Europe: Capital to Fuel Growth

As much needed confidence returned to the European market in 2005, it highlighted the changed landscape faced by technology-related companies and those who invest in them, compared to five years ago. Even as enterprises once again opened their wallets to spend money, they did so, on a very selective basis. As a result, not every company or segment is benefiting in the same manner. In this CEO Topic, we will discuss factors affecting growth prospects and capital availability in Europe.

For the first time, there are segments of the European technology landscape that might be characterized as mature. However, this does not mean that there is not an opportunity for growth. Niche segments within the "mature" markets are demonstrating high growth rates as strategic business needs benefit well-positioned suppliers. For example, while financial services IT spend has recovered only to a single digit growth rate, there are segments within this broad sector growing 20%+ per annum as increased regulatory requirements, changing capital markets and heightened security awareness make certain technology spend a C-level priority. Similarly, in the telecommunications market, while growth in overall spend in areas such as billing and operational support systems is estimated at only 6%, there are subsectors such as revenue assurance that are growing at three times the market rate. As the mobile market matures, demonstrable payback on the bottom line becomes a key priority.

As always in Europe, government initiatives are helping to determine some of these areas of growth, resulting in shifting spending patterns in the market: financial regulation such as Basel II; the technology-enabling of the National Health Service in the healthcare market; and continued telecom deregulation. One area of particular growth has been the energy markets – driven both by oil price rises and regulation related to the Kyoto accord. Wind farms, carbon credits and solar cell technology have all recently made front page headlines in the FT as companies and investors alike struggle to understand how to benefit from the new regulation-induced spend.

Growth in these niche areas has benefited small and fast-adapting companies who were able to offer specific solutions to the pressing technology issues faced by European enterprises. In the more traditional areas of technology spend, enterprises have gravitated to the largest and most established players. These dynamics led to a bifurcation of the technology market in Europe with large, established players now stable but struggling to find organic growth, and fast growing niche companies responding quickly to changing markets.

Similar to the U.S., private equity and debt providers’ increased comfort level with technology, coupled with an often unrewarding public market, has led to an increase in buyout interest in established European technology companies. While few large take-private transactions have taken place (Amadeus), financial leverage is common. Significant debt capital is available even in sectors where debt providers have shown a traditional aversion, such as networking services.

As the market reached new heights in 2005, 95% of European private equity investors polled by PE News felt that leverage multiples are reaching "dangerous and unsustainable levels". Perhaps of most concern, the restrictions that accompany these debt levels create the danger of hampering the strategic developments many of these companies will need to execute to emerge as ultimate survivors in a consolidating landscape.

At the other end of the spectrum for the growth companies, London’s Alternative Investment Market (AIM) has continued to expand. The market has seen over £27 billion in new capital raised for early-stage companies and the aggregate market value has doubled in just two years. AIM has not only been viewed as a viable alternative to growth equity funding for UK technology companies, its attraction to European and other international companies has risen with the increased administrative burden at Nasdaq, the traditional home of technology. However, as scale becomes more important, the ease of access to AIM may in fact be doing its participants a disservice by allowing companies to go public too early in their development. The average size of companies listed on the Nasdaq is now $1.2 billion, while on AIM, the average size is about £35 million ($65 million). Furthermore, an AIM listing is not without its limitations, especially the lack of liquidity in all but the largest names and the difficulty of raising significant acquisition capital.

Ultimately, acquisition capital has never been more important. Larger established companies struggle for growth and the ability to achieve a scale beyond their regional origins, while smaller companies seek to expand beyond a single niche segment. Global M&A activity has almost returned to 2000 levels. However, it appears that U.S. purchasers are still driving the market where technology is concerned. European companies have a brief window to gain the scale to be relevant in the market in the coming years. Valuations of technology companies are no longer cheap, but many are still attractive on a growth-adjusted basis. Unlike recent years, there is less competition from equity market valuations with only 10% of VC and PE exits through a public listing. Good companies are available to those management teams who can move aggressively.

While the ready availability of capital in Europe has made conveying the distinct nature of growth investing above the noise more difficult, the need for capital to consolidate in the industry leaves growth equity with an ever more powerful story to tell. The requirement for investors ready to back management to build both organically and inorganically the next generation of leading European technology-related companies has never been higher. Growth has returned to technology in Europe, but before we see large and growing European champions, some assembly is required.