With investments on a healthy upward trend, returns and money multiples growing, innovation hubs emerging, and serial entrepreneurs flourishing the European venture capital VC market may seem to be in rude health.
But according to a new report from The Boston Consulting Group (BCG) and IESE Business School, European fund-raising has steadily slowed, while US investment in European ventures is on a sharp upward trend.
The report challenges the conventional wisdom about the European VC scene, which holds that:
the top VC performers' returns can't compete with those in other asset classes; the investor mix is skewed far too heavily toward government entities, whose main objective is to build up regional or national champions rather than to earn financial returns; and the general partner landscape is opaque and highly fragmented, with many subscale VC funds.
"Such criticisms have some foundation in fact," says Michael Brigl (pictured), a BCG partner and coauthor of the report. "But a closer look at the European VC market reveals that, in fact, not only did returns on VC investments grow at a 7 per cent compound annual rate from 2011 through 2014, but also that VC investments in Europe are at a secular peak. They surged strongly from 2012 through 2014, growing by 73 per cent."
Investment levels now stand at their highest point since the bursting of the dot-com bubble.
But since 2012, European fund-raising has plunged by 33 per cent, while US investment has increased by 45 per cent to approach a ten-year high. Although each of the top ten European funds raised more than EUR100 million in 2015, and three of them raised more than EUR300 million, the gap between US and European investment has widened by about EUR21 billion.
The chief cause of the slide in fund-raising is the relative absence of private European money. European institutional investors constitute a smaller share of the population of limited partners in VC funds than do US institutions. Pension funds, for example, make up 14 per cent of all private VC limited partners in Europe, compared with 29 percent in the US.
Making the situation worse, private investors have slashed their VC investment in both relative and absolute terms since 2008. Government agencies have covered the shortfall, stepping in to ensure that European start-ups obtain at least minimal funding. As a result, the government share of investment in VC funds more than doubled from 2008 through 2014.
What is scaring off private European investors? For one thing, the current European financial-regulatory regime discourages equity investing. What's more, the European VC market is highly opaque, fragmented, and marked by a large number of small, nationally focused funds, making it difficult for institutional investors to write large investment tickets. As a result, many successful young companies lack the later-stage support they need.
According to the report, several reforms are necessary to draw in private European capital to support the continent's entrepreneurs. Most important, investors must be confident that they can earn returns on equity of at least 20 percent. But such performance requires further development of the European VC ecosystem. The following few points are mission critical.
Firstly, to attract institutional investors accustomed to writing tickets of EUR50 million or more, the market has to feature investment opportunities with a pan-European focus.
There must also be funds that are large enough–- potentially with capitalisations of EUR350 million or more – to invest in start-ups at all stages of development, especially the late and growth stages.
VC funds and managers meanwhile, need transatlantic expertise and networking to support the growth of ventures in the US, and though Governments can act as catalysts, they cannot lead private investors in new fund vehicles.
Market performance must also be sufficiently transparent, trustworthy, and timely to enable efficient investment decisions.
The report suggests that as a potential interim step, market players should consider setting up a fund-of-funds layer that could attract both private and public money. Such a structure could leverage public capital as catalyst to scale up quickly. Canada has implemented a successful version of this approach.
In Europe, five to ten sector-focused funds of funds would be sufficient to cover the most important high-growth sectors. VC funds focused on these sectors could be selected on the basis of their track records or future performance expectations, because of the management team's expertise and experience. Fund strategies should privilege and encourage cross-border investment.
The structure outlined above would be an interim arrangement that would endure until private investments have scaled up sufficiently to establish a robust European VC ecosystem supported mainly by private capital. At that point, Europe's VC market would be largely a private affair, and Europe's status as a healthy, well-funded hub of innovation would be assured.