European venture capital (VC) investments are on a healthy upward trend, returns and money multiples are growing, innovation hubs are emerging, and serial entrepreneurs are flourishing. However, European fund-raising has steadily slowed, while governments in Europe have filled the funding gap, at a time when US investment in European ventures is on a sharp upward trend, according to a new report from the Boston Consulting Group (BCG) and Spain's IESE Business School.

 

The report challenges the conventional wisdom about the European VC scene, which holds that:

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;
The general partner landscape is opaque and highly fragmented, with many subscale VC funds.

“Such criticisms have some foundation in fact,” said Michael Brigl, 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% 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%.”

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%, while US investment has increased by 45% to approach a ten-year high. Although each of the top ten European funds raised more than €100m in 2015, and three of them raised more than €300m, the gap between US and European investment has widened by about €21bn.

The report says that 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% of all private VC limited partners in Europe, compared with 29% 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 startups obtain at least minimal funding. As a result, the government share of investment in VC funds more than doubled from 2008 through 2014.

We estimated last year that the Irish Government indirectly provides about 40% of the VC funding in Ireland.

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.

European VC, venture capital funds, 2015

Toward a more investor-friendly European VC market

The report says 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%. But such performance requires further development of the European VC ecosystem. The following few points are mission critical:

To attract institutional investors accustomed to writing tickets of €50m or more, the market has to feature investment opportunities with a pan-European focus;
There must be funds that are large enough — potentially with capitalisations of €350m or more — to invest in startups at all stages of development, especially the late and growth stages;
VC funds and managers need transatlantic expertise and networking to support the growth of ventures in the US;
Governments can act as catalysts, but they cannot lead private investors in new fund vehicles;
Market performance must be sufficiently transparent, trustworthy, and timely to enable efficient investment decisions.

As a potential interim step, the report says 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.

Most global tech startup exits have no venture capital funding

Irish, US firms with Irish HQs raise €415m to end Sept 2015

European firms raised €7.9bn in venture capital in 2014; US firms raised $52bn

Europe venture capital 2015