Diminishing returns

As the UK’s Chancellor of the Exchequer prepared to make the 2011 budget announcement at press time, there was hope from the venture capital industry that lobbying by the British Private Equity and Venture Capital Association (BVCA) would pay off and the part that venture capital can play in economic recovery would be recognised.

With this in mind, however, recently released performance figures for European venture capital will not make easy reading for those involved in the market segment. According to Thomson Reuters’ annual European private equity benchmark study, over a 20-year time horizon, all European venture capital has generated a miserable annualised return of 0.2 percent. Over a 10-year horizon, the figure is -3.78 percent.

Institutional investors may not fall of their chairs when they read these numbers. European venture as a whole has been in the doghouse for years. According to research among limited partners commissioned by secondaries group Coller Capital, European LPs see venture as showing less promise over the next two years than any other stage of private equity investment. Private markets investor Partners Group, which manages assets of more than €20 billion, is also very cautious on the segment. According to the firm’s “Relative Value Matrix”, a tool which maps the various segments of the private equity market around the world, European venture funds are one of the few areas the firm currently “underweights”.

The funk endured by European venture means that historically industry debate has centred on how the sector can more effectively mirror the performance of its larger US cousin. At this year’s EVCA Investors’ Forum in Geneva, it seemed the discussion may have moved on.

Some of the traditional barriers that stood in the way of European venture were being broken down, according to panellists at the conference. The problem presented by a fragmented continent, with multiple borders, cultures and languages was becoming less of an issue. Two technology venture home-runs in the form of Skype and MySQL were testament to that. Skype in particular, which was sold for €3.3 billion in 2005, was created by one entrepreneur from Sweden and one from Denmark, headquartered in Luxembourg and effectively run from London. Swedish created MySQL was sold to Oracle for $1 billion in 2008.

In the last five years US venture capital firms and corporates have “cottoned on” to the potential of European growth stories, said Neil Rimer, co-founder and partner of Index Ventures. US VCs were among the backers of both MySQL and Skype, for example. The subsequent buyers for both companies were US-headquartered.

With the cost of starting up a business – in particular a technology business – falling considerably and businesses becoming “global” almost instantaneously, defining “European venture capital” is becoming harder. “I don’t really know what a European venture capital fund or a European business is any more,” said Rimer, again referring to the multi-jurisdictional Skype. “The list of world-class venture capital-backed companies that have emanated from Europe is impressive and it is getting longer,” he added.

So how does this optimism fit with the cold hard data that says European venture capital continues to underperform? A large part of the problem, said panellists at the event, was simple scale. Simon Cook, chief executive officer of UK-based venture firm DFJ Esprit, said the average size of a European venture capital fund – somewhere in the region of €50 million – was simply not enough to back the “winners” in the portfolio to become world leaders and to “shoot the losers”.

It is also worth noting that statistics can be deceptive. Average performance figures, for example, may be a misleading benchmark. Venture capital is a craft and you get disproportionate rewards for investing in the top managers. “Average US performance sucks,” said Index’s Rimer. “You wouldn’t invest in the average.”

The top-quartile returns from European venture look a lot more encouraging: the segment has returned an average IRR of 13.43 percent since inception, according to Thomson Reuters’ figures. And if this seems to pale in comparison to buyout returns (the equivalent figure being 24.83 percent), remember the VCs are plying their trade without the use of leverage.

LPs with capital to invest – and indeed European governments – would do well to bear this in mind.