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Retooling 3i

When the Internet frenzy was nearing its climax, Brian Larcombe, chief executive of London-based 3i Group, happened to find himself seated next to an executive who oversaw e-business investments as he was lunching in the company canteen.

When the Internet frenzy was nearing its climax, Brian Larcombe, chief executive of London-based 3i Group, happened to find himself seated next to an executive who oversaw e-business investments as he was lunching in the company canteen.

"Where's your tie?" Larcombe growled.

"I've stopped wearing it," replied the executive. "I only wear it for important meetings."

"I think you should regard this as an important meeting," Larcombe snapped.

The silly trappings of the dot-com era didn't sit well with a lot of middle-aged financial executives -- with good cause, as it turned out. But in Larcombe's case the awkward lunchtime encounter was even more surprising. After all, the 48-year-old 3i chief oversees one of the biggest venture capital portfolios in the world, including £1.1 billion ($1.8 billion) in information technology start-ups.

But 3i, Europe's largest private equity firm, likes to do things differently. One of a handful of venture capital vehicles whose shares are publicly traded, it not only seeds fledgling tech companies but also invests in all financing stages -- buyouts included -- of industrial, consumer goods and financial companies. And unlike the more narrowly focused, assertive ten- to 20-person partnerships popular in Silicon Valley, 3i has 300 investment professionals (more than 900 employees in all) toiling in three dozen offices around the globe. Until recently, it rarely took board seats to push its views on portfolio companies. Although the 57-year-old firm shares some characteristics with other international investors, such as Apax Partners, Carlyle Group and J.P. Morgan Partners, it is ultimately "a company unto itself," says Walter Pompliano, a financial institutions analyst with Standard & Poor's in London.

To be sure, the one thing the company does have in common with most venture capitalists is a ravaged portfolio. The value of 3i's diversified £5.1 billion investment portfolio declined by a sharp £960 million in fiscal 2002, ended March 31, with much of the damage not surprisingly done by failing tech holdings. (The company, which in addition to its own funds manages £2.8 billion for others, sustained a net loss of £39 million on transactions actually completed during the year.) Boosted by the firm's connection to high tech, 3i shares peaked in September 2000 at about £18, before falling below £5 in mid-September this year. Not even 3i's agreement in May to sell its biggest and choicest holding -- a 62 percent stake in U.K. cut-rate airline Go -- to EasyJet for a profit of £147.5 million on a one-year investment revived interest in the shares.

"A lot of people are questioning how good a business this is -- not just venture capital, but early-stage and buyouts," laments Larcombe. "They are questioning whether the returns of the 1990s are going to be repeated in future."

As well they might, for venture capital and private equity investing are in a wrenching, global funk: Investment activity plummeted 50 percent last year, to $100 billion, and is likely to fall another one third in 2002, according to a joint PricewaterhouseCoopers-3i study released last month. Firms have more money on hand than they are able to place; $180 billion is sitting idle globally, and in the second quarter this year, U.S. venture funds returned $2.7 billion to limited partners, $900 million more than they raised. As of March 31, one-year returns on U.S. venture funds were ­24 percent, while European funds lost 30 percent in 2001, based on the most recent data from U.S. and European venture capital associations.

Larcombe is trying to persuade investors that he has the vision to pull 3i through the crisis and turn it into "the leading international venture capital company." He wants a more efficient organization, with the bulk of its investments and operations in the U.K. and Europe backed by smaller, but formidable, units in the U.S. and Asia. This global network would use its portfolio companies as a sounding board and laboratory for new product ideas and corporate strategies, and as a ready market for one another's products.

Over the past two years, Larcombe has bought four European venture capital companies to begin to shift more of 3i's activities beyond the U.K.; he's bulked up operations in the U.S. and Asia and continued to pour money into tech start-ups despite the market meltdown. He's closed offices and laid off a substantial chunk of his staff. Even though its stock price has been devastated, the company's investment philosophy is gaining currency in some quarters: "3i has a reputation for taking a long view, and today that's not a bad thing," says Steve King, an entrepreneur who's dealt with many venture capitalists while heading Zantaz, a Pleasanton, California, company that handles e-mail archiving for large financial institutions.

But can a complicated entity with a staggering 2,700 investments (some dating back to the 1940s), a multilayered management and a relatively conservative investment approach take full advantage of opportunities in many fast-changing market sectors around the globe? The head of one of 3i's own portfolio companies, speaking anonymously, is skeptical. "What we see is a disjointed management team spending a lot of time fighting itself," he says. "You wind up with a relationship not with a company but with a few individuals, entrenched in one geographical area but needing everything about your particular industry explained to them."

Even the tough-minded Larcombe, who has spent his entire 28-year career at 3i and has run it since 1997, concedes it's an uphill climb. "Making an international group really sing is pretty hard to do. We haven't got there yet -- we have to ensure that we work as an integrated group," the CEO allows. "We are probably about a third of the way toward achieving what we should achieve."

ADAPTING TO ALTERED ENVIRONMENTS IS nothing new for 3i. Initially known as Industrial and Commercial Finance Corp., the firm began in 1945 as a British-government-sponsored initiative to extend long-term credit to small and medium-size businesses trying to get back on their feet after World War II. The firm pretty much stuck to this brief, making capital expansion and start-up investments of less than £100,000 each, for three decades. Along the way it grew into a sprawling bureaucracy with 14 offices responsible for lending in their regions. These regional groups gained a reputation for small, cookie-cutter deals, relying on legions of relatively junior managers to make decisions according to strict guidelines. No one can fault their industry. Since its start 3i has made £15 billion in debt and equity investments; that works out to an average of 263 deals a year at £1 million each.

Capitalizing on Britain's resurgent economy and the entrepreneurial spirit championed by then­prime minister Margaret Thatcher in the 1980s, 3i (renamed in 1985 as a shortened form of "investors in industry") broadened its mandate to include buyouts. It also widened its geographic scope. Led for most of the decade by chief executive Jon Foulds, 3i started pursuing buyout deals abroad and opened offices in Boston in 1982, Paris in 1983, Frankfurt in 1986 and Milan and Madrid in 1990. Under Foulds's successor, David Marlow, 3i also planned to float its shares on the London Stock Exchange. However, the 1990­'91 recession forced a delay, and 3i closed its U.S. operation to keep its cost structure in line. Finally, in July 1994 3i successfully sold about 600 million shares at 272 pence, and two months later it became a component of the FTSE 100 index.

Contributing significantly to 3i's torrent of 1980s buyouts was Larcombe, an accounting graduate of the University of Birmingham. A formidable negotiator, he thrived as a deal maker in the heyday of management buyouts. In 1992 he rose to finance director. Five years later, at age 43, Larcombe became one of the youngest CEOs of a FTSE 100 company. Says Foulds, who left the top spot in 1988: "Brian was a premium performer for a long time before he was CEO. He was able to rise above departmental issues to get people to see when there was more at stake, and he had a natural shrewdness."

Like Foulds, Larcombe was keen on global expansion. In 1999 he opened offices in Menlo Park, California, and Waltham, Massachusetts. In fiscal 2002, for the first time in its history, 3i made the majority of its new investments outside the U.K. And its venture deals, which rarely exceeded £1 million previously, now routinely go much higher. In August 3i and Apax Partners jointly secured $18 million in funding for California-based wireless messaging company Sonim Technologies. That came just a month after 3i raised £35 million to launch Partners for Finance, a U.K. financial services industry outsourcing venture headed by former National & Provincial Building Society CEO Alastair Lyons.

For all its global ambitions, 3i remains firmly rooted in Britain. It maintains its headquarters at an unfashionable London address near Waterloo Station, south of the Thames. Nearly two thirds of its portfolio is invested in U.K. companies, with 27 percent in continental Europe and the remainder in the U.S. and Asia. And long after its privatization, it retains close ties to the government. In January it appointed Baroness Sarah Hogg as nonexecutive chairman. A former journalist and adviser to prime minister John Major, the 56-year-old Hogg is also a governor of the British Broadcasting Corp.

Larcombe launched an acquisition binge to accelerate 3i's push onto the Continent. In a 12-month stretch that started in February 2000, Larcombe spent £518 million in both cash and in 3i's then-rising stock to acquire four European venture capital firms specializing in early-stage investments, particularly technology: Sweden's Atle, Bank Austria TFV, Finland's SFK Finance and Germany's Technologieholding.

Those purchases came on the heels of a painful learning experience closer to home. In 1999 Larcombe launched a £1.3 billion hostile bid for Electra Investment Trust, 3i's largest market-quoted competitor. His objectives: to fuse the two companies' skills and to gain efficiencies by eliminating redundant overhead. A source close to Larcombe says he displayed an uncharacteristic clumsiness in the negotiations. "Brian effectively told the world he wanted the assets but not the people," says the source. The overture failed, and Electra remains an independent entity.

ONE OF 3I'S MOST IMPORTANT CURRENT initiatives is in Silicon Valley, where the company is still very much an unknown quantity. Despite the technology market's collapse, 3i isn't backing away. It has invested £253 million in U.S. deals over the past two years -- up from a mere £30 million in the three years before that -- and is keeping its commitment there relatively steady while sharply reducing its spending elsewhere. Martin Gagen, the 46-year-old executive director who runs the firm's U.S. operation from Menlo Park, believes that as other firms retrench, 3i will be able to pick off some of the local talent and augment its U.S. staff of 30.

In the heartland of American venture capital, 3i may meet its sternest test. The company's $300 million U.S. portfolio is dwarfed by those of leading Silicon Valley firms like Kleiner Perkins Caufield and Byers, which has $1.7 billion under management. However, 3i's worldwide tech investments alone exceed Kleiner Perkins's total. It's that international heft and scope that Larcombe and Gagen emphasize to potential hires.

To build the U.S. operation, Gagen is hoping to lure "key teams" away from other venture firms. The attraction? Gagen argues that 3i is expansion-minded and that, with its vast network of portfolio companies and investment professionals on three continents, the firm is unmatched in its ability to leverage customer lists and intellectual capital.

A case in point is Intelliden Corp., a Colorado Springs, Colorado, company that raised $15 million last fall in a funding round co-led by 3i and Waltham­based Matrix Partners. Dale Hecht, president and CEO of Intelliden, says that 3i was instrumental in bringing his company's network communications management systems to the attention of "C-level executives" -- chief executive officers, chief operating officers and so on -- at other portfolio companies that provided advice and sales.

Clearly, 3i has made some headway in breaking into the clubby world of U.S. venture capital. "We have been accepted straightaway by top-drawer VC firms," declares J. Sanford Miller, 52, who oversees 3i's late-stage technology investing in Menlo Park and who, before joining the firm in 2001, served as chief administrative and strategic officer of San Francisco­based Thomas Weisel Partners. In August 3i co-led one deal with Hummer Winblad Venture Partners and brought Investcorp, Wasserstein Ventures and Westbury Partners into another transaction.

The U.S. effort also marks a shift for 3i toward a more active investment role. For example, Miller in August joined the board of portfolio company Top Layer Networks, a Westboro, Massachusetts, security technology vendor. "We will leverage our three-continent network to help Top Layer form strategic partnerships that will support its expansion into additional international markets," he says. Another 3i partner, Robin Murray, recently became a director of Knowmadic, a Santa Clara, California, developer of data aggregation software.

Intelliden's Hecht has no reservations about his 3i experience. "We were really impressed with the professionalism and rigor of the vetting process," he says. "They knew exactly what to ask, and we had a term sheet within 45 days despite the September 11 events."

Larcombe and his colleagues are hoping they can leverage the knowledge gained in these sorts of transactions to grow elsewhere. One of 3i's first big successes last year in Asia, for example, was a management buyout in the logistics business -- a $120 million sale of Yokohama-based Vantec Corp., a unit of Nissan Motor Co. Directors from several other portfolio companies provided key input, says 3i managing director Jane Crawford, who recently moved from Singapore to take charge of 3i Germany. "The experience of other directors and our 20-year history in logistics gave us a tremendous platform."

While targeting markets like the U.S. for additional spending, Larcombe has been trying to squeeze out efficiencies elsewhere. A year ago 3i cut 17 percent of its staff, or 185 people (including the tech banker whose casual appearance so irritated Larcombe) -- an unaccustomed step by a company that prizes stability. "Many of us were surprised by the dramatic scale of the job cuts," says Iain Scouller, a UBS Warburg analyst who tracks 3i. The cuts, made halfway through fiscal 2002, saved the company £18 million, Larcombe said in his March report to shareholders.

"The cost savings were helpful, but the underlying need was to address our markets differently," explains Larcombe. "We closed an office in Leipzig, for example, which is only an hour and a half from our Berlin office. We had too many technology investors in Germany following an acquisition [Technologieholding] and so on."

Larcombe believes the closings left 3i with the right infrastructure. It includes 10 U.K. offices and 20 more on the Continent. The company is also on the ground in Hong Kong, Japan and Singapore -- it has set a goal of tripling the Asian portion of its portfolio, to 5 percent, by 2006 -- and on both coasts of the U.S., where Larcombe wants to see the portfolio share double, to 10 percent.

Possibly more important in sharpening the firm's focus is the disposition of its 1,200-company "legacy" portfolio, the remnants of its early days cranking out financings of small and medium-size companies. Today many of these positions require time and effort that might be better devoted elsewhere. Larcombe has assigned the sell-off task to a 35-person staff headed by Charles Richardson, a 48-year-old executive who formerly headed 3i's Manchester office and more recently supervised its seven offices in North England and Scotland. It's hardly a straightforward harvest. The firm plans to keep solid, decades-old performers like Pashley, the English icon that makes the ubiquitous red delivery bicycles used by British postal workers, and Cannon Avent, a former hot-water-bottle manufacturer that now makes baby bottles.

But Richardson's main goal is divesting, which is likely to be a painstaking process because so many holdings are small, low-yielding interests in family-owned enterprises. "We are trying to speed up the rate of realizations," says Richardson. "We enter into dialogue with the owners -- talks can go on for years." The firm wants to exit as many as 200 legacy holdings per year.

Larcombe is also trying to confront organizational legacies stemming from 3i's original regional approach to investing. Even though most of the firm's deal flow still comes from its far-flung offices, the setup hasn't always contributed to teamwork. "If you go back ten years, there was an attitude that 'this is my fiefdom, I will find the investment opportunities I want within my territory, and the contacts within it belong to me,'" says Larcombe.

To ensure that new investments make sense for 3i, the company has designated sector specialists, or domain experts, to vet proposals regardless of location. "A deal is looked at from a global perspective," explains Gagen. "What looks like a very good deal at a local level can on an international basis look very poor." Professional staff anywhere can propose an investment, but it must be reviewed by a sector expert. For example, Ere Kariola, the 52-year-old head of 3i Finland, takes a look at many proposals relating to his specialty in telecommunications. But in a bow to internal political realities, the country team can veto an expert's demurral and proceed with the investment.

No matter what efficiencies Larcombe is able to wring out, 3i will remain a complicated firm. Just consider its £5.1 billion portfolio. As of March 31, buyouts made up 41 percent of the holdings, early-stage venture capital 20 percent, growth (later-stage) capital 29 percent and listed shares 10 percent. In terms of industry representation, information technology accounted for 21 percent -- about equal to both the industrial and the consumer goods components, and a little less than the 26 percent devoted to the services and utilities category.

And Larcombe isn't about to abandon the investing principles that have produced this matrixlike portfolio: "If someone offers me 50 percent over two years or 30 percent over ten, I'd take 30 percent over ten."

Unfortunately, even a diversified portfolio hasn't provided much cushion from recent volatility. Successful early-stage investments tend to take longer to emerge than failures, and right now losers predominate. "For a volume investor such as 3i, this [weakness] will be accentuated, particularly after a number of years of strong investments in the early-stage arena," explains Dresdner Kleinwort Wasserstein analyst William Barnard.

Larcombe is expected to see the firm through to better days. Turnover is rare in 3i's tight-knit upper ranks. "I don't see why Brian shouldn't be there for ten more years," says Stephen Ross, a former 3i director who now runs U.K. venture capital firm Springboard. "He's hugely respected, and he has the stamina and the ambition." Or as Gagen, a veteran of nearly 20 years at the firm, puts it, "If you cut him, he bleeds 3i." It may take a while, but he -- and 3i -- should heal.