“The traditional European VC market is better at making excuses than returns, such as ‘there aren’t any entrepreneurs’ and ‘there is no exit market in Europe’,” says Guy Fraser-Sampson, co-founder of Mowbray Capital. His take on this, given the buoyancy of the London Stock Market, especially the Alternative Investment Market alone, over the last year or more, is harsh, but probably fair: “Too right there’s no exit market; for your small unexciting company!”
Fraser-Sampson is in the somewhat unusual position of running a fund-of-funds business that will ultimately invest purely in European venture funds. Although Mowbray Capital does not as yet have a fund to invest, it has secured a cornerstone investor and expects to make a formal announcement regarding its fund raising status towards the end of this year. Mowbray Capital is somewhat unusual in the sense that the vast bulk of the fund-of-funds industry is placing its capital with a combination of European buyout and US venture capital funds, each of which are the best performers within their geography’s private equity landscape.
The reason Mowbray Capital is sticking its neck out for the so-far mostly unexciting and largely disappointing European venture capital market is that, like many observers in this space, the founders feel European venture capital is approaching a seismic shift that ultimately could lead to as great, if not greater, riches than currently promised and delivered by US VC funds.
The seismic shift is the move from the current European venture capital model, which has so far proved itself unable consistently to generate the stellar, and consistent among the top quartile funds, returns of its US counterpart, to a more US Silicon Valley-style of investing. Fraser-Sampson, like many, believes comparing US and European venture is currently akin to comparing apples and pears. He says: “What people don’t understand when they look at US venture capital and European venture capital is that they are looking at the difference between venture capital in the US and something completely different in Europe. You’ve really got to call it something like development capital.”
Silicon Valley-style investing includes a combination of earlier seed and start-up stage investing than European VCs are typically comfortable with or set up to deal with, larger funds able to follow through these earlier stage investments for longer without getting their equity interest squeezed out by investors in follow-on rounds, plus a willingness to accept and move on from failed investments relatively quickly.
Sebastien de Lafond, co-founder of UK-based Add Partners, which has adopted Silicon Valley-style investment since founding in 2000, says the willingness to fund companies longer and to concentrate primarily on the promising performers is borne out by research. “Horsley Bridge invested in 96 funds over 20 years that posted 5.2 times returns and with a strong US economy it took on average eight years to return the principal capital to investors. They also found that 77% of the portfolio value was found in 8% of the money invested in portfolio companies,” he says.
European VCs, for their part, point out that in the US there are many more repeat entrepreneurs, which to an extent reduces the can-they-pull-it-off fear factor of an investment, plus the issue of a continuous and vibrant exit market in the shape of the NASDAQ. Granted, there is no exchange in Europe that can even hold a candle to NASDAQ, but arguably European VC funds should take some of the responsibility for that rather than simply looking askance.
The issue of repeat entrepreneurs is a real one, but increasingly less so. If you look purely at the level of angel investment in the UK, for example, it is supporting early stage and start-up businesses to a far greater monetary extent than formal VC funds and the majority of these angels are entrepreneurs and successful business people looking to invest money they have made themselves while at the same time putting their intellectual capital at the disposal of the companies in which they invest.
In other words, the entrepreneurs are out there, European VCs just need to tap into them. Of course European VCs, much like their US counterparts, treated angel investors miserably when the tech bubble burst. Any subsequent funding companies were able to secure was largely done at the expense of the angel investors, who saw their equity completely squeezed out. So these investors are trying, where possible, to club together to raise enough funding for their investments that they don’t need VC fund support. So, instead of whining about how much luckier their US counterparts are, European VC funds need to address this, potentially long-term damaging, issue.
The reason many believe that if European VC funds successfully embrace Silicon Valley-style investment philosophy they could potentially become the most exciting part of the global private equity landscape, outperforming even the US pros, is because the long-term economic environment in Europe is seen as having greater potential than the US.
But elements of the deal dynamics in Europe are far more favourable in Europe than they are in the US. Fraser-Sampson says: “Now there are a small, but growing number of European firms starting to adopt the US [VC] model. The opportunity is enormous because in America pre-money valuation on seed investments is US$4.5m, whereas in Europe it’s officially about US$0.5m, although in reality it’s nothing because there is very little seed money available.”
Jamille Jinnah, co-founder of placement agent and research house Almeida Capital, points to a microeconomic issue that potentially puts European VC funds in a better position than their US counterparts. He says: “It’s 30% cheaper to build a company in Europe. The main reason it’s cheaper is that in the US there is often a personnel turnover (churn rate) of between 20% and 30% each year, much higher than in Europe. In certain areas of the US there are many start-up businesses with great backing that are offering great packages and it’s almost always the good people you lose and never the bad.” If they are both right and early stage investments in Europe are in essence cheap and cheaper to run during their lifecycle, this hands European VC funds a massive advantage.
But one of the key points that must change is the willingness to accept and deal with failure. “In Europe a lot of time is spent on failing companies that are never going to make money,” says Fraser-Sampson. Jinnah is in broad agreement. He says: “In the US, their aim is to produce three or four home runs, rather than preventing companies from going bust. Europeans, on the other hand, have histrically focused on not losing money, rather than going for the big wins.”
But in defence of European VC funds, they haven’t had the encouragement to take those decisions and many are aware that they are exiting investments on 3x or 4x return because this is enough to keep their institutional investors happy whereas to continue to hold and invest would raise questions, plus for the most part European VC funds haven’t been large enough to keep committing capital to the same companies without undermining their diversification. It’s that same last point that has caused many European VC funds to go into companies later in their lifecycle when less capital is required, thereby avoiding the risk that they will be squeezed out at later funding stages.
Jinnah says of the relationship between US institutional investors and US VC funds: “Good quality US funds have a supportive and long-term investor base. Because they have produced quality returns over time, if one fund blows up investors are more likely to stick with them for successive funds. European VCs haven’t produced the same sort of performance in the long term and haven’t generated that good will among investors. If they have a poor performing fund it could well be stop them from raising new funds in the future..”
There is clear evidence of changes in the way European VC funds are approaching the market, with 20-year old UK tech investor MTI Partners having recently announced it is opening a US office, for example. Given the number of European VC firms that are clean out of new funds to invest, who are waiting on the fund raising starting blocks, it is recognised that a new approach is needed if these firms are to go forward. And, if they pull it off, perhaps development capital and buyout players will not be so keen to banish the word venture from their name, in the way that central Eastern European investor 3TS Venture Capital and PPM Ventures recently felt the need to rebrand to 3TS Capital Partners and PPM Capital, respectively.