This is a guest post by Paul Jozefak of Neuhaus Partners, commenting on the release of a working paper put out by the European Investment Fund about the performance and prospects for European venture capital. You can follow Paul at his blog or on Twitter.
The European Investment Fund (EIF) put out a working paper recently that initially sounds like bad news. Fortunately, for those of us in the market long enough, it's actually good news. As a side note, I'm glad to see this paper come out from the EIF. For those of you not in the know, they are one of the largest limited partners (LP's: investors in venture capital funds) in Europe and are basically in almost all the funds throughout the market. Hence anything from them is going to be based on information that truly represents the situation in Europe.
I wanted to address each of their hypothesis directly though. I personally believe that when you read through this working paper, there is pent up energy behind the hypothesis just waiting to explode. So many things have happened in the past 10 years in the European market that hindsight sure does paint an ugly picture. But if you dig a bit further, the ground work has been laid. Each and every one of these hypothesis is derived from a rear-view mirror perspective. I far prefer to look forward!
Hypothesis 1: Insufficient VC investment in Europe
This may have been the case in the past but what has happened recently? Well, you've had a stabilization of the Tier 1 funds. The top firms have come through the dip, raised additional funds and proved that they can generate significant exits. Micro-VC's or "super angels" have also established themselves in Europe. Guys like the Samwers have made a killing and if you look at what the Kleins are doing via Index and Seedcamp, you clearly see players at the seed end of the spectrum. Further, a lot of former entrepreneurs are launching their own funds, such as Atomico or very recently Heiko Hubertz in Germany. I also know of other serial entrepreneurs who are soon launching their own vehicles. There may have been insufficient VC investment in the past but we're in a position to finally increase the number of deals.
Hypothesis 2: Available funding is spread too thinly
This is still somewhat true but we are finally starting to see larger rounds taking place in Europe. Look at Wooga or Wimdu. The size of rounds basically is dependant on exits. No one is going to invest more initially if at the tail end one can't expect a significant return. Further, once you have established players in the market with larger funds, you'll also see larger rounds initially, making European start-ups far more competitive with their US counterparts. Additionally, once the funds themselves have significant capital, they will double-down on the good deals in their portfolio and put more money to work. This is very difficult to do if you constantly have to worry about running out of capital in your fund or not having enough reserves to avoid dilution. This is very much the case if your portfolio company explodes and is able to raise from others with more capital than you yourself have available.
Hypothesis 3: Insufficient diversification in European VC managers’ portfolios
This again is connected to the size of funds and the number of available target investments. Funds at the top end have increased in size and seed funds which have established themselves tend to have more to work with than 10 years ago. In general, eyeballing it, I'd say there is more money in funds across the board (the ones that survived or recently launched). We also see far more companies getting started in multiple segments. Hence the possibility to diversify ones portfolio is clearly there and is connected with professional management within funds. Smart players know to diversify early and to continue to diversify throughout the life of the fund. This is far easier to do if you can expect to raise additional funds down the road and can concentrate on your fund's strategy.
Hypothesis 4: European VC managers have an inappropriate background
This is very clearly disappearing quickly. The former bankers and consultants simply can't raise new funds. They will slowly but surely disappear in the coming years. If you see the new funds which have recently been launched you can tell the LP's are putting their money with former entrepreneurs. Another year or two and we'll be close to the end of the consolidation in the market and mostly entrepreneur driven funds will survive. This for me is a no-brainer.
Hypothesis 5: European VC managers are targeting the wrong sectors and have insufficient focus
By having more former entrepreneurs driving fund decisions you'll also get specialization. In the near term, you'll still have insufficient focus but once teams are in place with the right structure and the number of deals available increases, this becomes less of an issue. Further, with the ease of launching start-ups in multiple segments going up, you'll see entrepreneurs forming cliques around the funds focused on them. Exits will feed future intermingling amongst the entrepreneurs and the funds financing them. With an ecosystem established focus will be inevitable.
Hypothesis 6: European VC managers are targeting the wrong investment stages
This is very clearly intertwined with fund size and ability to raise future funds. With the right teams in place, a sector focus and sufficient funds, you'll see funds looking more towards the seed stage to make sure they are in the best deals early enough to generate necessary returns. Historically, because it was so difficult to bet on your next fund, you chased the deals and exits. Funds grew to be able to play at the growth stage of the sector. This was also driven by a dependence on management fees as carry wasn't typically often paid in European funds. This trend has reversed and the smart players in the market know that if they don't feed the ecosystem, they'll have nowhere to invest their funds. No ecosystem means no start-ups, means no exits, means no future funds. After the bubble burst, the players who remain in the market learned this the hard way.
Hypothesis 7: European exit markets are too fragmented
This is a tough one. You will always have multiple markets in Europe verses one market in the US. Although attempts are being made to unify things, I am skeptical about this one. At the same time, US buyers are looking more to Europe and are actually buying companies. If IPO's return, you basically will have two to three public markets you can sell into. Nevertheless, this will remain a hurdle for some time and is dependant on future performance. Historic performance will be a major issue in this regard until the new players can prove that the EU can generate necessary returns for LP's to be investing here.
Hypothesis 8: Pension fund regulations and practices limit European access to funds
This too is a major pain the ass for funds in Europe. Pension funds hardly invest into VC funds right now and I am not too sure this will happen in the near future. If you look at Germany specifically, hardly any LP's invest in local funds, preferring to invest the little that they do, in the US. Therefore we may have to wait a bit on this one in terms of performance. Once European funds start to perform better, the local LP's will adapt. Further I believe pension funds in Europe will also come around if the numbers are right. Unfortunately this takes time and has so many political implications that I too remain skeptical. At the same time, other players such as large family offices have stepped up their investments in funds and backfilled the holes left by a lack of pension funds in the market. Further many funds went to other areas to search for money such as the Middle East or Asia. I believe this will very much remain a necessary channel for capital into funds in the future.
Hypothesis 9: The problem is on the demand side
This one is in my mind changing the fastest. There are a ton of new start-ups appearing. Just go hang out in London or Berlin to get a sense of this. Further, the copycat movement is coming to an end and entrepreneurs are genuinely trying to innovate again. If I look at recent financing in Europe I am positively convinced that we are at the cusp of positive developments on the demand side. This is truly a hypothesis that is extremely subjective. I prefer to remain optimistic about this one and the upcoming generation of entrepreneurs. They are leaving their "Europeanness" behind and are becoming global players right from the start.
Hypothesis 10: European venture capital lacks critical mass
I've been arguing this for some time. In Europe, two clusters have established themselves: London & Berlin. Both are quickly striving for critical mass. One could even argue that they are close to reaching it. If I were an LP, I'd be investing right now in the top players. Give it another two to three years and you'll have missed the boat.
Hypothesis 11: European VC does not have critical mass because Europe lacks a venture capital ecosystem
Just as the previous hypothesis falsely looks backwards, I believe things are about to change quickly here. Once clusters establish themselves, the ecosystems grow. London and Berlin will have a combination of VC's, angels, serial entrepreneurs and potential buyers in place. M&A might not happen via buyers who are local to London or Berlin but the US guys are constantly snooping around these geographies. Further, once exits take place, the system feeds upon itself. The entrepreneurs go into funds or start angel investing while launching their next gig. An ecosystem needs time to establish itself and the past ten to fifteen years have been just that: The Beginning.