September marks the end of summer and the beginning of the conference circuit for the brave band of VCs that gathered in London for the Ernst & Young/VentureOne Venture Journey Europe conference. It has been three long years since the capital markets called time on the speculative boom in technology assets and Europe’s venture capital community looks tired and worn out.

Despite a convincing recovery in the global equity markets since March, venture capitalists know there is still plenty of pain out there. Beneath the salesman’s smile, there are few investors that expect the exit market to suddenly burst open and rid them of all their portfolio pains.

Data from research company VentureOne shows that of the 5,437 European firms that received venture funding between July 1999 and June 2003, one sixth have gone out of business, losing their investors a total of 7.6 billion euro. One hundred fifty-six venture–backed companies (2.9 percent) staged an IPO and a further 355 companies (6.5 percent) were acquired by corporate investors.

The companies that are left, which have so far inhaled up 38 billion euro in venture capital funding, are in the market for follow-on financing rounds. Given that the rate of venture investment has fallen to just 1.3 billion euro in the first half of this year (compared to 11.1 billion euro in the first half of 2000), a significant number of these survivors is in reality little more than the living dead – waiting to be written off by their long-suffering investors.

The crash and subsequent mudslide in European early stage investing has already claimed the scalps of a number of high-profile investors including Europatweb, the venture capital arm of Bernard Arnault’s luxury goods empire, and DB eVentures, a captive fund launched by Deutsche Bank to seek out opportunities in financial services startups. However, the real extent of the shakeout will not be understood until the general partners at Europe’s venture capital houses return to the market to raise their next generation funds.

Unsurprisingly, Europe’s venture investors have not exactly been rushing back to the market with cup in hand. Many have simply slowed down their investment pace, living on their management fees in the hope that the green shoots of a long-awaited recovery might miraculously open up the exit market. There was only one initial public offering of a VC-backed company in the second quarter of this year, raising 21 million euro. This compares to 66 IPOs raising 3,701 million euro in the second quarter of 2000, according to VentureOne.

Securing a few trade exits or, heaven forbid, the odd IPO would do wonders for a fund’s performance and significantly boost the chances of its managers raising fresh capital. While waiting for things to get better may have been a plausible, if not entirely creditable, strategy in 2001, time has unfortunately run out on those hoping to raise new funds without the hoped-for recovery taking place.

"Two thousand four is going to be the key year for the class of new arrivals who raised funds in 1999 and 2000," says Andrew Sealey, a director at Campbell Lutyens, a London-based corporate finance advisor and placement agent for private equity houses seeking to raise new funds. "By the end of 2004 we will know which of these managers was successful in raising a second fund."

Mr. Sealey argues that allocations to European venture capital funds are clearly lower than they were in 1999 but there is still an appetite for the very best venture capital funds among sophisticated institutional investors.

According to this argument, Europe’s venture capital industry, which experienced such spectacular growth at the end of the decade, is about to become a great deal smaller. In the second quarter of 2000 at the height of the technology asset bubble, European VCs invested a total of 6.1 billion euro in 1,085 companies. However, after a three-year crash and slide, European venture activity in the second quarter of this year had fallen to 0.7 billion euro invested in 222 companies, according to data from VentureOne.

The traditional method for identifying quality venture managers is to look at the money returned to investors from fully invested funds. Since a large proportion of European venture capitalists are managing first-time funds and the overwhelming majority of these funds have produced negative returns, it is safe to assume that not more than a handful of general partners in each European country will survive to raise next generation funds.

Nonetheless, a small number of VCs have managed to raise funds in recent months. This exclusive club of general partners may modestly attribute their good luck to market timing, but their successful fundraising efforts reflect a solid track record and sector performance. Abingworth, a UK venture capital firm that has focused on the life sciences sector since 1987, closed a 290 million euro fund in August that was twice oversubscribed only two months after launching. In January, Ireland’s ACT Venture Capital held a final close at 170 million euro on its third fund, while PolyTechnos Venture-Partners, one of Germany’s more established venture investors, successfully raised a 130 million euro fund in February.

And the good news is that the IPO window may be about to open. Stuart Watson, the head of Ernst & Young’s Venture Capital Advisory Group, says he is advising four U.K. technology companies with plans to float on the public markets. He nonetheless insisted that the climate remained fragile. "A chief executive taking a technology company to market would be advised to be very confident about meeting earnings targets," he says. "The IPO window is a fragile thing and can close as quickly as it opened".

Europe’s fragile entrepreneurial ecosystem has clearly taken a huge knock from the fallout of the technology, media, and telecommunications (TMT) crash but, in true Darwinian style, a fitter venture industry has survived - even if most people on the conference circuit look as though they could use another vacation.

2001. This downturn could have shut off the private-equity supply for European biotech startups, but it didn't.

The amount of money invested in venture-backed biotech companies in Europe remains close to the record levels of 2000. By the end of July 2001, more than $650 million went to venture-backed deals, according to the industry research firm BioCentury. In the absence of public-market support, venture capital is now the European biotech industry's chief engine for growth.

The average size of venture rounds is steadily increasing. In 1997, 25 companies raised a total of $191 million, according to BioCentury, an average of $7.6 million per company. By 2000, this figure had grown to $17 million for each of 70 companies. Despite the effective closure of the IPO markets, the figure for 2001 through the third quarter is only marginally lower, with 63 companies raising an average of $14 million each.

The ever larger deals are a reaction to the current economic climate. Helmut Schьhsler, a managing partner of TVM Techno Venture Management in Munich, Germany, says in order to keep its half-dozen portfolio companies that are in the IPO pipeline thriving, his firm's investment planning has changed from exit strategies to maintenance schemes. TVM is in the process of raising additional funds to enable those companies to last until "mid-2003 or longer," he says.

The overall result of this shift is likely to be larger funding rounds to meet the growth needs of startups. "You can expect to see a number of private financings in the biotech arena whose size you would more typically associate with an IPO," says Mr. Schьhsler.

This is not to say, of course, that VCs are ditching their exit plans. Rather, they are pragmatically playing wait-and-see, as public- and private-company valuations continue to fall. Flooding back into the minds of many VCs is the downturn of 1990 and 1991.

"At that time, we were the only fund with a focus on life sciences in France, and private money was simply not available to fund further rounds," says Antoine Papiernik, a partner with Sofinnova Partners, one of France's oldest VC firms. "Investors have become more picky in the last few months, but no one is panicking."

Robert Zegelaar of Atlas Venture in London agrees. "Downturns were very scary in the past," he says, "because you never knew for sure whether your portfolio companies were going to survive. The amount of money companies were able to raise was very small, their stock value crashed in the downturns, and the down periods lasted a long time." This time, Mr. Zegelaar says, he is confident that the downturn will be shorter and that his portfolio companies will get the funding needed to survive.

Though his optimism flies in the face of conventional wisdom, it's grounded in reality. The IPO shutdown has not hobbled VC investment in European biotech as it has in the past. This time around, VCs recognize that the fundamentals underpinning Europe's biotech sector are strong. Biotech companies are delivering products and revenue, rather than promises of future riches. But equally important is a widespread awareness of an obvious fact: biotech has never been about making a quick buck.

"It can take anywhere between 6 and 15 years to develop a new drug," says Mike Ward a London-based associate director in the life sciences team at the Friedman, Billings, Ramsey Group, an investment bank. "The best venture capitalists in biotech are patient. They don't drop out at the first sign of trouble on the public markets."

Indeed, more VCs are entering the sector. Europe's strengths--proteomics and regenerative medicine--won the interest of several U.S. and Asian firms for the first time last year. Another selling point is the growing pool of experienced management for startups--the spate of big pharma mergers across Europe has freed up executives. There is also anecdotal evidence of an emerging class of serial entrepreneurs.

Of course, Europe's biotech startups and their backers still have a long way to go. A decade ago, the London Stock Exchange was the only exchange in Europe that accepted biotech stocks. Now biotech stocks are scattered across 12 European exchanges. This glut of stock exchange options prevents any one exchange from gaining a critical mass of companies and providing meaningful liquidity for biotech stocks. This will remain a concern for investors until a dominant European exchange emerges for biotech listings. Simply listing on the Nasdaq is not the answer; most European companies would be dwarfed by the big U.S. players.

Biotech VCs will, no doubt, adopt some creative financing approaches to survive the downturn. "European VCs now realize that if the companies in which they're invested are to have any chance of competing with the U.S., they will need a similar level of funding," says Glenn Crocker, a senior consultant in Ernst & Young's life sciences group.

One technique catching on in Europe is to combine a private company with limited cash and a pipeline of products, with a struggling publicly traded company that has significant cash reserves. Many of these struggling public companies were financed by "soft money" in the form of grants from federal and state agencies to stimulate the biotech industry in Germany. They are now considered ripe targets for this maneuver. Indeed, absent a market for biotech IPOs, Kai Deusch, an Apax Partners VC based in Munich, Germany, says that finding such companies is one of the key goals of his life sciences team. "These companies are not sustainable as stand-alone biotech companies, and you can expect to see a number of mergers over the next year as the sector consolidates," he says.

But even VCs that are not pursuing this exit strategy have reasons to feel confident in the long term: diseases are not about to disappear, the European biotech sector is maturing, and a roster of strong IPO candidates is being created as more products move from Phase II to Phase III trials. The capital markets will need to reopen if VCs want to make big returns, but for the moment, they seem content to keep making big bets while they wait.

Guy Paisner is a freelance writer based in London. Write to letters@redherring.com.

2001. This downturn could have shut off the private-equity supply for European biotech startups, but it didn't.

The amount of money invested in venture-backed biotech companies in Europe remains close to the record levels of 2000. By the end of July 2001, more than $650 million went to venture-backed deals, according to the industry research firm BioCentury. In the absence of public-market support, venture capital is now the European biotech industry's chief engine for growth.

The average size of venture rounds is steadily increasing. In 1997, 25 companies raised a total of $191 million, according to BioCentury, an average of $7.6 million per company. By 2000, this figure had grown to $17 million for each of 70 companies. Despite the effective closure of the IPO markets, the figure for 2001 through the third quarter is only marginally lower, with 63 companies raising an average of $14 million each.

The ever larger deals are a reaction to the current economic climate. Helmut Schьhsler, a managing partner of TVM Techno Venture Management in Munich, Germany, says in order to keep its half-dozen portfolio companies that are in the IPO pipeline thriving, his firm's investment planning has changed from exit strategies to maintenance schemes. TVM is in the process of raising additional funds to enable those companies to last until "mid-2003 or longer," he says.

The overall result of this shift is likely to be larger funding rounds to meet the growth needs of startups. "You can expect to see a number of private financings in the biotech arena whose size you would more typically associate with an IPO," says Mr. Schьhsler.

This is not to say, of course, that VCs are ditching their exit plans. Rather, they are pragmatically playing wait-and-see, as public- and private-company valuations continue to fall. Flooding back into the minds of many VCs is the downturn of 1990 and 1991.

"At that time, we were the only fund with a focus on life sciences in France, and private money was simply not available to fund further rounds," says Antoine Papiernik, a partner with Sofinnova Partners, one of France's oldest VC firms. "Investors have become more picky in the last few months, but no one is panicking."

Robert Zegelaar of Atlas Venture in London agrees. "Downturns were very scary in the past," he says, "because you never knew for sure whether your portfolio companies were going to survive. The amount of money companies were able to raise was very small, their stock value crashed in the downturns, and the down periods lasted a long time." This time, Mr. Zegelaar says, he is confident that the downturn will be shorter and that his portfolio companies will get the funding needed to survive.

Though his optimism flies in the face of conventional wisdom, it's grounded in reality. The IPO shutdown has not hobbled VC investment in European biotech as it has in the past. This time around, VCs recognize that the fundamentals underpinning Europe's biotech sector are strong. Biotech companies are delivering products and revenue, rather than promises of future riches. But equally important is a widespread awareness of an obvious fact: biotech has never been about making a quick buck.

"It can take anywhere between 6 and 15 years to develop a new drug," says Mike Ward a London-based associate director in the life sciences team at the Friedman, Billings, Ramsey Group, an investment bank. "The best venture capitalists in biotech are patient. They don't drop out at the first sign of trouble on the public markets."

Indeed, more VCs are entering the sector. Europe's strengths--proteomics and regenerative medicine--won the interest of several U.S. and Asian firms for the first time last year. Another selling point is the growing pool of experienced management for startups--the spate of big pharma mergers across Europe has freed up executives. There is also anecdotal evidence of an emerging class of serial entrepreneurs.

Of course, Europe's biotech startups and their backers still have a long way to go. A decade ago, the London Stock Exchange was the only exchange in Europe that accepted biotech stocks. Now biotech stocks are scattered across 12 European exchanges. This glut of stock exchange options prevents any one exchange from gaining a critical mass of companies and providing meaningful liquidity for biotech stocks. This will remain a concern for investors until a dominant European exchange emerges for biotech listings. Simply listing on the Nasdaq is not the answer; most European companies would be dwarfed by the big U.S. players.

Biotech VCs will, no doubt, adopt some creative financing approaches to survive the downturn. "European VCs now realize that if the companies in which they're invested are to have any chance of competing with the U.S., they will need a similar level of funding," says Glenn Crocker, a senior consultant in Ernst & Young's life sciences group.

One technique catching on in Europe is to combine a private company with limited cash and a pipeline of products, with a struggling publicly traded company that has significant cash reserves. Many of these struggling public companies were financed by "soft money" in the form of grants from federal and state agencies to stimulate the biotech industry in Germany. They are now considered ripe targets for this maneuver. Indeed, absent a market for biotech IPOs, Kai Deusch, an Apax Partners VC based in Munich, Germany, says that finding such companies is one of the key goals of his life sciences team. "These companies are not sustainable as stand-alone biotech companies, and you can expect to see a number of mergers over the next year as the sector consolidates," he says.

But even VCs that are not pursuing this exit strategy have reasons to feel confident in the long term: diseases are not about to disappear, the European biotech sector is maturing, and a roster of strong IPO candidates is being created as more products move from Phase II to Phase III trials. The capital markets will need to reopen if VCs want to make big returns, but for the moment, they seem content to keep making big bets while they wait.

Guy Paisner is a freelance writer based in London. Write to letters@redherring.com.

Anthropics Technology, a London-based startup, has developed a specialized video compression technology called Synthactor, which enables true TV-quality video of people's faces to be delivered over bandwidth as low as 7 Kbps. The technology also enables real-time image manipulation and special effects, humanizing Web sites with lifelike talking heads for customer support or online tutoring.

Anthropics was cofounded by Andrew Berend, now its CEO, and Mark Williams, the chief technical officer. They worked together at Cambridge Animation, which Mr. Berend founded in 1990 and which has become one of the world's leading suppliers of cartoon animation software, used in films like Space Jam and The Prince of Egypt.

The duo joined forces again in 1997 at Createc, a government-funded initiative with the humble mission of "inventing the future of digital media." Anthropics was established to commercialize Createc's technology, and its founders hoped their animation research might be useful to communication service providers.

Working with business schools in the United Kingdom to ensure the technology would have commercial legs, Anthropics developed compression software that could broadcast the human head and shoulders and enable humanlike communication using the minimum possible bandwidth. "There's a real technology need for a system that will project faces with all the subtlety and accuracy necessary for effective nonverbal communication," says Mr. Berend.

The technology was designed to complement media offerings like RealPlayer and Microsoft Media. One application is streaming video, in which Anthropics software allows a newscaster's head to be transmitted.

Anthropics claims that it can already make multimedia messaging a reality on existing GSM networks, and that its compression software will make streaming media much more cost-effective on faster second-generation wireless and third-generation wireless infrastructure, whenever that finally appears.

Anthropics closed an $8.2 million first round in August; it was led by Quester, a U.K. venture capital house, and included Skandia Media Invest, a VC unit of Skandia, one of Sweden's largest conglomerates, and SkyVentures, a Swedish venture house partially owned by Skandia. In the present bleak environment for what we used to call rich content, Anthropics may prove a tasty morsel for a media company, rather than a big business in its own right, but we loved that demo.

Despite the fact that adult content remains one of the best-performing Internet sectors, mainstream U.S. Internet companies are keen to distance themselves from the murkier side of the Net. Earlier this year, Yahoo removed all adult-related products from its sites. America Online has no proprietary adult content on its Web sites.

The deal with Ya.com was negotiated by Bjorn Skarlen, Internet director at the Private Media Group, a Barcelona company that claims to be the world's biggest producer of adult content. He also recently completed a deal with Prisacom, a Madrid company that provides media products. Mr. Skarlen is frustrated by attempts to enter the mainstream U.S. market. "In the U.S., every Internet company wants to make money through porn and gambling, but nobody has the balls to tell their investors that this is what people want," he says.

Clearly, not every company is keen to provide hard-core pornography as part of its product mix, but Mr. Skarlen feels European companies deal with the issue less furtively. "There are some portals in Europe that say no to porn and some that say yes," he says. "In the U.S. they say, Yeah, we want it, but how can we hide it?"

"The institutional presence was not there," says Ms. Glover, "and the perceived wisdom was that Europe doesn't build great technology companies."

Undeterred, she teamed up in 1997 with Hermann Hauser, a well-known Cambridge-based angel investor and technology entrepreneur, to form Amadeus Capital Partners.

Five years later, Amadeus has emerged as one of a handful of independent European venture capital houses with a proven track record and money in the bank. To date, none of its 36 investments have been written off. It managed to rack up six exits from the 24 companies in its first fund and, on the back of this success, raised a Ј235 million ($334.6 million) second fund in October 2000, just as institutional support for tech investing was beginning to dry up.

Amadeus has now grown to 25 staff members in London and Cambridge, including 13 investment executives. Its portfolio has a core focus in communications technologies but also covers a surprisingly wide range of different sectors. In 1999, it was a second-round investor in Lastminute.com, the online leisure specialist, and last year it invested in LeatherXchange, a Spanish business-to-business hub for the worldwide leather industry. At the end of 2000, the fund was the sole investor in Plastic Logic, a Cambridge-based company developing a new type of printable plastic circuit intended to supersede silicon circuits in mass applications.

Ms. Glover is unique: private equity in the Old World is still the preserve of male investment executives, and she is the only female CEO of a major VC house. But then, Ms. Glover has always been a pioneer. Born and raised in Liverpool, she went to the University of Cambridge in 1973 to study material sciences and metallurgy when the male-only colleges were just beginning to accept female undergraduates. After completing her undergraduate degree at Cambridge, Ms. Glover went to Yale University for an M.B.A., much to the consternation of her fellow students.

"Most of my peers at Cambridge thought that I was throwing my life away. Business and industry were not well respected in the U.K. in the '70s," she says.

Unable to find a job in British industry, Ms. Glover worked in the United States, eventually joining Bain & Company in Boston. In 1988, she joined Apax Partners, then called APA. She started work just as the U.K. economy went careering into a recession.

"It was a pretty damn sobering time to start doing VC," she recalls. "I learned about 13-week rolling cash flows and being on starvation diets and insolvency."

By the end of 1993, Ms. Glover found herself spending more and more time with a company called Virtuality, which developed virtual-reality software. When the company went public in 1994, she joined as CEO. "I said to myself that I would do this for two years to give myself the experience. I was ticking that box before I became an early-stage VC," she says.

Ms. Glover explains that her desire to "tick every box"--that is, to cover all the bases--stemmed from a fear that someone might tell her she wasn't qualified to do the job. She had capped her educational background with operating experience, line experience, strategic experience, and tech experience. "I was creating an ironclad story to the outside world. I think that this is something that women do, as it's so easy to be turned down," she says.

Following Virtuality, Ms. Glover believed she was finally ready to set up an early-stage VC fund. However, in 1996, the VC industry in the United Kingdom was still in its infancy, and she knew that it would be impossible to raise money on her own. She toyed with the idea of opening a London office for a U.S.-based VC firm, but none was willing to take the plunge into unknown European waters.

At the same time, she began to consult with Mr. Hauser on several technology startups. "As a business angel, Hermann was completely unconnected to the disciplines of venture capital," she jokes. "We have different skill sets, backgrounds, and personalities, but crucially, we share a surprisingly similar professional value system." Their working relationship grew into Amadeus Capital Partners, which raised its first Ј50 million in 1997.

The technology bubble may have burst, but Ms. Glover believes that European venture capital has just begun. "Europe and the U.K. are only beginning to create flagship IT companies that attract a deep pool of talent in both managerial and technical terms," she says. "You only need to look at the flagship European mobile companies to see the cascading effect these have on startup activity in the wireless sector."

Amadeus has already made 12 investments from its second, Ј235 million fund. In June 2000, Amadeus was part of a $53 million first-round investment in Southampton Photonics, a spinoff from the University of Southampton's Optoelectronics Research Centre and a promising optical networking startup (see "One to Watch," April 15, www.redherring .com/mag/96/photonics.html). Amadeus's most recent investment was a $10 million first-round investment in Clearswift, an email content-security business.

"There is obviously a huge shake-out going on that makes us cautious about investing in companies with significant capital demands, but this is a long-term business," Ms. Glover says. "If the markets don't recover until 2003, we will still be here."

Write to guy.paisner@redherring.com.

Central to the company's expansion plans is a buying spree. In the past year alone, it has bought four European competitors: Technologieholding, Germany's largest early-stage technology VC firm; Atle, one of Sweden's most established private equity groups; Bank Austria TFV High Tech-Unternehmens Beteiligung (BA TFV), a VC-fund-management company; and SFK Finance, an investor in the Finnish telecommunications, IT, and environmental technology sectors. 3i has a network of 43 offices,

including locations in the United States and Asia, but its real power is in Europe, where it has a presence that no other VC group can match (see "Investors Without Borders," page 53).

An integrated international VC network is 3i's big idea, and with it the company plans to march on rivals worldwide--especially in the United States, which still dominates the business of providing risk capital to technology startups. "VCs in Silicon Valley have made such a ton of money in their own backyards that they haven't needed to bother looking elsewhere," says Brian Larcombe, the CEO of 3i.

Mr. Larcombe is only partly right. U.S.-based VC firms like Walden International and Benchmark Capital have international offices and manage international funds. But no U.S. firm has an integrated approach like 3i's or is pursuing as aggressive an expansion plan. Yet beneath its formidable presence, 3i is risk-averse and maintains a balanced portfolio, a strategy that is peculiarly well suited to Europe and one that seems to work abroad as well.

3i's cryptic name stands for "Investors In Industry," and it was formed in 1945 as a government initiative to encourage the Bank of England and the domestic clearing banks to help fund small and midsize U.K. businesses in the aftermath of World War II. In its first 40 years, 3i built a reputation as a quasi-public sector institution with a sprawling bureaucracy of 14 British offices that specialized in boring, management buyouts of U.K. "metal-bashing" companies.

In keeping with its staid beginnings, 3i functions on an entirely different scale than famous Silicon Valley firms. Whereas big-name Valley firms like New Enterprise Associates and Sequoia Capital have big-name partners like Dick Kramlich and Don Valentine, and other firms have only a handful of partners, 3i has 1,050 employees. This includes about 400 investment executives, who monitor more than 3,000 portfolio companies and manage nearly $12 billion in investments. The firm's general policy is that its executives do not take board seats with portfolio companies. It's because they're overwhelmed by the number of deals they have to handle. In fact, the average portfolio of a 3i investment executive is 5 to 10 investments, down from 10 to 20 investments only five years ago. 3i is also publicly traded; it was floated on the London Stock Exchange in July 1994, and it is now one of the United Kingdom's largest 100 companies by market capitalization. It is considered a high-risk, high-return investment, regularly outperforming blue-chip stocks. However, its returns (about 20 percent over ten years) are not in the top quartile by Silicon Valley VC standards. This is largely because of the firm's diversified approach to investing--and its bottom-line focused CEO.

Mr. Larcombe joined the company in 1974 and became CEO in 1997. But don't think Silicon Valley GoKart races, sports cars, and supermodels. He's good on detail, he's not into chitchat, he's a keen golfer, and that's about it. U.K. venture capital does not produce charismatic personalities. Mr. Larcombe is the quintessential 3i company man--an amiable, smiling accountant.

But he's an accountant with a plan. Only two years ago, 87 percent of 3i's investment portfolio was located in the United Kingdom. That figure has dropped to 71 percent, and Mr. Larcombe wants to see it fall to 50 percent within five years. In 1999, Mr. Larcombe said that he would increase 3i's technology holdings from 10 percent to 30 percent of its total portfolio by 2003. An ambitious investment program, combined with public-market enthusiasm for anything technology related, meant that by September 30, 2000, no less than 49 percent of 3i's portfolio by value was in technology. Following the crash and subsequent mud slide of tech stocks in the past year, that figure is now closer to 40 percent, but Mr. Larcombe says an ongoing commitment to technology is central to 3i's growth.

Mr. Larcombe's commitment is also central to the future of the European technology companies that remain dependent on risk capital. The contrast with U.S. investing strategies is stark: in the United States, technology firms get funding from VCs, while nontechnology sectors typically receive private equity from leveraged buyouts, banks, and merger-and-acquisition firms. 3i does not make this distinction and invests across all industry sectors, as well as all investment stages.

3i's technology portfolio includes more than 800 companies managed by an international team of more than 150 technology specialists (see "Three's Companies," below). From March 2000 to March 2001, 3i took 33 tech companies public on ten different exchanges. And in April 2001, it floated Marlborough Stirling, a Cheltenham, England, software provider for financial services firms, and one of only a handful of European tech IPOs this year.

Born Three

One of 3i's brightest investments was Kymata, a designer and manufacturer of planar-optical components and subsystems in Livingston, Scotland. In October 1998, 3i invested $1.5 million in the company to attract a couple of team members to research the space and draft a formal business plan. Kymata hired a management team of tech entrepreneurs and experts in optoelectronics and licensed intellectual property from the University of Glasgow and the University of Southampton, both optical-networking research centers.

In May 1999, 3i was the sole investor in Kymata's $8.5 million second round, increasing its stake to more than 40 percent. Then at the end of 1999, 3i and Kymata went to the United States in search of third-round shareholders to create a balance of European and U.S. investors. By March 2000, Kymata had raised $72 million more from a variety of backers, including Kleiner Perkins Caufield & Byers--the firm's first non-U.S. investment. A $67 million fourth round was raised in October 2000. A few months later, however, investors grew wary of optical-networking companies, and Kymata's value plummeted. At the end of July 2001, Kymata was sold to a unit of Alcatel for about $117 million. 3i's return was healthy, but it was substantially lower than the firm had hoped.

The Kymata deal was exceptional because a 3i executive held a seat on the company's board. While hardly indicative of a change in philosophy, the move was consistent with what is seen as a sound practice in Silicon Valley, where VCs use board seats to monitor and enhance their investments. But 3i's general policy is viewed with skepticism on both sides of the Atlantic.

"You can't be a real VC if you don't take a board seat. This is a real chink in their armor," says Simon Cook, who was a technology investment executive for 3i from 1997 to 2000 and is now an investment director at Elderstreet Investments, a London-based VC firm.

While Mr. Cook admits that 3i has been effective at exploiting its huge network, he argues that the firm has found some of its best deals by default--by being in so many places at once. "3i gets into all the emerging hot sectors, but because of its generalist approach tends to arrive a bit later. The net effect is that over the long term it achieves a sub-20 percent return," he says.

3i's blanket coverage of any sector perceived to be hot--no matter where it is--has produced some significant misses, including a pair of U.K.-based companies, TheStreet.co.uk, an Internet news site, and Breathe.com, an ISP. In the six months leading up to September 2000, when valuations were still sky-high, 3i invested $667 million in 313 tech companies. Some of those investments look considerably less robust now.

The New World

With its solid European position, 3i continues to expand. Two years ago, the firm opened offices in Boston and Palo Alto, California, that today are staffed by a total of 29 employees. To date they have invested $233 million in 27 U.S. IT companies.

But despite this obvious U.S. focus, Martin Gagen, CEO of 3i's U.S. operations, is evangelical about opportunities outside the States and says he is trying to use the firm's outsider status as a calling card. "We play a different game than the other Silicon Valley VCs," he says. "The key thing we have that no one else in the U.S. has is an international network that really delivers."

3i's first U.S. deal was with GlobalSight, a San Jose, California, startup that builds software to automate the development of multilingual and multicultural Web sites. International connections were vital for Doug Chapin, CEO of GlobalSight, when selecting backers. "We wanted 3i's global reach," says Mr. Chapin. "They have spectacular reach in Europe and Asia compared to other venture teams."

3i's emphasis on its international network also plays well with large tech companies. In May 2000, it led a $15 million first-round investment in DevelopOnline.com, in Tempe, Arizona, a company (spun off from Intel) that helps its clients develop software more quickly. In September 2000, 3i spun off from Hewlett-Packard the company CoCreate Software, in Fort Collins, Colorado, a developer of collaborative product-design software. Mr. Gagen says that HP's Palo Alto office introduced 3i to the deal because "U.S. venture capitalists didn't know what to make of it."

All this is a far cry from 3i's initial attempt to penetrate the U.S. market in the early '80s. Focusing on the buyout market, 3i built a portfolio of 50 investments before deciding to wind up the operation in 1991. A former 3i executive says that at that time, 3i was a very conservative outfit with methods of financing that were less attractive than those of its U.S. competitors. The decision to pull out just in time to miss out on the biggest bull market in U.S. history may have been slightly painful, but Mr. Gagen has no regrets. "3i is in a better position having built overseas for years before attacking the U.S. market. It's much more difficult doing it the other way round," he says.

3i works because the company follows a different investment model than the high-risk/high-reward capitalism made popular by Silicon Valley. It's no secret that European institutional investors are less tolerant of risk than U.S. investors, and 3i's approach is a rational response. The company has moved into tech investing from more established industries, allowing it to control carefully its exposure to the sector's considerable risks. By doing so, 3i has created a brand of private equity investing that feels comfortably "institutional" to investors and is a world away from the frontier spirit of U.S. early-stage VC. Mr. Larcombe remains tight-lipped about the future strategic direction of 3i and the precise mix of technology and nontechnology companies.

3i's success, of course, is less than spectacular. The firm did not achieve the triple-digit returns of Silicon Valley's top funds during the recent boom years, but its balanced portfolio means that 3i is far less exposed to the wild swings in the technology sectors. Its cautious attitude is a very British compromise: it satisfies the needs of European investors while fulfilling the risk-capital needs of European entrepreneurs.

And as the jigsaw puzzle of European offices nears completion, 3i will be pushing even harder in the U.S. market. "I'll know that our international strategy is a success the day that I'm invited to deliver the keynote address at the NVCA," he says, referring to the National Venture Capital Association's annual dinner.

Mr. Larcombe may be joking, but his comment reveals just how seriously 3i wants to be taken in the U.S. venture market. The steady stream of revenue from 3i's old-school management buyouts should provide the financial muscle for the firm to grow its U.S. operations. At a time when Silicon Valley firms are feeling humbled by the technology downturn, they could learn from this European veteran.

Write to guy.paisner@redherring.com.

But like the rest of the telecom sector, hosting suffers from massive overcapacity, and demand has fallen as customers tighten their belts.

The failure of CityReach, a high-end service provider with blue-chip financial backers, reveals the precarious financial health of Europe's entire Internet hosting sector. It leaves behind former rivals including TeleCity, IXEurope, DigiPlex, and InterXion, all of whom face an uncertain future as independent companies.

Founded in 1999, CityReach raised a total of 375 million euros ($332 million) in equity and debt over four funding rounds. The company's original equity backers in September 1999 were Battery Ventures and Chase Capital Partners (now JP Morgan Capital Partners). Later shareholders included Investcorp, Vulcan Ventures, and MC Venture Partners. Chase and Merrill Lynch (NYSE: MER) provided the debt.

CityReach prided itself on providing state-of-the-art technology and services in a market that was rapidly becoming commoditized by new entrants. The company opened data centers in London, Amsterdam, Budapest, Stockholm, Dublin, Munich, Berlin, and Paris. It hoped to float an initial public offering in November 2000.

Company executives and backers declined to comment, but a source close to CityReach said that problems began to emerge in May 2001 when second-quarter sales proved weaker than expected and it became clear that an additional 50 million euros ($44 million) in funding would be needed.

Refinancing a company with a variety of equity backers can be difficult enough, but the different risk profile of the debt providers made it impossible to cut a deal, says the source. The lenders who had pumped 121 million euros ($107 million) into CityReach stood to recoup 30 million euros ($27 million) by shutting the company down, and with the prospect of an IPO indefinitely stalled, they were unwilling to pump more debt into the beleaguered telecom sector.

Coming off their biggest year in history, European venture capitalists are following their U.S. counterparts and slowing the pace of new deals. But European entrepreneurs can take some solace in the fact that a record amount of capital is still available, and at least three segments continue to pique VC interest: wireless, optical networking, and security.

Investments in European technology companies totaled 11.5 billion euros ($10.8 billion) in 2000, up 68 percent from 1999, according to a report by PricewaterhouseCoopers. Overall, VC investments topped investments in buyout deals for the first time.

In addition, VCs nearly doubled the amount of money they have raised for tech investments to 15.2 billion euros, or 32 percent of all private equity funds raised. Even after their 2000 spending spree, private equity funds have about 3.7 billion euros on hand to invest. (Overall, the European venture business is about one-eighth the size of the $84.8 billion U.S. VC market.)

"We are expecting a downturn in the tech industry as a whole, but Europe will fare better than the 40 percent reduction in investment activity that took place in the U.S. between Q4 2000 and Q1 2001," says Keith Arundale, director of business development for the global technology industry group at PricewaterhouseCoopers.

HARD FACTS However, at least one other VC research firm paints a far gloomier picture. Thomson Financial/Venture Economics reports that the number of dollars invested in European technology companies totaled $854 million in first quarter 2001, down an astonishing 74 percent from $3.3 billion in fourth quarter 2000. The number of tech deals was down 32 percent during the same period, from 282 to 193. The medical/health/life sciences sector saw the most dramatic increase in the amount of capital invested from the prior quarter, according to Venture Economics.

Still, some VCs remain upbeat. "It's going to be hard everywhere, but we're of the opinion that Europe's deal flow will offer some better early-stage investment opportunities than the U.S.," says Marc Goldberg, chief technology officer at Reuters Venture Capital (also known as Reuters Greenhouse Fund).

Deal flow in European wireless startups remains strong, despite a general malaise in the telecom sector due to the crippling capital expenditures required to build out third-generation networks. Vesa Jormakka, a London-based partner and vice president at Argo Global Capital, a transatlantic fund that specializes in wireless, says he has seen 120 wireless business plans in the last six weeks. The big difference is that investors are now firmly in the driver's seat. "VCs are, quite rightly, being much more cautious about deploying their funds than they were in 2000," Mr. Jormakka says.

The white-hot optical-networking sector has cooled, but investors continue to be excited by European clusters of optoelectronic startups that have grown up around academic institutions, like the University of Glasgow and the University of Southampton.

Andrew Davison, investment director at the Glasgow office of the VC firm 3i, recently led a $10.9 million Series A round for Intense Photonics, which makes photonic integrated circuits. "The challenge right now is not to be seduced by some very attractive valuations in the optoelectronics space," Mr. Davison says. "These types of startups require substantial ongoing support at a time when exit opportunities are significantly diminished." (As in the United States, the public markets have tumbled throughout Western Europe.)

QUALITY OVER QUANTITY While the number of deals getting done has declined, the quality of the deals, notably in optical-enabling component startups, compares favorably with opportunities in the United States, Mr. Davison says.

Europe has an advantage in the area of e-security because of the political complexity of its business environment, says Justin Rea, a principal in the Dublin office of Cross Atlantic Capital Partners. "With more governments and nations involved, there are a lot of regulatory and social concerns that help to stimulate the market demand for security products," he says. "We're perhaps slightly more paranoid about our communication than in the U.S."

In January, Cross Atlantic joined lead investor 3i and Draper Fisher Jurvetson (DFJ) in an $11.8 million investment in SafeStone Technologies, which provides cross-platform security software.

U.S.-based firms like DFJ may help take the sting off the European VCs' slower investment pace. Among the high-profile U.S. firms to enter Europe are Accel Partners, Benchmark Capital, The Carlyle Group, DFJ, and Summit Partners. Summit recently raised a $2.1 billion global fund for later-stage investments, while Benchmark raised a $750 million fund aimed at Europe.

Bruce Dunlevie, a general partner for Benchmark who will spend a year in the firm's London office, dismissed the notion that the new European fund is a legacy of yesteryear's frothy venture market: "Our intention in Europe is to duplicate what we have created in the U.S.," he says.

Write to guy.paisner@redherring.com.

PeopleNews.com, based in London, has called in the liquidators after failing to find new investors. The company was formed at the start of 2000 and managed to raise $7.8 million over six rounds of venture funding from Antfactory and Syntek Capital Group.

Simon Walker, the company's CEO, maintains that the site, which attracted 300,000 visitors monthly, was due to break even in just a couple of months. "It didn't help that our original backers knew nothing about the media industry, and it's frustrating for this to fall through when we had come so close to breaking even," he says.

Celebrity gossip is big business in the UK. A feeding frenzy of celebrity trivia increasingly dominates national newspapers, while magazines devoted to giving readers a glimpse into the lifestyles of the rich and famous have become a publishing phenomenon.

There were two winners of the rather less snappily named LaunchIT 2001, announced in London on June 19, but they faced a rather more professional panel of judges. The competition was organized by Cross Atlantic Capital Partners (XACP), a venture capital firm with offices in the UK, Ireland, and the U.S.; and Brainspark, a London-based publicly floated incubator and one of XACP's portfolio companies. Students and university professionals at British academic institutions submitted technology-related business plans for the chance to win up to $700,000 in direct investment for their businesses.

The competition is the latest example of venture capital firms waking up to the largely untapped commercial potential of European academia. Stanford University and the Massachusetts Institute of Technology have become established spin-out factories in the U.S., but the commercialization of UK academic institutions has only just begun.

A number of university technology transfer offices now serve some of the better-known institutions, including Oxford University, Cambridge University, and the University of Glasgow. They still have a long way to go: capital creation from Cambridge, one of the more sophisticated universities, is less than 2 percent of that from Stanford. However, the phenomenal growth of European venture capital and the collapse of the "concept-driven" Net startup means VCs are now a little more eager to hunt for technology in the academy.

THE WINNERS The two winners of LaunchIT 2001, selected from several hundred entries, were Keele High Density and Pocket Watch Projects. Keele High Density is developing a memory technology using a new family of metal alloys; the company hopes to raise data storage densities by a factor of 20. This project is the result of research undertaken in the now-defunct electrical engineering department of Keele University by professor emeritus Ted Williams.

Mike Downey, the managing director of Cavendish Management Resources, who is handling the commercial aspects of Keele High Density, says funding from XACP would help the startup to improve its technology and increase its intellectual property base. About $2.8 million in seed funding from a network of angel investors has already been put into the company.

Pocket Watch Projects is developing software that it says will enable users to access and control information remotely on a personal PC via a mobile device. Last year it won the university-sponsored Edinburgh Technology Fund 2000 Business Plan Competition, and so far it has raised œ720,000 in seed funding from Scottish angel investors.

Grace Maa, a director and cofounder of Pocket Watch, says the company is excited about the possibility of venture capital investment from XACP. She estimates that Pocket Watch will need $4.5 million to $7 million to take it to profitability.

XACP is in the preliminary stages of due diligence with both companies. "LaunchIT 2001 has been a great way for us to further our collaborative efforts with core technology coming out of academia," says Sheryl Daniels-Young, a managing director at XACP. In these dark days of the downturn, what could have been an expensive marketing gimmick may turn out to be a relatively cheap way of securing a few good deals.

Last year was the biggest ever for private equity. European-based funds invested 34.9 billion euros ($29.8 billion) in 10,440 companies, an increase of 39 percent on the 1999 figure of 25.1 billion euros ($21.4 billion). Even more impressive was the increase in funds raised -- up 89 percent at 49 billion euros ($41.8 billion) -- on the 1999 record of 25.4 billion euros ($21.7 billion).

But the really big news was that for the first time, the lion's share of European money -- 56 percent -- was invested in risky, early-stage venture capital, rather than in later-stage buyouts. Fifty-six percent of funds invested in 2000, 19.6 billion euros ($16.7 billion), went into venture capital, compared with 10.6 billion euros ($9.1 billion), 43 percent, in 1999.

It's going to be hard to do that again. The conference organizers chose a low-key theme for the event, "Andante e Sostenuto," which translates to "slow and sustained" -- a musical direction to set the pace for what should be a slow march of European private equity this year.

The early-stage technology sector is in the doldrums, fears of a slowdown in the economy have almost ground buyout activity to a halt, the markets continue to sag, and vendors are having to adjust to depressingly lower valuations.

SLOSHING AROUND There is also 13 billion euros ($11.1 billion) of unspent venture capital sloshing around the system, and more and more money is chasing fewer deals. This will drive up the entry prices of deals and bring down the eventual returns that investors can expect. It also means that institutional investors, who have a limited capacity for risk investment, will have even less cash to allocate in the future.

Susan Flynn, portfolio manager for global private markets at GM Investment Trustees, said in open forum at the conference: "In the U.S., draw-downs by our general partners have declined noticeably in the first five months of this year. In Europe it is not so bad, but it will take longer to invest, and that has implications for how much we can commit in the future, so we do not exceed our allocations."

The annual EVCA symposium, now in its 16th year, is designed to bring together the industry's top guns and help to create some basic benchmarks to help record and promote the growth of private equity in Europe. This year's chairman, Edoardo Bugnone, a founding partner of Argos Soditic, a private equity firm specializing in midsize buyouts, is keen to present the coming slowdown in a positive light: "We don't anticipate a collapse in the industry, but rather a slowdown with a fairly consistent pace of investment."

However, Mr. Bugnone forecasted that the slowdown would be in the realm of 20 to 25 percent in terms of funds raised and invested. He claims this falloff may be even worse in the U.S., as European institutional investors are only just beginning to make allocations to alternative assets such as private equity.

FASHIONABLY LATE "Europe is lucky to be late to the party, as money will continue to flow into private equity funds from new investors in the institutional investor side," Mr Bugnone said. The big money is still coming in from the pension funds, which accounted for 24 percent of the total amount raised. Corporate investors have significantly increased their appetite for risk, doubling their investments over the year from 2.4 billion euros ($2 billion) in 1999 to 4.8 billion euros ($4.1 billion) in 2000, or 10.9 percent of the total.

But the appetite for exposure to technology startups has greatly diminished since March 2000, when the Nasdaq began its painful decline.

Established players like Apax Partners, Atlas Venture, Crescendo Ventures, and Amadeus Capital Partners made it to Rome, but there were far fewer upstart funds than in the past couple of years. One exception was Digital Networks, a first-time fund focusing on European hardware and software services in communications, which is expecting to hold a 50 million-euro ($43 million) first closing in the next month.

Nenad Marovac, managing partner of Digital Networks, hopes to buck the negative sentiment toward first-time funds in the technology sector. "New funds with no legacy portfolio companies, yet with experience in the sector, have a great opportunity to do well," Mr. Marovac said.

Perhaps, but many on the European investment scene don't share this optimism. James MacMillan-Scott, the managing director of Friedman, Billings, Ramsey International (FBR), a U.S.-based investment bank focused on European growth companies, said the prevailing mood was extremely cautious.

"The thing that I heard most from investors was that they couldn't find things to invest in. The money is available but the number of quality investments remains pretty limited," he said.

With its $61.5 million deal, the Nasdaq is investing in a new clearance and settlement system, under which the Depository Trust and Clearing Corporation will provide operating systems and support to the Easdaq's existing post-trading processing and risk-management capabilities. This could lead to a dramatic fall in the cost of European back-office clearing and settlement, bolstering Nasdaq Europe's competitive position against several national exchanges for high-growth companies that have sprung up in recent years.

The Nasdaq has been angling for a share of European listings for several years, and some industry observers believe its chances of succeeding through the Easdaq are high. "Nasdaq is a global brand name," says Stephen Barclay, a former executive chairman of Seymour Pierce, an investment bank specializing in high-growth companies. "It will get the backing of the major investment banks," he adds.

But the timing of the deal could have been better. With the current market downturn, the number of IPOs has plummeted. Moreover, the Easdaq was never viewed as a roaring success.

THE SINCEREST FORM OF FLATTERY Indeed, the Easdaq, set up in 1996 amid hopes that it could emulate the success of the Nasdaq in providing public market exits for growth companies in Europe, never took off. It offered less stringent requirements for listing stocks -- euro 0.5 million ($0.44 million) in assets, capital reserves of euro 2 million ($1.75 million), and an investor base of 100 shareholders at the start of trading. But at the time of the Nasdaq takeover, the Easdaq only listed 60 companies, with a combined market capitalization of less than $18 billion and a paltry $13 million in average daily trading volume.

"When we did the projection for Easdaq, we estimated that 500 growth companies would go public in Europe," says Jos Peeters, a founder and vice chairman of the Easdaq. "This turned out to be right, but not in the way we had anticipated," adds Mr. Peeters, who is also managing director of Belgian VC firm Capricorn Venture Partners.

While the Easdaq scored some high profile floats, including knowledge management software firm Autonomy (Nasdaq: AUTN) and wireless chip manufacturer Dialog Semiconductor (Nasdaq: DLGS), it quickly fell victim to a growing number of local imitators in Europe. As many as 500 companies opted to list not on the Easdaq but on local exchange startups, including Germany's Neuer Markt, France's Nouveau March‚, Italy's Nuovo Mercato, and the U.K.'s Alternative Investment Market (AIM), all of which emerged in response to the implied threat that the Easdaq represented to entrenched interests of national exchanges.

"Easdaq demonstrated that there was big business to be done catering to growth companies," says Mr. Peeters.

IF YOU CAN'T JOIN 'EM... Frank Zarb, chairman of the Nasdaq, says the creation of a pan-European growth market like Nasdaq Europe will act as a "fragmentation terminator," referring to an expected consolidation of listings in Europe.

Over the past four years, several attempts to set up regional exchanges in Europe have been aborted. A planned merger of the London Stock Exchange (LSE) and the Deutsche B”rse, its German counterpart, was called off in October 2000 when sufficient shareholder approval did not materialize. At the same time OM Group, a Swedish exchange, failed in its daring bid for the LSE. The Nasdaq was involved in negotiations with all of these exchanges but could not strike a deal.

Back in 1996, the Nasdaq was an original, albeit minority, shareholder in the Easdaq, so the decision to take a more active role was hardly spontaneous. Some industry observers see the Nasdaq's move on the Easdaq as an admission of failure to secure a deal with one of Europe's major stock exchanges.

At any rate, the creation of Nasdaq Europe is further proof that exchanges are increasingly run as businesses in their own right instead of as mutual organizations to look after the interests of their members. As an example, the Deutsche B”rse began trading February 5, paving the way for similar plans from the LSE and Euronext (a merger between the Amsterdam, Brussels, and Paris bourses).

The Nasdaq itself is in the process of transforming itself not only into a global player with operations like its fledgling Nasdaq Japan, but also into a for-profit securities market. Earlier this week Hellman & Friedman, a private equity firm, agreed to invest $240 million in the Nasdaq in return for a 9.8 percent equity stake. "The change from mutual organizations to for-profit businesses is difficult to achieve smoothly because the interests of mutual members are usually different to those of future shareholders," says Andrew Beeson, chairman of investment bank Beeson Gregory and chairman of EASD, the parent organization of the Easdaq. "But this is undoubtedly the way that exchanges are going."

This oddly named hybrid investment group, set up by a club of prominent angel investors called the "Fighting Ants," burst onto London's financial scene in September 1999, just in time to catch the end of the Internet boom. But when its original business plans -- which included importing proven business models of U.S. dot-coms and investing in and incubating a spurt of European startups -- proved disappointing, Antfactory began advising and investing with old-economy companies on new technologies. Now Antfactory is refocusing again as its complex corporate partnerships failed to produce quick returns. This time, it aims to use its sizable global network to introduce startups to blue-chip corporations, generating fees from advisory work as well as syndication fees for capital-raising.

While Antfactory has been changing focus in response to grueling market conditions for technology investors, the quick shifts also underscore a fickleness that continues to associate the firm with the opportunists of the Internet bubble. Worse, Antfactory has yet to create a viable revenue stream.

Defending Antfactory's sudden shifts, its chairman and CEO Harpal Randhawa says, "Companies whose business plans do not evolve will suffer in the long run."

EAT OR BE EATEN Certainly Antfactory needs to evolve. After spending $21 million opening 15 offices (not including a soon-to-open China location), it only earned $10.8 million during its first 15 months, $6.41 million of which was income from interest on the funds it had raised. Antfactory has been forced to slice its budget by 25 percent this year and cut staff numbers to 110 from 140. "While these results are hardly anything to boast about," a recently released annual report states, "we believe that we have come to the bottom of the J-curve involved in building any new investment firm."

Since its launch, Antfactory has made 22 investments worth $33 million, an amount that Mr. Randhawa calls "conservative," pointing out that the group has made investments totaling less than $5 million since mid-May. Performance has been mixed. Antfactory scored a hit with Acequote, an online IT procurement solutions provider, turning a $900,000 investment into $6.6 million when the company was sold in May 2000. But it fared less well with a $900,000 investment in ShipDesk, an independent business-to-business (B2B) marketplace for sea freight that went into liquidation in December, victim in part to the greater liquidity of LevelSeas, a competing exchange.

A month ago Antfactory published its first annual report, a comprehensive 84-page tome that reviews the year 2000 in detail quite rich for a privately held company. The report covers its business model, investment strategy, international network, audited accounts, and a portfolio of investments.

Such transparency stood in stark contrast to the degree of mystery surrounding the firm's activities in recent months. Reports of staff reductions, failed investments, and the death of an Argentinean employee that was reported in the press as a gangland hit for the nonpayment of bribes gave the impression that Antfactory was not a happy place. An almost Stalinist company Web site that removed any trace of former employees, even to the point of modifying and removing historic press releases, added to the general feeling that something was not quite right.

STRENGTH IN NUMBERS Throughout, Antfactory's fund-raising skills have not been in question. The company raised the considerable amount of $190 million in two rounds from blue-chip investors including Whitney, Citigroup Venture Capital, CVC Capital Partners, and Allianz Capital. Thomas Putter, CEO of Allianz Capital, the private equity arm of one of Germany's leading insurance groups, praises Antfactory's management team. "Antfactory has an unusually talented group of professionals who we believe in, and that's why we invested," he says. Its appetite for capital is not yet sated, and a third round is scheduled for later this year.

Antfactory "knows how to raise money from significant investors," says Larry Levy, founder and CEO of the Prot‚g‚ Group, an accelerator that specializes in building technology businesses internationally. "But it has taken them some time to realize what their strengths are," he adds.

Antfactory also created a joint Latin American fund with $25 million from Citigroup Venture Capital Latin America and a Japan fund with a $15 million commitment from Nikko Securities.

The fruits of these international matches are so far undetermined. Geoff Crossley, CEO of Antfactory Latin America, says offices in Mexico, Buenos Aires, and Sao Paulo are starting up. "At the moment these offices are cost centers, but once deals get done, a series of revenue streams start up. Just five of our deals in Latin America, should they go through, will earn us revenue of $6 million."

At the same time, Antfactory has set up investment partnerships with high-profile players like UK retail banking group Lloyds and global consultancy Accenture. "I think that Lloyds feels that the underlying proposition of evaluating opportunities alongside Antfactory is still valid," says Michael Joseph, managing director of Lloyds TSB Development Capital and an investment committee member of Valuefactory, a joint venture between Antfactory and Lloyds.

Moreover, Antfactory shareholders structured a $350 million side fund to co-invest alongside Antfactory in investments greater than $10 million. The fund gives Antfactory 10 points of carry above an 8 percent hurdle, with no management fee. This fund remains untapped, causing some industry insiders to question how easily commitments can be drawn down from the shareholders. At the very least it demonstrates increased investor caution since the volatility and subsequent downturn in valuations of early-stage technology investments.

Indeed, if Antfactory is going to be successful in its next capital-raising, it will need to start delivering the goods.

Capturing the imagination of retail investors, the Cambridge, UK-based company floated on the Nasdaq in May 2000 and made its debut on the London Stock Exchange in November 2000 with a market capitalization of $6.4 billion, propelling it into the FTSE 100, an index of the UK's top 100 companies.

In the process, Autonomy's venture capital backers -- Apax Partners, ENIC, and Durlacher -- turned a $22 million investment into a reported return of over $1.45 billion, and founder Mike Lynch was widely touted as the UK's first software billionaire.

But in mid-February Apax Partners exited from its remaining 7 percent stake in Autonomy, wiping 10 percent off the share price in one day. Explaining the sale, John McMonigall, a director at Apax Partners who sits on Autonomy's board, says, 'There is always pressure for VCs to liquidate their public equities and return funds to their limited partners.' But questions remain about the timing of that sale because VCs typically do not sell holdings that may have some upside potential.

DOWN AND OUT IN LONDON This week Autonomy will be ejected from the FTSE 100 Index, as its market capitalization sinks to $2.1 billion. Its stock price has fallen from $50.60 in November to just $17.25 on Wednesday's close, a decline of 66 percent.

'Autonomy had a decent window of opportunity, but the competition is catching up,' says Simon Andrews, a software analyst at Merrill Lynch, who issued a 'neutral' rating note on Autonomy in January and again at the beginning of February. 'The expectations of their business model is perhaps overstated, and the current valuation is reflecting some of these concerns.'

The company reported $65 million in sales for 2000, with sales growing by roughly 20 percent each quarter over the last year. The fear is that even at these reduced levels Autonomy is still trading at 45 times estimated 2002 earnings, and a lot of expectation is built into the share price. According to Mr. Andrews, this price implies an annual earnings growth rate of around 90 percent.

Some of that expectation stems from Autonomy's strategy of partnering with third parties, embedding its technology in others' software through original equipment manufacturer (OEM) deals. Such a strategy, if successful, produces very high margins without incurring big sales costs. But Autonomy has not yet secured OEM deals with any of the tier-one software vendors such as IBM, SAP, or Siebel. Moreover, doubts remain about the depth of some of its existing OEM relationships.

Steve Purdham, CEO of SurfControl (LSE: SRF), a software-filtering company and Autonomy OEM partner, views Autonomy's embedded software more as a marketing tool than as a source of revenue. 'The appetite for knowledge-based technology is still very much untested. We offer Autonomy's embedded software as an option because the jury is still out as to whether knowledge management software is a desirable rather than a mandatory item.'

COULD'VE BEEN A CONTENDER Autonomy also has been buffeted by increased competition in several businesses that its platform encompasses. Contenders include SmartLogik, Albert, and Verity (Nasdaq: VRTY) in the knowledge management space. Additionally, customer relationship management software from Epiphany and NetPerceptions are giving Autonomy a battle in real-time recognition technologies, while Microsoft is developing software for sound categorization.

Most observers agree, however, that Autonomy remains the standard bearer in its core business of handling unstructured information. Michael Wand, a software analyst at Deutsche Bank, recently issued a Buy rating for Autonomy. 'I don't believe that there is anything available in the market as a packaged application that would compete with the Autonomy offering,' says Mr. Wand, who has been covering Autonomy since it first went public in July 1998 on EASDAQ, a European exchange for high-growth companies.

Dominic Johnson, chief marketing officer at Autonomy, concedes there's a lot of noise in the market. 'Autonomy is unique in its ability to handle any form of unstructured information and to automate business operations on that information. There may be other solutions at hand for specific operations,' he says, 'but none of the competition provides a complete platform.'

Autonomy is undoubtedly the most recognized brand for this type of software. It has attracted more than 400 customers, many of them global industry players such as General Motors, Merrill Lynch, News Corporation, and Lucent. In addition to developing software for text and sound, Autonomy recently announced that it was looking at digital TV to understand video, the missing piece of its digital content offering.

Overall, however, the question remains as to whether the market for this type of software is big enough to sustain Autonomy's valuation, even if it holds on to its lead in this sector.