ANN ARBOR – The U.S. venture capital market is in the midst of a strong recovery, characterized by a return to fundamentals and a sharp awareness of the excesses of the late 1990?s and their debilitating effect upon investment returns. This recovery and conservative philosophy augers well for the nation and for emerging growth companies and VC firms located in the Midwest that offer investment opportunities to investors around the country.

The Drivers of the VC Recovery: Increasing M&A and IPO Activity

Perhaps the single most important driver of the VC recovery is the availability of investor liquidity and investment realization through merger and acquisition (M&A) and initial public offering (IPO) harvesting of VC portfolio companies. Year to date through Q3, 2004, total transaction dollar value of VC-backed mergers & acquisitions (a favorite VC ?harvesting? vehicle) was nearly 60 percent higher than 2003, with total deal volume 12.7percent higher. As well, VC-backed IPO activity continued its comeback, marking the fourth consecutive quarter of total realized volume over $1 billion.

In addition to the 66 IPOs in Q 1-3, 2004, there were 81 companies ?in registration? for IPO at the end of Q3, reflecting the steady comeback of a healthy IPO market.

VC Deals Increasing in Number and Volume

The increasingly healthy ?harvesting market? validated the VC community’s strategy since 2000 of sustaining their stronger portfolio companies through later round investment and patiently working toward the harvests mentioned above. This liquidity justified and supported an expansion of new VC investment. An encouraging sign in these data is that early stage as well as later stage investment is increasing. After declining in each year since 2001, with a six-year low of $18.9 billion in 2003, the Q4, 2005 investment of $5.3 billion is the 11th consecutive quarter of VC investing between $4 billion and $6 billion. VC firms nationally invested $20.9 billion in 2,876 deals in 2004 according to the MoneyTree Survey by PricewaterhouseCoopers (PWC), Thomson Venture Economics and the National Venture Capital Association.

VC Returns to Limited Partners Have Improved

Driven by the increasingly robust M&A and IPO ?harvest markets,? by the end of Q2, 2004, investment returns on VC portfolio companies held for longer terms exceeded those of the NASDAQ and the S&P 500 indexes of matching term by significant amounts, as shown below.

ALL VC

1 Year – 7.4 percent

3 Year ? (12.1 percent)

5 Year ? 14.4 percent

10 Year ? 26.7 percent

20 Year ? 15.6 percent

NASDAQ

1 Year ? 26.2 percent

3 Year ? (1.9 percent)

5 Year ? (5.3 percent)

10 Year ? 11.2 percent

20 Year ? 13.2 percent

SP500

1 Year ? 17.1 percent

3 Year ? (2.3 percent)

5 Year ? (3.6 percent)

10 Year ? 9.9 percent

20 Year ? 13.5 percent

Source: MoneyTree Survey by PricewaterhouseCoopers

Short term returns still lag the public markets, partly due to the “J curve effect” on early stage investments and partly due to write-offs and depressed values of VC investment made in the 1999-2000 period. These factors couple with the 2000 – 2002 VC strategy of investing in later rounds of their more successful portfolio companies to set up the revalorizations of gains through M&A and IPO harvesting. The resulting returns have an encouraging effect upon entrepreneurs, VCs and institutional investors and have stimulated the type of VC investment activity shown above.

The Increase in Institutional Capital Flows to VC Firms

While much of the investment by VC firms described above was done with cash reserves that they raised in the late 1990?s and 2000, some has come from new institutional investment in VC funds. While institutional investors are “back in the market”, their approach is more cautious and the level of their participation is well below levels of the late-1990?s boom period…After declining nationally from a level of $106.021 mm invested in 635 VC funds in 2000 to $3,661 mm invested in 164 funds in 2002, the 2004 EOQ3 level of investment reached $11,249 mm in 125 funds. The cautious tone of institutional investors is reflected in the fact that 87 percent of the 2004 investment has gone into follow-on funds vs. a ratio of 3 to 1 in follow-on over first-time funds in earlier years. However, as the recovery proceeds there is growing evidence of increased early stage investment as well as investment in new funds by high net worth individual investors and institutions. This has been accompanied by a robust return to the market of “angel” investors, increasingly acting in organized groups as well as individuals.

Implications for Entrepreneurs and VC Firms in the Midwest

The Midwest Region (as classified by MoneyTree Survey, PricewaterhouseCoopers) received $154 mm of VC investment in 31 deals during Q3, 2004, ranking it 10th among PWC regions with 3.4 percent of the nations total in dollars and 5percent of the nation?s VC deals in the quarter. Regional distributions for 2004 have not yet been published.

Using PWC Money Tree data, research under way at the Ross School’s Center for Venture Capital and Private Equity Finance, shows that the Midwest region accounted for $ 1.2 billion of VC investment in the Midwest in the Q1 2002 – Q1 2004 period. The major investment categories were Biotechnology (21 percent of the total), Financial Services (21 percent), Information Technology (20 percent) and Computer Equipment and Semiconductors (19 percent). These proportions are comparable to national averages, suggesting that this region is “in step” with the U.S. coastal areas of traditionally dense VC investment. Preliminary findings of this research indicate that approximately two-thirds of the VC funds investing in these deals were located outside the region. The ability of the region’s companies and their VC investors to attract VC co-investors from other parts of the countries suggests high quality in the region’s management teams and attractive investment potential of the region’s deals. It also suggests that as the national VC market recovers, the Midwest is positioned to compete for an increased share of this flow of growth capital.

The Midwest appears to be poised to profit from the recovery of the VC and growth capital market. The region’s universities and its industrial companies and business firms are producing a significant number of startup and university spin-off companies annually and placing them in the networks of Research Parks being developed in the region. The high technology orientation and global scope of these entrepreneurial companies is leading to wealth creation and the region’s retention of a growing number of young workers, many from the large number of students who graduate from the region’s universities each year. They provide an attractive investment target for the region’s VC firms and the co-investors drawn to them from the rest of the country. The Midwest can look forward to a strong flow of VC and growth capital in 2005.