European venture capital rises from the ashes

Not long ago, the European venture capital industry looked doomed. Following the dotcom crash in 2000 returns had been miserly, leading limited partners to flee this part of the market. Why, they reasoned, throw good money after bad?

For a decade, many European VC funds limped across the finish line when fundraising, often having to make do with less than they had targeted. Either that or they simply disappeared as the amount of capital on offer was not viable.

Today, it’s a different story. While the figures may not yet be showing through, the fact is that many European VC funds are now closing at or above their targets – and with relative ease. The most recent fundraising figures from Invest Europe show a marginal increase in 2013 and 2014, to above the €4 billion ($3.5 billion) mark, compared with around €3 billion most years since the crisis.

Yet there is anecdotal evidence to suggest that the numbers are trending further upwards. “There has been a huge change in perception among LPs,” says Uli Grabenwarter, head of venture capital at the European Investment Fund (EIF). “We are now seeing European VC funds that are over-subscribed and we are prepared to scale back our participation so that we don’t crowd out private investors. That is a great situation and one that we haven’t seen for a very long time.”

Nenad Marovac at DN Capital agrees. His firm is currently raising a new fund and is finding that the environment is different this time round. “Investors are much more interested in European VC,” he says. “We now have in-bound interest (ie, not solicited) and that just didn’t happen before. And we are also seeing new LPs looking here that haven’t invested in European VC before.”

QUIET REVOLUTION

So what has changed? Why is European VC suddenly a hot topic for LPs? While LP interest may only be relatively recent, the quiet revolution that has been taking place in European VC has happened over a number of years.

The overarching change, says Hendrik Brandis, partner at Earlybird, is the growth of the internet. “This technology has opened up a global universe of people to reach,” he says.

“One of the issues Europe struggled with before the internet became widespread was that it was 27 different countries and markets. That fragmentation has disappeared and levelled the playing field for new companies across the globe.”

The internet’s penetration, together with other technological developments, has also sharply reduced the cost of going international. The cash burn that characterised the early internet pioneers is not a feature of today’s internet start-ups.

“The cost of bringing a business to scale has really changed the dynamic for venture capital,” says Grabenwarter. “Today’s costs to start a company are 10 percent of what was needed in 2000 in the internet space, for example. You can in-source all the services you need, where before you had to build out your own expensive infrastructure – that has really changed the game.

“Nowadays, you can prove traction for your business model with between €50,000 and €250,000, ie, before the real VC money gets involved. VC investors can now see proof of concept before investing – and that just wasn’t possible before.” And while this may be a global phenomenon, it has enabled some far-reaching changes at a local level.

“There are five key areas where we’ve seen important developments in Europe,” says Marovac. “One is the emergence of serial entrepreneurs who have created companies in the past and are now either starting up again or involved in start-ups. We’ve also seen the growth of angel networks – these are able to write the first cheques to get companies off the ground.”

Added to this is the emergence of a new breed of venture capital funds, often founded by these serial entrepreneurs, and these are able to provide funding to bring companies to the next growth phase. “Then there are the ecosystems such as the Slush, Founders Forum and Techcrunch events that bring together entrepreneurs and funders,” adds Marovac. “And finally, Europe now has a good story to tell – there have been at least 26 unicorns across Europe in the last few years. This demonstrates that investors can make money.”

UNICORNS NO LONGER RARE

Indeed, it’s this last point that has got many investors interested. A recent report by GP Bullhound suggested that there were now 40 unicorns (VC-backed companies that have reached a valuation of $1 billion or more) in Europe, compared with 30 last year. Newcomers include Rocket Internet, Powa, Shazam, TransferWise and Delivery Hero. It’s a far cry from 2000-10, when just a small number of unicorns had been created.

And what’s interesting to note is that while some of these businesses are relatively newly-created, the majority are companies that have been nurtured over the years by the European VC community. The average age of these unicorns is eight years. So, while LPs’ interest is only just emerging, Europe’s VCs have been busy behind the scenes supporting these future European champions.

It’s only over the last 18-24 months that the exits of these companies have started to come through. IPOs have become a feature of the European exit scene like never before: where, historically, you could count on one hand the number of European VC-backed IPOs each year, since the start of 2014, public listings have been on a roll, with 55 last year and 27 in H1 2015, according to Dow Jones VentureSource.

“Until around three years ago, it was very difficult to exit via IPO in Europe,” says Rafaèle Tordjman, managing partner at Sofinnova Partners. “The volume of trading and the liquidity just wasn’t there. This has changed, in part because there is now interest in investing pre-IPO. There are now a number of hedge funds and cross-over funds that are seeking to get in early. Their involvement secures an IPO and helps create volume of trading in the shares.”

A more buoyant IPO market has added competitive tension for trade buyers, flush with cash and seeking M&A opportunities that will enable them access to disruptive technologies. “There is a lot of trade interest at the moment,” says Marovac. “We’ve completed five trade sales this year alone. Yet it’s not just the US buyers that are coming to Europe. We’re also seeing interest from Asian and European companies.”

Overall, there were 191 exits via M&A of European VC-backed companies in 2014, according to Dow Jones VentureSource, up from 159 in 2013. And as these realisations start to show up in returns data, so more LPs will sit up and take notice.

CLUSTERS CREATING A BUZZ

Allied to all of the above is, of course, the development of Europe’s tech clusters. Cities such as London, Berlin, Stockholm and Paris now attract entrepreneurial talent from around the globe. Start-ups seek to benefit from the buzz created by these clusters as well as the cross-fertilisation of ideas.

The findings of a recent TechCity UK report demonstrated some of the value such clusters can bring to young companies: over half of those located in a cluster (54 percent) said that this helped build their reputation and attract talent, 40 percent said it helped them find affordable premises (in co-working spaces and science parks, for example), while a third said that being located in a cluster helped them attract funding.

With an increasingly vibrant ecosystem developing, it’s perhaps unsurprising that Europe has been attracting the attention of US VCs over recent years. These have included top brass names: Kleiner Perkins Caufield Byers, which has invested in Soundcloud, Spotify and Shazam; Sequoia Capital, which has helped fund Wunderkinder, Klarna, Skyscanner and Songkick; and Bessemer Venture Partners, an investor in companies such as Criteo, Metalogix, Zopa and Intego.

Given the scale of the US VC market, it may seem puzzling that these players are venturing to Europe’s shores. Yet there are some very sound reasons for the trend.

“There are a lot of US VCs interested in Europe,” says Brandis. “And they are often the ones that have access to the best US deals. They are here because of the quality of the deals in Europe – they can see a lot of value here.”

The other reason is that Europe’s young companies are managing to scale up on a shoestring relative to their US counterparts (in large part by necessity because of the scarcity of capital that has been a feature of the European market).

A recent CB Insights report found that Europe’s VC-backed companies were the least capital hungry, with exits of $100 million-plus showing a capital efficiency of 18.56x, compared with 8.14x in the US. This, says CB Insights, means “investors in Europe may see the best cash on cash returns”.

Small wonder, then, that there is so much optimism around European VC right now – it looks as though the changes we have seen over the last five years or so are embedded, unlike the dotcom rush we saw at the end of the 1990s.

Grabenwarter sums up the situation: “We now have a healthier environment in Europe. We have serial entrepreneurs that have created a series of companies, we have fund managers that have actually created carried interest and are able to take companies onto a global stage and we have many more visible successes – just look at the unicorns. The whole ecosystem has improved.”

LIFE SCIENCES CATCHING UP
While much of the buzz in the VC community is around the digital economy, the life sciences sector is now picking up, too (writes Vicky Meek). This has taken rather longer to start seeing more promising results, in part because of the nature of the industry.

“We are starting to see something of a revival in life sciences now, although this has come later than the technology space,” says the EIF’s Grabenwarter.

“The Darwinian process in this space in Europe has been much more severe and so there aren’t as many players now as there were. The slower revival and higher failure rate is largely because this remains a highly capital-intensive area that also takes longer to bear fruit. For those that have come through the other side, we are now starting to see much more interest in their funds among investors as they are starting to tell a good story.”

One of these is Sofinnova Partners. The firm has succeeded in realising 19 companies since 2009, over half of which have been exits via IPO. In addition, over half of these exits have been in 2014 and 2015.

While an increasingly active European IPO market has clearly been one of the drivers behind some of these exits, there has also been a new development in the M&A space.

“Big pharma tends not to be so acquisitive these days,” says Sofinnova’s Tordjman. “Instead we’ve seen the emergence of big biotech businesses – there are over 100 in the US, for example. These are now on the acquisition trail and proving a good source of exits for life sciences investors.”

She points to the sale of Italian business Ethical Oncology Science in 2013, which went to Clovis Oncology for €310 million. “Clovis wasn’t even around six or seven years ago, so it shows how quickly the market is developing,” says Tordjman.