by Joel Bainerman

Oh how the times have changed for Israeli venture capital fund managers.

In 2001, Israeli venture funds raised about $1 billion, compared with $3.2 billion in 2000. Since 1998, Israeli funds have managed to raise nearly $7 billion.

Another 70-80 VC funds and corporate fund from outside of Israel made investments in Israel in recent years. All but a handful of these foreign investors have totally ceased their activities.

Why?

Because Israel took a double beating when the tech crash came. It's "success in high tech" was directly related to the froth on Wall St. and the ability of US tech companies to issue new paper to buy Israeli startups. Without the "Nasdaq exit" that used to take place, and as few technology companies from the US are making M&As in Israel a very high priority, the local Israel private equity market hardly looks like a compelling opportunity.

The outbreak of violence that began in September 2000 didn't help matters - but it really isn't the main reason for the downturn in the attraction of Israeli high tech for foreign investors. To be sure, very few foreigners relish the thought of traveling to Israel these days (even through the security in the majority of the areas where high tech development takes place is as safe as it was pre-September 2000). However, the reason why foreign investment has dried up is because of the general downturn in high tech worldwide. Going forward it is difficult to see how Israeli fund managers will equal the 30% in IIR (realized) that they did in 1996-1999 - or put another way, it is very likely the investors in earlier funds will give back any profits they made there to offset the losses they will incur on the later Israeli funds from 1999-2001.

That isn't to say that many Israeli startup companies aren't weathering the storm. Despite hundreds of startups going under, the stronger ones are persevering. For Israeli VCs, that has meant a shift away from seed investments to mezzanine and expansion investments. Companies such as InterWise, MystiCom, D-Pharm, LaserComm, and PowerDsine have managed to raise $20-30M in the past four months - most of that from local sources. From this perspective, Israel's VC industry has another three or four years left of capital from funds raised in the heydays of 1999-2000 - even without foreign capital.

The shying away from investing in new companies has some Israeli VCs concerned. Yigal Erlich, general partner in the Yozma fund, called his colleagues at other funds to task in a recent newspaper article in which he expressed worry over the increasing amount of that venture capital being invested in PIPEs or public companies whose valuations have shrunk dramatically in 2001, and not seed-stage Israeli startups.

In other ways, the times have certainly changed in Israeli high tech circles.
There was a time not too long ago when Israel's venture capitalist community would make periodic pronouncements to instruct the government what it needs to do to better support Israel's technology-based industries. The daily business newspaper Globes ran a piece by analyst Eli Tzippori, who wrote:

"To some extent, the venture capital industry organized a cheerleading squad for itself. The cheerleaders erroneously turned them into uber-managers of the Israeli economy. Under their adulation, they began to pass out grades on the management of the Israeli economy. These new economy Ph.D.s had excellent ideas especially where their pockets were concerned. The idolatry of the venture capital managers created an illusion that the industry's money was created by marvelous talents: Creativity, imagination, assertiveness and all the other mantras. A totally different impression now prevails: venture capital money was mostly created by luck."

Luck, and a thriving stock market in the US.

Today, as most venture funds in Israel shy away from making seed investments in companies due to their need to deal with their existing portfolio, fund managers successfully lobbied the Israeli government to make these investments instead, and thus free up their funds for add-on investments in existing companies.

Under the pressure of the country's VCS, the Israeli government has agreed to put up the first $112 million to form a "venture capital fund" to support seed-stage firms. The government will lend companies sums equivalent to those being invested by the VC funds. Government assistance to the companies will be in the form of a loan of up to 100 percent of the VC funds' investment in the company, to a maximum of $1M per company. The company or the VC fund will have to repay the loan, with interest and linkage to the cost-of-living index, within three years. If the loan is not repaid, the government will have the option of converting it into shares in the company.

Government official Amir Hayek noted that "There is a market shortfall these days in investments in seed-stage companies, and we are interested in correcting it." Says Minister of Industry and Trade, Dalia Itzik: "Wise and limited government investment, if made in time, could boost investments in startups, and constitute a positive signal to investors in Israel and overseas." (if there is one thing governments, in Israel and abroad, are not capable of, it is "wise and limited government investment").

That isn't the end of the demands. In an effort to win back foreign investors to Israeli venture funds, the Finance Ministry suspended capital gains taxes for investors in Israeli private equity funds. Until the law was passed in November, Israeli venture funds had to win a waver for their LPs from the Ministry of Finance to prevent double taxation. While in most cases it was granted, the new law negates the need for such actions.

Israeli fund managers also want their government to help the funds with new fundraising efforts as foreign investors are not nearly as interested in investing in Israeli funds as they used to be. Israeli VCS want a program of government-backed guarantees for losses instituted to cover losses by local institutional investors if they invested in an Israeli venture fund. This would replace the need for Israeli funds to enlist foreign Limited Partners. Senior industry VC Zeev Holtzman warned Israeli Finance Minister Silvan Shalom that unless the government steps in and helps the VC funds at this moment with fundraising of new funds, "Israel's entire venture capital industry could shrivel up and die."

"Stop right there," said Guy Rolanik, one of Israel's most astute high tech and economic analysts and a regular columnist for Haaretz and The Marker.Com

"Don't even think in that direction. Nobody said you could invest our pension money in venture schemes. Israeli institutional investors can bless their lucky stars that NASDAQ crashed in March 2000, before their managers "discovered" the wonders of Wall St."

Rolanik, whose views and insights are shared by few other Israeli writers or economic critics, warns that "without any expertise to invest in high risk funds, Israel's institutional players shouldn't be allowed to go near these types of investments nor should the government back their losses if they do."

As an aside, it is worth hearing some of the other comments Rolanik has made in the past year since the crisis in Israel high tech began: "Of those that are now asking for government handouts. Are these the same omnipotent giants who raised billions, who skipped lightly from raising money in Silicon Valley in the morning to a Wall Street offering in the afternoon? Until a year ago Israel's VC industry was awash in foreign capital. The industry's lack of funds today results from its improvident investment yesterday, and from madcap investments by their portfolio companies. Billions were thrown at silly projects, enormous salaries and inflated standards of spending. Many of the startup success stories of the last three years weren't about real creation of technological innovation, but about the Wall Street bubble."

With all the risks out there today and the huge unknown of how well Israeli fund managers will operate over the next three to five years with their existing portfolio and any new investments, and the increasing encroachment of the Israeli government in what should be a totally private market, doesn't bode well for the future of Israel's venture capital industry. To be quite blunt, it would be simply foolish for US investment managers to consider an investment in a new Israeli venture fund.

However that doesn't mean there are no private equity investment opportunities in Israel. In specialized areas, such as materials science or life sciences, Israeli funds have done well, are doing very well, and will continue to do so. The same "Wall St. hype" syndrome that is part of the funds investing in information technology doesn't afflict those investment vehicles targeting life sciences where Israeli companies have an excellent technological reputation.

Unlike venture funds focused on IT which see the US as their major market, in life sciences Europe is the place to be for Israeli startups as their technological capabilities are more respected in Europe - and the market is much closer to home and hence easier to penetrate. According to Ernst & Young (Israel), investments by local VC funds in life sciences startups totaled $286 million in 2001, a rise of 39% from the $205 million in 2000 and 133% more than the $122 million rise in 1999. The most recent fund to raise capital, Vitalife Life Sciences Fund, managed to bring on board Boston Scientific as a lead investor.

The reason why Israeli life science funds are not feeling the pinch as much as non-life science funds is the track record of many Israeli life sciences companies that have oriented themselves towards Europe (both as a market for their products and as an exit strategy) have done well- especially those that have gone public on the new Swiss exchange, Oridion, SHL, and CardGuard, all of which are building major operations worldwide with their corporate headquarters now in Europe. Other Israeli winners from the biomedical industry include XTL, Keryx, Compugen, ESC Medical, Medinol, and Biosense. The IPO this past November of Given Imaging is further testimony to the great potential that exists in this industrial segment in Israel - intifada or no intifada. Given Imaging's technology enables non-invasive examination of the gastrointestinal tract.

Another area of private equity which could be a huge opportunity for foreign investors is the non-venture side of the private equity market. Israel's non-high tech economy of manufacturers and service companies is huge, and full of strong companies which could greatly benefit from the different types of financing that LBO, MBO, mezzanine, distressed debt, and "buy and build" funds could provide, thus providing tremendous benefit to the local economy. A fund just to do Pipes in the more than 100 Israeli companies traded on NASDAQ is another area which nobody is currently targeting.

There are a large number of companies in the Israeli economy that could reap benefits from having access to non-venture private equity. Take the veteran Israeli company Amcor which recently signed its first $3M order for air purifiers and dehumidifiers from China. Another oldtime Israeli electronics manufacturer - Electra - creates more than $100 million worth of air conditioners a year. Or how about MultiLock which manufactures a sophisticated locking device. In 2001 it will export $30 million worth of products - a 50% increase over the previous year - to more than 70 countries worldwide. Pitkit Printing Enterprises was founded back in 1967 and went public on the Tel Aviv Stock Exchange in 1993. It will register sales of $10 million in 2001 with net profits of $1.5 million. The company makes labels, low-tech labels which it sells in Israel and abroad. It realized the problem of counterfeiting clothes labels, and thus went out and looked for technology that the market was asking for. It then invested in a Swiss company that made the special inks to write on the labels so they couldn't be counterfeited. Or how about Tadbik. It was established in 1983 and with a staff of 400 is much larger than Pitkit with revenues of $55 million and net profits of $13 million. Unlike the shaky startups that the venture capitalists support, these enterprises are profitable, and don't have their future tied to what happens on Wall St.

In the "service sector," particularly in the information technology sector, there are many Israeli companies that operate globally and could benefit from an injection of $20M or so, from an experienced fund manager who can help the company grow along with making the capital injection. The two areas of top interest include real estate developers targeting Eastern and Central Europe, and information technology companies that carry out large scale projects outside of Israel. Baruch Gindin, the Israel manager for The Gartner Group, believes that many Israeli companies are poised to benefit from the switchover to "services" from "technology developers" that have taken over market sentiment recently.

So it isn't all totally bleak when reviewing potential investment opportunities in Israel's private equity market. The only question is where one looks.

Joel Bainerman has been writing on Israeli high tech since 1982. His wrote a 75 page report on the current state of Israeli high tech: Broken Promises: The Rise and Fall of Israel's Technology-Based Industries. He can be contacted directly at Isratech@netvision.net.il