $1.19 billion in 2006.

“The continued drift downward in Canadian venture capital investment reflects a slower pace of activity in all of our major market sectors and regions,” said Rick Nathan, president of the CVCA and managing director of Kensington Capital Partners. “On the positive side, Canadian venture firms are becoming more focused, concentrating more attention and scarce capital on fewer investments, in order to provide their more promising companies with a better chance to succeed.”

The number of companies receiving investment capital fell 27%, from 168 funded companies in Q3 2005 to 122 this year. Funding was also aimed at later stage companies, with 85% of capital deployed as follow-on investment in existing portfolios.

Technology firms remained the most popular among venture capitalists, receiving 59% of disbursed capital in the quarter, representing $195 million flowing into 59 companies. The previous quarter saw $251 million invested in IT.

Within the tech sector, software firms attracted $68 million in new investment, with communications and networking firms attracting $47 million. Internet-based investments totaled $33 million.

The life sciences sector saw $61 million in new investment, a decrease of 59% from the previous quarter.

The slowdown in disbursements reflects a trend among venture capital funds themselves, as they have struggled to attract fresh capital. In the first nine months of 2006, they attracted almost $1.29 billion, compared to $2.21 billion raised in full-year 2005.

The Canadian venture capital industry generally falls short of that in the U.S., even after factoring in the difference in population and overall economies. In both measures, the U.S. is generally estimated to be 10 times larger than Canada, but in terms of venture capital disbursements, the U.S. industry disburses 20 times the capital.

That amounted to $6.2 billion US in Q3 2006 alone. Year to date, the U.S. industry has invested $19.1 billion US, an increase of 13% from the first nine months of 2005.

Ontario, for example, ranked only 11th among North American jurisdictions, behind mid-market states like Colorado, Pennsylvania, Virginia, Washington and Arizona. Canadian companies are increasingly turning to foreign sources of capital, with non-Canadian investors accounting for one-third of activity in the Canadian market, up from 25% through the previous five years. Foreign investors have brought in $90 million in the first three quarters of 2006.

Venture capital funds are not the only private equity group lagging behind past fundraising performance. Mezzanine financing funds have so far raised only $181 million for the year, according to the CVCA report. That’s well below the $912 million they raised in full-year 2004, but possibly on track to match 2005’s $248 million.

But the overall private equity financing trend looks much better when buyout funds are added to the mix. In the first nine months of 2006, these funds raised more than $6.4 billion, blowing past the $1.44 billion raised in 2005 and the $956 million raised in 2004.

“The Canadian buyout sector is emerging as a serious player in the global private equity markets, as the strong returns achieved by Canadian fund managers are attracting more and more attention — and capital — to their funds,” said Nathan. “The dramatic growth in Canadian fundraising is part of a major trend in global capital markets, which is increasingly focusing on the natural advantages of the private equity asset class.

“As more and more companies choose to go private, or to raise growth capital from private sources, the opportunities for private equity investors are building rapidly. It is very good news for Canada to see such a strong class of Canadian private equity funds emerging in 2006 — we need to develop strong Canadian investors for strong Canadian companies.”

Total private equity fundraising hit $7.868 billion by the end of Q3 2006, more than doubling full-year fundraising for 2005 and 2004, and handily eclipsing a strong 2003, when $5.173 billion was raised.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(11/14/06)

Steven Lamb