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Israeli high tech still strong

The market sees a basic funding shift: from U.S. investors looking to expand operations to a global pool of investors integrating Israeli innovation into their strategies.

Despite the ongoing political and economic upheaval in the Middle East, Israel's innovative high-tech sector has lost little of its dynamism.

The country has sprouted, in just 15 years, into the world's second most important high-tech cluster after Silicon Valley, and there are now nearly as many Israeli companies listed on the Nasdaq as European ones. Last year, Israeli high-tech start-ups attracted $3.2 billion in capital investment, mostly foreign--a 30-fold increase in three years--and more investment per head than any other country. In a land with a population of six million, that capital helped produce 3,000 start-up companies, one for every 2,000 inhabitants.

The Nasdaq meltdown put a damper on the stellar performance of the country's high-tech cluster, though Israel's Nasdaq companies have declined far less than the overall average. But the market correction has masked a fundamental shift in the nature of investor interest in the Israeli high-tech economy: from U.S. investors looking for relatively inexpensive ways to expand current operations to an increasingly global pool of investors integrating Israeli innovation into their global strategies. These changes are creating new opportunities.

U.S. investment in Israeli venture-capital funds--investment that has been a mainstay of the cluster since it was founded by a coalition of government, business, and academic leaders--has fallen sharply as a result of the Nasdaq crash. But it has been replaced in part by unprecedented interest from Asian and European companies and financial investors, and this interest is likely to continue. In recent months, companies such as Deutsche Telekom, France Telecom, and Nokia have not only established or enlarged their investments in Israeli venture-capital funds and new companies in order to access the innovations developed by more than 1,000 Israeli start-ups in communications technology alone but also cultivated commercial relationships with more mature Israeli companies. Asian and European players such as SAP, Siemens and Sony have invested in other sectors in which Israeli technology has proved its worth, including enterprise and consumer software. Israel's high-tech economy has seen a basic funding shift: from U.S. investors looking for inexpensive ways to expand current operations to a global pool of investors integrating Israeli innovation into their strategies.

At the same time, the U.S. companies that pioneered investment in Israel also seem to be leading a shift in investment objectives. They are moving away from a focus on simple cost reduction--Israel was for many years a source of high-quality, relatively cheap R&D staff, for example--and toward a broader vision: making Israeli innovation and innovators an integral part of the long-term overall corporate R&D strategy.

Activist government
Initially, Israel's high-tech sector wasn't integrated into a broad global investor base. Instead, Israeli high-tech companies were mainly linked to the United States, through U.S. investment in Israeli R&D sites and production facilities. In addition, more than half of Israeli companies were incorporated in the United States, for tax reasons and for the sake of proximity to the world's largest English-speaking market.

In this early stage of development, the Israeli government's particularly activist role was a substitute for private investment from Israel and other countries. Besides subsidizing the labs and factories of foreign companies, the government did everything from setting up a seed-money venture-capital fund (the basis of the country's private equity industry) to creating a high-tech incubator that trained many of the one million Russian immigrants who came to the country in the early 1990s. This flurry of government-sponsored activity played a key role in accelerating the development of the cluster; as a result, it can now offer more alternatives to global strategic investors--particularly Europeans--than they could find at home. That fact has increasingly attracted both those investors and other sources of private capital, such as venture-capital companies, of which there are now more than 100.

Another unique factor helping Israeli high-tech companies to develop products that are now generating interest around the world was the close connection between such companies and Israel's security and military apparatus. The army, for instance, instituted a training program that enrolled the best technology students and taught them to work in teams focused on optimal performance and tangible results--attitudes that were efficiently exported to the civilian sector. Many of the technologies these researchers developed--such as the Internet firewalls originally created for the army and commercialized by a leading Israeli company, Check Point Software Technologies--proved highly exportable.

Thus Israeli high tech has gained global appeal--the more so recently because its focus on fundamental technological innovation is what has made the sector less vulnerable to the current Nasdaq downturn than were the many service-oriented dot-coms. Israel's particular strengths include biotechnology, communications infrastructure (where Israeli companies such as Comverse Technology are global leaders), customer-care services (Amdocs), Internet security and software (Check Point and Mercury Interactive), and optics.

Israeli innovations catching on
Increasingly, foreign companies have also been recognizing the competitive benefits of integrating leading Israeli high-tech innovations into their strategic plans. Texas Instruments, for example, gained a 6- to 12-month advantage over its competitors in supplying chips for the emerging Bluetooth wireless standard by acquiring the Israeli company Butterfly VLSI in 1999. Butterfly, which had experience developing a closely related kind of chip, quickly refocused its researchers on the new problem, benefiting everyone. The Israeli high-tech sector's focus on fundamental technological innovation is what has made it less vulnerable to the current Nasdaq downturn than were the many service-oriented dot-coms.

Indeed, from 1997 to 2000, the number of acquisitions of Israeli start-ups by corporations, mainly foreign, grew at a compound annual rate of more than 100 percent--two and a half times faster than initial public offerings. Many of the newer acquirers are Asian and European. The German software company SAP, for example, recently spent $400 million to buy TopTier Software, an Israeli enterprise-portal software company that strengthened SAP's offerings. And the integration is progressing: TopTier's former chief executive officer now runs SAP Portals, a new SAP subsidiary dedicated to developing and marketing enterprise portals and business-intelligence software.

At present, one of the hottest sectors for foreign investors in Israel is optics. Israeli companies are working on a range of products, especially new kinds of switches for the fiber-optic lines that are increasingly significant parts of telecommunications networks. Morgan Stanley estimates that every year four to six Israeli optics companies will be acquired by global players--such as Alcatel, Corning and JDS Uniphase--that are seeking to integrate innovations of this kind into their broad strategic plans.

Achieving true integration won't be easy, even for experienced global players. It was relatively straightforward to invest in high-performing Israeli venture-capital funds--a very common first step--and to make simple acquisitions. But establishing the right level of local R&D and business commitment is a higher hurdle. Meeting it will require deep knowledge of the sector, close partnerships with leading local venture capitalists, and a strong commitment to integration.

It is clear that many companies can gain competitive advantage by truly integrating the fruits of Israeli innovation. And Israel too has much to gain from these new trends. The high-tech sector is less affected by political upheaval than much of the rest of the Israeli economy, so the sector's continued success is extremely significant for the economy as a whole. Finding diversified sources of financing and integrating Israeli innovation into a more global corporate network will give Israeli companies, and the entire sector, more stability. This development will in turn allow the country's government to take further needed steps, including stepping back from a hands-on development role and focusing on issues such as tax reform and much-needed deregulation.

For more insight, go to the McKinsey Quarterly Web site.

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