A cyclical perspective on European venture capital, Fintech and Blockchain (part I)
Updated: Mar 9
It is quite surprising to find out that it took Blackstone, the quintessential private equity firm, 15 years to figure out that market cycles mattered. In the book King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone, authors D. Carey and J. E. Morris describe some of the lousy picks that Blackstone had made in the late nineties and which went bust in the early 2000s, 15 years after the firm’s incorporation in 1985:
“With hindsight, there was a pattern to failures. All were highly cyclical companies whose fortunes seesawed with the economy. […] Blackstone bought many of them at the wrong time in the economic cycle. It wound up overpaying and piling on too much debt. It had stacked the deck against itself.”
As evidenced just above, timing markets and predicting cycles is an arduous task, even for the most skilful investors. However, since it became evident that COVID-19 would have deep implications on our economies and in spite of lavish helicopter money programs, I cannot help but think that we are closing a chapter and transitioning into a new cycle.
Under this assumption, this two-part series looks back on the dynamics of venture capital during the last cycle. The first part examines venture capital as an asset class and how it fared in Europe and the second part focuses on Fintech and Blockchain.
Keeping things private
Let’s first put venture capital in context by looking at what private markets are, what they look like and how they fared in the last cycle, with help from an excellent report from the strategy consultancy firm McKinsey and Company.
At the end of the first half of 2019, private markets assets under management (AUM) amounted to $6.4 trillion, a 2.7x increase when compared to 2010. Assets can be categorised into three big families: Private Equity, the most predominant asset class with c. 60% of total private markets AUM, Private Debt and Real Assets.
Investors traditionally value private market investments as a mean to increase diversification and decrease volatility in their portfolios, which mainly comprise public equity (stocks) and public debt (government and corporate bonds).
Private Equity funds outperformed their public market counterparts every year since 2009 (even when public markets were enjoying the longest bull run in history), solidifying investor demand for the asset class. As a result, the global net asset value of Private Equity has grown eightfold since 2000, almost three times more than public equities
To put things into perspective, the report notes that when compared to public markets, the size of private equity is still very modest with total AUM at less than 8% of the total public equity market capitalisation. As a matter of fact, institutional investors are currently under-allocated to private equity.
According to the authors of the study, increasing their exposure to match their allocation targets “would require more than $500 billion in additional capital commitments — as much as the global amount raised for PE in 2019. Further, the gap does not account for the continued growth in LPs (Limited Partners — investors in private equity funds) target allocations, which increased by an average of 1 to 2 percentage points for most LP types over the last decade. All the evidence suggests that despite the record amount of capital committed to [private equity] over the last several years, there’s likely more to come.”
When combined with “Growth”, which is arguably a form of (late stage) venture capital, the venture capital asset class represented c. 43% of the total private equity AUM, standing at $1.7 trillion.
As a proud European, the split of AUM per geography saddened me: at $158 bn, European VC accounted for only 9% of the total venture capital AUM. Even when taking into account the usual geographical discrepancies, Europe’s share of venture capital AUM fell very short of its average of 26% of AUM for other asset classes.
This result cannot be entirely dismissed with the usual narrative revolving around the development of Silicon Valley and the American entrepreneurial spirit; the lion’s share belonged to Asian fund managers, who possessed nearly half of the global venture capital assets.
What happened to European venture capital?
I am not the only one asking this question. Actually, the old continent’s shortcomings are too well known. An article from the Boston Consulting Group (BCG) summarised the issues in these terms:
“The complaints are old and familiar. Returns on venture capital aren’t competitive with those of 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. The general partner (note: fund manager) landscape is opaque and highly fragmented, with many subscale VC funds.”
The authors of the publication subsequently noted that, contrarily to popular beliefs, venture capital returns were improving, entrepreneurial ecosystems were growing across Europe and money was flowing from overseas to snatch undervalued startups. Finally, the article went on to recommend ways to foster investments in European VC funds and grow the VC ecosystem: easing regulatory restrictions weighing on institutional investors and/or creating a layer of funds-of-funds that could attract both private and public money. More on that later on.
In hindsight this article appears prophetic. It was written in 2015 with data from 2014. Back then, both US and European venture capital investments were soaring, reaching levels respectively 2.8x and 2.6x greater than the trough of the market in 2009. On the fundraising side, however, American funds were raising 3 times more money than just after the global financial crisis whereas their European counterparts only raised 1.4x the amount of 2009. As the article suggested, basic supply and demand dynamics justified American managers making the effort to cross the pond.
So much so that, even if in absolute terms European venture capital investments remained subdued when compared to US investments from 2015 to 2019 (4.2 times lower), in relative terms European startup funding grew at a compounded annual growth rate (CAGR) of +23% during the same period, at a higher pace than in the US (+18%).
Happy days for European venture capital. Last month the venture capital arm of the well-known publisher PEI, Venture Capital Journal, published an article aptly titled “VC finally makes the map in Europe”. Filled with optimism, the author offered reasons explaining the recent attractiveness of European tech, citing for example public bodies’ (such as the European Investment Fund) injection of fresh equity into venture capital funds and portfolio companies.
The article also mentioned a maturing entrepreneur ecosystem with a broadening range of support structures (such as incubators and accelerators) as well as cohorts of successful entrepreneurs who feed the ecosystem with their experience and newly acquired capital. In a “self-reinforcing cycle”, in turn, those success stories encourage the new generations to choose startups as a career path, no longer perceived as precarious.
Another crucial element came to the rescue of the lack of attractiveness of European venture capital funds: the newly found dynamism of the European innovation ecosystem translated into higher returns. Cambridge Associates, a global investment firm recognised for its first-class benchmarks and analysis, noted that the short-term performance of their Europe Developed Venture Capital Index was better than the firm’s US Venture Capital Index: 23.5% for the European Index vs 21.8% for the American Index for one-year returns, 21% vs 15% for three-year returns and at a draw of 13.8% vs 14% for five-year returns.
In spite of this stream of good news, observers lamented that contrary to the situation on the other side of the Atlantic, institutional investors were still skittish about making significative contributions to European venture capital. As a result, European VC fundraising remained flat at c. €11 bn per year from 2015 to 2019 — as opposed to American funds, where fundraising grew at a CAGR of +5.6% during the same period.
Part of this phenomenon can be explained by the fact that it takes the same time and effort for an institutional investor to write a €100 million cheque than it does for a €10 million ticket, so why bother investing in smaller funds? The fragmented European VC landscape was no ideal hunting ground for large allocators and only a handful of performing managers who were able to set up larger funds were well positioned to get commitments from those institutions.
Behold the micro fund
This phenomenon in turn affected startups; as successful managers raised larger funds, they had to make higher initial investments to avoid the hassle of sourcing and managing a broad number of portfolio companies. Consequently, those who initially targeted startups at the earliest stage of development (such as pre-seed and seed) had to move down the risk curve towards later series and larger rounds.
The effects were very visible both in Europe and in the US. After peaking in 2015, the number of “Angel & Seed” stage financings dropped dramatically to c. 60% of the number of financings for that category in 2014 in Europe and c. 80% in the US. Worse, the number of startups receiving financing for the first time dropped to 50% (Europe) and 75% (US) from the levels of 2014.
These observations raise a few questions:
While the maturation of venture capital ecosystems is a good thing and capital available to help startups remain private longer to create long term value is positive, what happens when most of investors’ capital is only available to late stage companies?
Notwithstanding the higher failure rates of seed startups, if this trend continues and angel and seed financings keep decreasing, would there not be a limited and declining number of new startups advancing to Series A and later stages?
Wouldn’t such an environment encourage founders to stretch reality to appear more mature than they really are to unlock investments?
Conversely, would fund managers not encourage larger rounds (thus higher valuations), even when such amounts would not be immediately needed, in order to allocate the dry powder burning a hole in their pockets?
Finally, why is there such a difference between Europe and the US?
The first four questions are rhetorical but I believe that part of the answer to the fifth one would be the emergence, early in the cycle, of a strong trend in the US: the micro fund.
Micro venture capital funds are usually defined as funds that are $100 million or less in size. They are generally launched by emerging managers (i.e. managers who launched one or two funds) and usually target early stage startups, sometimes with a specific thematic or geography focus, which the manager believes gives them an edge over generalist funds.
From the beginning of the cycle in 2009, micro funds grew very popular in the US, expanding at a rate of +23% per annum until peaking in 2015. In contrast, the number of European micro VC funds raised shrunk by -8% per year during the same period and consistently continued to decrease thereafter.
Do not be fooled by the apparent high number of European micro funds at the beginning of the period, this was more by necessity than by design: in Europe, the average fund size at fundraising was $27 million at the market trough in 2010 and did not exceed $100 million before 2015. In the more mature US environment, the average fund size at fundraising was persistently over $100 million throughout the cycle with a 10-year average standing at $133 million.
So why did micro venture capital funds not become popular in Europe? Was it because of fears over potentially subpar returns?
A piece of research from Cambridge Associates tends to actually prove the contrary: when measuring the performance of VC funds since 2004, emerging fund managers were consistently rated among top performers.
Michael Kim, Founder & Managing Partner at Cendana Capital, came to the same conclusion. Cendana is a fund of funds, often cited when talking about micro venture capital funds since its thesis lies in investing exclusively in seed funds (hence, according to Kim, smaller than $100 million).
The firm is currently raising a $195 million fourth fund on the back of strong previous performance; according to an interview Kim had with the Venture Capital Journal in January this year, “most of Cendana’s funds are generating a more than 20% IRR and four funds are performing at the top 5 percent in their category of Cambridge Associates benchmark statistics.”
In an interview for TechCrunch in 2017, Kim explained why his firm was not present in Europe: “We haven’t invested internationally. We felt that the ecosystems outside the U.S. were substantially weaker, owing to the lack of available follow-on capital. That was a huge concern in Europe, where for a long time it was basically Accel and Balderton and Index. But now there’s BlueYard Capital in Berlin and Felix Capital and Mosaic Ventures in London. There’s a lot more going on, so we think the ecosystem has gotten better.”
More specifically, the Venture Capital Journal reported in January that “Another criterion Kim looks for is a robust local venture ecosystem, including strong exit markets and an abundance of later-stage venture firms that can make follow-on investments. For example, Cendana has been keeping a close eye on Europe where ‘Series A funds have been getting bigger,’ but the LP has yet to back a Europe-based manager largely because exits have not been big enough, Kim says.”
The missing piece of the puzzle
Unfortunately, Kim is not alone. What he mentioned is the one criticism that almost always comes up when talking about the European venture capital landscape. Even amongst European fund managers, exits are perceived as the number 1 challenge, as revealed by a recent survey by the European Investment Fund.
With reason: since 2009, exits in Europe have rarely surpassed €20 bn per year, minuscule when compared with €70 bn yearly on average in the US. 2018 carried hope for Europe as the successful IPOs of unicorns Ayden, Farfetch and Spotify pushed the envelope to €53 bn. Unfortunately, exits fell back to €15 bn in 2019 while the US ecosystem celebrated a record-breaking year at €184 bn. Observers nonetheless commented that WeWork’s fiasco and Uber’s disappointing IPO might make founders think twice about going public in the future, especially since the emergence of abundant late-stage capital and the explosion of “mega-rounds” ($100 m+).
Yet another trend that started at the beginning of the cycle in the US and was almost inexistent in Europe: the number of late-stage mega-rounds exploded in the US in 2018 and 2019, doubling from the average number of deals of c. 100 from 2014 to 2017. In Europe, mega-rounds have been more subdued but increased steadily at a CAGR of +35% per year from 2015 to 2019 (vs. +22% in the US).
Under such market conditions, I am not surprised by the lack of European exits at this stage. Since it takes on average 8 years from founding date to exit, most European startups from the last cycle had not yet reached maturity at the end of 2019. And for those who may have, they were offered the luxury of choosing between readily available long-term capital or going through a tedious IPO process for the same result. A no-brainer.
A counter-argument that is often used to respond to the low number of European exits and which reinforces the observations made in the previous paragraph is the mounting valuation of European unicorns, some of which raised mega-rounds. In 2019, the European ecosystem gained 16 unicorns adding €32 bn in value to an aggregate of €88 bn, a +57% jump when compared to 2018.
A report by tech.eu from the end of last year lamented that the providers of late stage financing in mega-rounds to European startups were predominantly outsiders as only 27% of the capital provided originated from Europe-based investors.
It seems like European policy makers were well aware of the stakes at play and (as if they had read the BCG publication mentioned above) set up a series of initiatives dedicated to support the emergence of European late-stage investors, such as:
In 2018, the European Commission created VentureEU, a program that distributed €410 million to six funds of funds which invest in venture capital: Aberdeen Standard Investments, Axon Partners Group, Isomer Capital (who, like Cendana Capital, invests in seed fund managers), LGT Capital Partners, Lombard Odier Asset Management and Schroder Adveq. The objective is to anchor those funds and help them raise enough capital to allocate a total amount of c. €2.1 bn in venture funds across Europe.
In May 2019, the European Investment Fund announced it would guarantee 50% of the “innovation loans” provided by Bpifrance, the investment arm of the French sovereign wealth fund Caisse des Dépôts et Consignations.
In September 2019, French president Emmanuel Macro pledged €5 bn, supported by French private and public investors, dedicated to supply capital to French late-stage startups.
“VC finally makes the map in Europe”. The title from the Venture Capital Journal article could not better resonate as the common voice of all those within the European venture capital ecosystem, as if breathing a big sigh of relief.
During the last cycle private markets and private equity were booming and more capital is expected to become available from investors in the future. Despite European institutional investors historically shunning venture capital, the underlying fundamentals of the asset class have changed: entrepreneurial ecosystems have finally flourished and matured across Europe.
An unprecedented number of unicorns have emerged during the last cycle, validating the potential of Europe as a global innovation hub. Venture capital funds from the old continent have been growing larger and able to accommodate large allocations from institutional investors.
In the last three years, readily available foreign capital and successful IPOs have transformed the late stage landscape. Public bodies have shown that they are fully engaged in continuing to support the growth of the ecosystem with pro-startup policies and additional capital for European investors.
In my opinion it is too early in the cycle to judge Europe on its public exits. The few European startups that went through an IPO in recent years validated the continent’s potential for successful exits. But what if the new normal, in Europe and elsewhere, was to remain private longer?
Proven support from local public bodies and foreign investors are entrenching a new layer of late-stage growth capital thanks to which unicorns flourish and valuations swell. Therein lie portfolio management and value unlocking opportunities for venture capital fund managers.
I believe this new layer of capital might just be the missing piece of the puzzle for fund managers to crystallise returns and solidify investors’ confidence in European venture capital as a performing asset class.
If you feel like keeping on reading, don’t miss out part II of this series, where I go over the birth and boom of both Fintech and Blockchain.
About Schema Capital:
Schema Capital is a venture capital investment and advisory company dedicated to supporting European fintech founders from inception to seed.
We focus on “deep fintech”, where emerging technologies (blockchain, AI, IoT, quantum) are revolutionising the infrastructure of financial services and enabling entirely novel ways of creating and consuming financial products and services.
We also run The Drawing Board, a rolling advisory programme destined to help entrepreneurs hit the ground running and raise an institutional seed round.
The programme offers hands-on assistance with business strategy, product design and development, business development, investor documentation, pitch preparation and all things finance until a CFO steps in. The Drawing Board is open to Fintech startups only.