Historically, a lot of research and books have been written about the US venture capital markets. Strangely enough, there is fairly little to be found on European VCs. While I won’t be able to provide a peek-under-the-hood, I delved deeper into the VC market in Europe to understand how it differs from the US.
Why would this matter? If you’re an entrepreneur looking to raise a Series A in the next few years, you should better understand how to look and find your new investors.
State of European VC Market
The European VC industry has come a long way with investments doubling from USD 18bn in 2014 to USD 36bn in 2019, according to Crunchbase. Meanwhile, VC funding in North America grew by almost 50% from USD 90bn to USD 132bn. Europe is catching up fast but it is still punching below its weight as its share of global GDP standing at 21% but the value of its start-up ecosystem is estimated at only 10% globally.
Fund performance is also lagging for European VCs. Looking at net IRR and TVPI, Preqin reports that top quartile US funds have outperformed top quartile European funds over the past 5 years. However, Cambridge Associates reports that, on a <5-year horizon, average European VC performance is equal or better than US VCs.
So, what’s causing these differences in the top-line figures? Well, they stem from a few key structural factors: funding landscape, market fragmentation, and investment strategy.
For 2019, Preqin estimates the average US VC fund size is USD ~440m while it is only USD ~217m in Europe. While fund size does not explain differences in performance per se, there are economies of scale in deploying capital in a bigger fund structure.
Unlike in the US, the biggest European VC fund investors are government agencies (specifically European institutions), followed by corporate investors and private individuals. Many European countries still do not permit their pension funds to invest in VC funds, thus limiting the overall capital pool available to its VCs. In the past, this reduced size of capital pool in Europe has resulted in late-stage companies struggling to close financing rounds or looking for funding from non-European investors.
The European market is fragmented across languages, cultural norms, consumer needs, jurisdictions, etc. A successful business model in one country does not necessarily transpose well to the rest of Europe. Even for Zalando, one of Rocket Internet’s portfolio stars, sales are still primarily driven by German speaking countries despite attempts to expand. For European VCs, this limits growth of portfolio companies to their home markets and, unless later-stage capital can be tapped, can limit their returns significantly.
Because of the fragmented market, European investment theses tend to focus more on geographies or language groups, while US VC funds tend to focus on specific industry niches or trends, which they research more deeply and build significant expertise on. Combined with the difference in fund size, this leads to different investment theses and corresponding drivers of portfolio performance: access to quality deals, follow-on strategy, and paths to exit.
Access to Quality Deals
To attract the most interesting deals, US VCs can leverage their brand reputation, their networks, and their track record. US funds also benefit from having a concentrated and highly sophisticated innovation cluster in Silicon Valley. As such, US VCs have access to a broader pool of investment-ready start-ups, albeit at high valuations as many funds chase the best deals.
While there is less valuation inflation in Europe, local VC funds do not have a long history and need to be more proactive in developing their deal funnel. In addition, European innovation clusters are typically more spread out and tech transfer programs are less developed, resulting in a chasm between idea and growth stage companies. Some funds, like Seraphim in the UK, are trying to solve this by setting up feeder accelerator programs.
US VC funds tend to cast a wide net in creating their portfolio before following through on the portfolio company most likely to reach a >10x return, i.e., the “unicorn” that will return the entire fund. In contrast, European VCs still place more emphasis on the existence of revenues and the path to profitability. Even though the European strategy might yield a higher number of successful exits, it cannot match fund performance that is driven by outliers, as shown by top quartile fund performance for US VC funds.
Paths to Exit
Finally, US VCs are more successful at securing an exit through IPOs or trade sales. The US has developed equity capital markets that offer good liquidity to small companies. US VCs also maintain a strong network of later-stage investors as well as strategic investors. These relationships allow them to gauge whether a portfolio company would be a good fit and has reached its optimal maturity for an exit. Thus, US VCs can broker a deal much easier but also negotiate better exit terms than EU VCs.
Trade sales are the most common exit strategy in Europe, but they tend to be less lucrative than IPOs. Exit activity in Europe is more haphazard and VCs find it difficult to secure competitive prices for their portfolio companies.
In conclusion, European VCs are developing swiftly and are finding ways to adapt the traditional VC methodology to the European landscape.
Home-grown European VC brands have started to appear over the past decade to rival the well-established US brands.
Meanwhile, several new US VCs are developing investment strategies to invest in so-called Zebras (instead of Unicorns). To do so, they had to create new (but old) investment instruments, such as revenue-based investing. This investment strategy might also be more appropriate for the European market.
This article originally appeared on SANZARU Group‘s blog on 11-Jul-2020.
- Dealroom venture capital investment flows in Europe report 2017