Venture Capital: Wise partner can lend a hand: The recession has forced the sector to accept lower returns, writes Jane Simms

Venture capital 'is gloriously inappropriate for most companies', says Gordon Murray, lecturer in strategic management at Warwick Business School. Venture capitalists need a rate of return on investment that reflects both the high level of risk and the illiquidity (their investment will not normally be realised in under five years).

As a result, only companies with significant growth potential are attractive to them. Venture capital is not, said Mr Murray a 'magic answer' to huge debts or the banks' refusal to extend overdraft facilities.

However, venture capital can be an effective way of both drawing new funds into the business and of profiting from the powerful management and industrial experience many of the venture capitalists have to offer. And that applies equally to companies that want to finance expansion and those that want to replace equity with debt to rebuild their overstretched balance sheets.

But any company seeking venture capital funding has to be aware of the implications of the relationship it is going into, he added. The investee company will inevitably have to cede an element of control to its new partner and understand that it will be playing a major role in business direction.

Recession has changed the focus of the venture capital industry. It is more interested today in adding value to companies through management expertise rather than trying to get rich quick through financial engineering or start-ups, and has resigned itself to more modest returns.

In the 1980s the annual internal rate of return venture capitalists expected was anywhere between about 40 and 80 per cent, depending on the nature of the investment, compared with an IRR on the capital markets of about 20 per cent. They had to aim for such returns because a high proportion of investments would fail. Recession has helped change attitudes and adapt or die has become the name of the game.

It is, said Mr Murray, 'a smaller and wiser' industry than it was five years ago. It has had to learn about strategy, about markets and about customer expectations.

Because the venture capitalists are having to think more carefully about how to deliver returns to their customers, they are also giving closer consideration to ensuring their investee companies thrive. And though there are now fewer providers, the power has shifted to the investee company. 'If you are a good, sound, solidly managed company, you will have a number of venture capitalists competing for you.'

Charles Sherwood, of Schroder Ventures, said: 'It makes sense for us to return existing businesses to profitability and preserve assets rather than start up new businesses.' This is because it is far less risky. Moreover, the IRR they are seeking is 30-40 on an MBO, 20-30 on a restructuring.

Some venture capitalists have also relaxed their exit criteria, choosing instead to make a return though dividends. Gresham Trust managing director, Trevor Jones, who prefers the term investment capital, said: 'We would never dream of putting pressure on a client for an exit.' Many others - with the notable exception of 3i - have traditionally aimed to realise their investments within five to seven years, normally through flotation or a trade sale. However, not only has this expectation often proved unrealistic during the recession, it has deterred some potential fund seekers.

Mr Murray welcomed the new latitude. While realisation is relatively easy for a quoted company - via a restructuring or a share issue - smaller, unquoted companies can be caught, he warns. The Unlisted Securities market is to be abolished and he doesn't expect the main market listing requirements to be relaxed. The other option is a trade sale. 'Why lose your independence that way?' asked Mr Murray. 'You may as well tout yourself round the M & A market in the first place.'

But Schroders' Mr Sherwood believes it is 'sensible' to take a business through a stage of development and then pass it on to a new set of shareholders. Moreover, 'a five- to seven- year time frame doesn't restrict a company's development' even in recession, he says. 'It's a good discipline and it's reasonable to expect a company to be able to manage a business well enough to be able to make a return during that time.'

The difference is that Schroders and others have become much more hands-on in the way they manage their investments. They will put a partner on the board of the investee company, who brings all the benefits of a non-executive director, acting as sounding board, adviser and guiding hand. 'They have in a sense taken over the traditional (and now defunct) bank manager role in their knowledge of the business, hand-holding and support,' said Mr Murray. But he points out that the venture capitalist is far more interested in what he'll get out of a business.

The venture capitalists now number more experienced industrialists, as well as corporate financiers and accountants, among their ranks. Consequently, said Mr Murray, companies reluctant to cede ownership could be missing out on 'significant sophistication and very high calibre management specialisms and industry knowledge'.

Bank debt and stock market funding represent cheaper sources of funds than venture capital and have longer strings attached. But for fundamentally sound companies the double benefit of capital and management expertise could make venture capital an appropriate instrument for expansion.