Europe’s venture capital landscape is a tale of two halves. Those that have money see things in a very positive light: lower (“fair”) valuations, little competition on terms sheets and a plethora of exciting opportunities, whose quality and capital efficiency is rising as the tough conditions serve to weed out all but the strongest.

Those whose funds are running dry are more circumspect. Fundraising is tougher than ever as some limited partners pull out of life sciences amid continued global financial turmoil; the euro uncertainty also means European VCs are even less likely to draw in U.S.-based limited partners to support new fundraising activity.

But although Europe’s financial woes may continue to make headlines, for investors and biotechs operating in the region, the story’s no longer new. It’s just gotten a bit worse. Capital supply has been limited for unprofitable, risky biopharma plays since the start of the financial crisis in 2008. Europe’s investors have always been more cautious, and less numerous, than those in the U.S., just as funds are generally smaller.

So, just as the crisis-linked flurry of government austerity in the past two years is only accelerating big pharma’s ongoing moves to cut costs, expand into emerging markets and trim portfolios, so the tougher funding environment for biotech will just accelerate young firms’ hunger for R&D-funding revenue streams, ultra-efficient (often virtual) operations and cash-driven M&A Also see "European Austerity Drama May Likely Spur The Pace But Not Change The Strategic Plot Line For Pharma" - Pink Sheet, 5 December, 2011..

Fewer Partners, Fewer LPs Mean Fewer New Investments

Still, it’s a good time for VCs that have capital to deploy it. “We can command quite favorable deal terms,” said Sander Slootweg, managing partner at Netherlands-based Forbion Partners, whose €140 million ($188 million) fund has room for one or two more investments. But it’s not just a question of snapping up all the good deals: investors have to ensure they can be supported through to a recognizable value inflection point, and won’t rely too heavily on attracting new investors down the line. “You’d better make sure they’re properly funded through subsequent rounds,” warned Slootweg, outlining the firm’s aim to syndicate with parties that “are in it for the long-haul”.

It’s a concern echoed by Regina Hodits, general partner at Munich, Germany-based Wellington Partners. “You need a strong syndicate around the table so you don’t get stuck somewhere if the pharma partner doesn’t show up on time,” she said.

Trouble is, there aren’t many good-sized syndication partners available in Europe. So finding a strong syndicate usually means getting in with those you know: Forbion recently contributed to a $26.5 million D round for still-preclinical Oxyrane UK Ltd. with Hong Kong-based Morningside and New York-based New Science Ventures – the same trio that co-invested in BioVex, sold to Amgen Inc.in January 2011 for up to $1 billion [See Deal] Also see "Aiming For Better, Cheaper ERT Drugs, Oxyrane Raises $26.5 Mil." - Pink Sheet, 17 November, 2011..

And indeed, it seems that when the smell of an exit is strong enough, LPs are prepared to cough up: Forbion in September 2010 raised a €54 million Co-Investment fund to support existing companies in its FCP 1 portfolio – including Biovex – and claimed the sale to Amgen helped repay the entire top-up find twice over. So on Dec. 8, Forbion announced it had raised a second, $50 million Co-Investment Fund to support help further close-to-exit investments to reach the finish line.

By and large, though, “the number of LPs investing in life sciences has shrunk significantly,” noted Denise Pollard-Knight, managing partner at Phase4 Ventures, spun out of parent investment bank Nomura in February 2011 Also see "Phase4 Spins Out Of Nomura To Focus On Europe" - Scrip, 1 March, 2011.. “When asset managers [typical LPs] are so uncertain about the assets they have, the last thing they want to do is tie up precious funds into completely illiquid high-risk vehicles,” reflects another VC. Indeed, notwithstanding the co-investment funds, “things will be more difficult when we raise our next fund.” noted Forbion’s Slootweg.

Tough Fundraising Means Corporate, Government Support Crucial

The rise of corporate VC has helped plug the gap to some extent, even though strategic interest can limit the number involved in a single company. But fund size is still small. “We need some of these big guys to raise more funds, which will take time,” remarked Kate Bingham, managing partner at SV Life Sciences. (Since raising its $523 million SVLSF V fund in June 2011, SVLS is one of the “haves”, with at least two years of further investment runway.)

But while AstraZeneca PLCmay have committed another $100 million to its VC arm MedImmune Ventures (increasing total managed capital to $400 million), much of that may fund further support for existing portfolio companies. Indeed, most traditional VCs with closed-end funds continue to hold back a higher share of those as reserve to support existing ventures, meaning there’s even less available for newcomers. Paris, France-based Sofinnova Partners has room for only one or two further investments from its current €260 million Sofinnova VI fund, but has invested only 45%, confirmed managing partner Antoine Papiernik. “The reserve amount [in our funds] has gradually increased,” he said.

Meanwhile, Europe’s national, transnational and regional government funding schemes – as well as capital provided by rich family entrepreneurs – are playing a more important role as traditional VC dries up. The U.K. government on Dec. 5 announced a package of measures to encourage start-ups and attract investment, including a £180 million BioCatalyst Fund, assumed to be soft-money Also see "Prime Minister Cameron Plans To Boost U.K. Biotech With New "Catalyst" Fund, Early Patient Access Scheme" - Pink Sheet, 5 December, 2011..

European-level public funding support for biotech also is becoming more prominent: On Dec. 7, the VC arm of Germany-based European Molecular Biology Laboratory, EMBL Ventures, announced the €40 million first-close of its EMBL Technology Fund II Also see "EMBL Ventures Snags $55 Million In First Closing For New European VC Fund" - Pink Sheet, 7 December, 2011.. Its cornerstone investor is the European Recovery Fund (ERF)-EIF Dachsfond, a fund-of-funds owned by several EU institutions plus public and private banks.

The shrinking LP pool, while forcing some VCs out of business, will force others to cast their nets wider, perhaps including new, more strategic LPs such as Merck & Co. Inc.’s newly created $250 million Research Venture Fund, or those with state support, such as the ERF-EIF Dachsfond. Also see "Merck's Capital Idea: Industry's Latest Push to Strengthen VC Ties" - In Vivo, 1 September, 2011. At the least, such players may help build a decent-sized first closing that can attract further backers.

Sofinnova Fundraising May Test Appetite For Early-Stage Investing

Sofinnova Partners may be one VC that has to expand its search for new LPs, as it starts to raise its seventh fund. The hope is that it can emulate the success of its U.S. counterpart, Sofinnova Ventures, which raised a $440 million fund, SVP VIII, in October 2011 Also see "Sofinnova Ventures' New $440M Eighth Fund Exceeds Expectations And Makes Adjustments" - Pink Sheet, 17 October, 2011.. Papiernik said he is confident his group could raise a fund similar in size to the group’s current one, but admitted that even though existing investors are supportive, “convincing the new ones is hard.”

Unlike many other VCs which have shifted their focus onto later-stage investments with nearer-term exit prospects, Sofinnova is sticking to its guns, however, and remaining in the early-stage, classic Series A territory. “It has paid off [in the past] for us to stay the course while others went into later-stage,” he argued, adding that Sofinnova has generated its best-ever returns over the last two years by doing just that, via lucrative exits from firms including Fovea Pharmaceuticals SA (acquired by Sanofi[See Deal]),Novexel SA (acquired by AstraZeneca [See Deal]) and Movetis NV (acquired by Shire PLC[See Deal]).“So why not in the future?”

With competition for LP funding coming, according to Papiernik, not so much from other VC funds but rather, from “buyout funds, or those focused on Chinese infrastructure,” those that are willing to invest in life sciences would at least want the possibility of a generous pay-back – which later-stage, less-risky investments are less likely to provide. “Why go in for only a 1.5x return?” Sofinnova will soon find out whether limited partners agree.

Can Europe’s Regulatory Context Outweigh The Euro Crisis?

According to an October 2011 study by the U.S. National Venture Capital Association, 36% of the 156 VC respondents said they expected to increase their investment in Europe over the next three years, while just 13% could say the same for the U.S. The main reason: a more favorable regulatory environment in Europe – or rather, a challenging FDA.

Certainly, approval (and thus marketing) for medical devices is widely acknowledged to be quicker and apparently less onerous in Europe than in the U.S.; this is one reason Wellington has shifted its overall investment focus away from therapeutics and into med-tech and diagnostics. “Investors like to see a concrete product” with clearly attributable value, explained Hodits.

But with Europe’s currency perhaps on the cusp of collapse, and an ongoing, spreading sovereign debt crisis – ratings agency Standard & Poor’s on Dec. 5 threatened to downgrade the ratings of 15 Eurozone countries – a possible regulatory advantage looks unlikely to attract hordes of U.S. investors.”Many don’t want euro exposure right now,” noted Phase4’s Pollard-Knight.

She and other U.K.-based VCs with the choice of U.K. sterling or U.S. dollar-denominated funds feel less exposed to the currency crisis. As for those like Forbion or Sofinnova, with euro-denominated funds and a majority of euro-based investments, they’re largely powerless. “I don’t think there’s anything we can do to hedge against the risk of a euro break-up,” admitted Forbion’s Slootweg.

Wellington’s Hodits argued that for Wellington, sitting in Europe’s strongest economy with most of its investments in France, Germany and the U.K., the issue “is a little less of a concern,” given less exposure to countries such as Spain, Greece or Italy where inflation could spiral. Sofinnova’s Papiernik also puts on a brave face. “Never mind the euro,” he said, opining that a break-up is “unthinkable”. He argued that the currency matters less than Europe’s more consistent regulators. And anyway, “we’ve lived through massive fluctuations in the dollar-euro exchange rate” but still made money, he argued. “The buyers [for our companies] will be there, whether they pay in dollars, euros or even rubles.” Also see "The End of The Euro: What Might It Mean For Pharma?" - Pink Sheet, 5 December, 2011.

That may be so, but the question is when. Meantime, even the optimists would have to agree with Alan O’Connell, a partner at Dublin, Ireland-based Seroba Kernel Life Sciences, whose euro-denominated fund has support from the Irish government. “It’s not helpful, this uncertainty.” Until there’s clarity on whether, and in what form, the euro will survive, Europe’s investment challenges are likely going to get worse, not better.

Euro Crisis Hits Investor Risk Appetite, But Opportunities Remain

More from Europe

More from Geography