In the July/August 2010 issue of IBJ, these co-authors described the “caste system” and other secrets of venture capital (VC) firms in America. In this article, they summarize their interviews with VCs in Europe. While firms in Europe and America share similarities, the authors note that there are important differences that may explain why European VC firms perform poorly in comparison to those in America.
Venture capital firms in Europe
Venture capital activity varies greatly across Europe. As one prominent fund of funds manager with investments in more than 50 VC funds across Europe put it to us:
The UK is far ahead of the rest. Holland and Scandinavian countries are next. There is not so much VC activity in Germany and Switzerland. France has some, but its law requiring pension funds to invest a certain percent in VC firms is controversial and perhaps counter-productive. There is very little VC activity in Italy, Spain and Portugal.
Available data for the total VC funds disbursed in 2005 (US $, billions) are as follows:1 U.S. (27), UK (10), Scandinavia (2.2), Holland and Belgium (1.4), Germany (8), France (6), Italy (2), Spain (0.7), Portugal (.003), and the total for Europe (32).
Despite the considerable variation across Europe, VCs there have more in common with each other than with VCs in America.2 Based on our interviews with firms in Europe and the limited research evidence available, this article highlights the key differences in VC activity between Europe and the United States.
As the authors who reported the figures for VC activity in Europe point out: 3
The venture capital industry started in the U. S. and spread slowly around the globe… the venture capital markets both in Europe and the U. S. grew rapidly in 1999 and 2000. Yet, while the U. S. VC markets experienced a rapid decline in 2001/2002, the European markets remained comparatively strong and actually overtook the U. S. in terms of total funding activity in 2004 and 2005.
We note that the above summary is not an apples-to-apples comparison, because in Europe the term “venture capital” often refers not only to early and later-stage investments as in America, but may include buyouts as well.4 An apples-to-apples comparison suggests that the level of early-stage financing in Europe has been roughly a quarter of that in the United States.5 To avoid any confusion, we will use the term “venture capital” in this article to refer to early and later-stage investments only, excluding buyouts.
Even with this narrower definition, it is clear that both public and private interest in venture capital and the volume of VC activity in Europe has been increasing in recent years. However, the performance of European VC funds lags far behind that of their American counterparts. For example, calculations by Venture Economics indicate that from the beginning of the VC industry in Europe in the early 1980s until 2007, the average European VC fund had an annual return of minus 4 percent versus 16 percent for the average U. S. VC fund.6
Why have increasing amounts of money been poured into European VC funds despite their dismal performance? The short answer? Because European VC firms are striving to emulate the success of their American counterparts in creating new wealth, and European governments are keen to duplicate American VC success in creating new industries and new jobs.
Why then have European VC funds performed so poorly relative to their American counterparts? One reason, beyond the scope of this short article, is that government intervention in venture capital markets is flawed in conception or in execution, or both. An authoritative analysis of why public efforts to boost entrepreneurship and venture capital have failed, and what governments can do about it, is the subject of Josh Lerner’s new book, Boulevard of Broken Dreams.7
Other reasons for the difference in performance between VC firms in Europe vs. America arise from differences in the external environments and differences in how these firms operate.
Differences in the external environments of VC firms in Europe and America
VC firms in America face markets for exit, capital and labor that are different from those in Europe. As well, American firms operate in a different institutional environment.
Despite many attempts to duplicate America’s NASDAQ, Europe does not have a vibrant market where its young new companies can exit via initial public offerings (IPOs). The 1990s ushered in several markets in Europe modeled after NASDAQ, including the German Neuer Markt, the French Nouveau Marche, London-based Techmark and EASDAQ in Brussels. But when the Internet bubble burst, a number of these markets folded or merged with the main stock markets. Those that still exist have very little IPO activity.
Given the weak public market for young companies in Europe, the primary avenue for their exit is a trade sale (merger or acquisition) rather than an IPO. Moreover, there is compelling evidence that exits via trade sales are, in general, not as lucrative as exits via IPOs.8 Thus, it has been argued, a key reason why VC firms in Europe underperform their American counterparts is the absence of a stock market that is eager to trade the shares of new companies.9
The VCs we interviewed in Europe did not fully buy this argument because of a chicken-and-egg problem: Are there fewer promising young companies in Europe because there is no stock market equivalent to NASDAQ, or are public markets for young companies much weaker in Europe because fewer promising young companies are available to trade on these markets? One academic study that controlled for the effects of multiple explanatory variables found that stock market development (market capitalization/GDP) did not have any statistically significant influence on the performance of VC-backed companies in Europe.10
The situation is changing but, unlike the U. S., many European countries do not permit pension funds to make investments in VCs, thus limiting the capital available for start-ups. Banks are much bigger investors in VC funds in Europe than those in the U. S.11 Since banks are typically conservative investors, this may partly explain the lower returns of European VC funds.
Turning to labour markets, the retention of highly qualified employees remains a problem in Europe. One reason is that VC activity in Europe took off much later than in the U. S., so there are fewer people with VC experience in Europe. Another reason is that compensation with stock options in the U. S. far exceeds what is offered in Europe, thus luring some talent from the old countries to greener pastures in America.
Those not familiar with the VC world are shocked to learn that its practitioners commonly regard people—not money or ideas—as the primary driver of VC success. It turns out that this piece of conventional VC wisdom is supported by academic studies on both sides of the Atlantic.12
Thus, improving the availability of postgraduate education in Europe, including executive education and professional training, is likely to enhance the performance of VC activity in Europe. Boot camps will also train entrepreneurs, including Seedcamp, the brainchild of Saul Klein, a partner at Index Ventures, perhaps the leading European fund for Internet investments.13
One dimension of the “people problem” that is not mentioned in the literature, and not discussed by practitioners, resonated with the VCs we interviewed in Europe. They agreed that the short supply of entrepreneurs in Europe is, in part, due to the high opportunity costs people incur in giving up the good life (relatively secure, well-paying jobs and safety nets) to strike out on their own as entrepreneurs.
If so, seed camps for entrepreneurs should focus on talented and committed people who have low opportunity costs. For example, entrepreneurs from countries such as Spain, Italy and Portugal, who come to Germany or Switzerland, experience lower opportunity costs than locals. European countries seeking to enhance VC activity would do well to allow immigration and work permits for entrepreneurs from non-EU countries as well. One of the VCs we interviewed in Switzerland has made this argument to the Swiss government by pointing out that most start-ups in Silicon Valley are run by immigrants, mainly from China and India, as well as from Europe.
Regarding the institutional environment, some practitioners and academics believe that, compared to America, VC activity in Europe suffers as a result of higher taxes on capital gains and less personal protection in case of bankruptcy.14 However, the VCs we interviewed in Europe had little sympathy for this line of reasoning because it did not fit their experience; it was seen as merely an excuse for the poor performance. Supporting their skepticism, one recent study found that neither differences in the legal environment (common law in the U.S., UK and Ireland versus civil law in other European countries) nor differences in tax regimes could account for the observed difference in VC performance in a statistically significant way.15
Differences in how VC firms operate in Europe and America
VC firms in Europe operate in a manner that is similar to VC firms in America (as described in our previous IBJ article), but there are important differences as well. These may be due to differences in the external environments of the VC firms in Europe vs. America as just described, and differences in culture and customs across the Atlantic.
In 2001, a survey comparing the practices of 104 VC firms in Europe with 67 American VC firms found that the former had a smaller percentage (38 percent) of early-stage investments in their portfolios than the latter (50 percent). However, the difference was greater for older VC firms (those established prior to 1997; 31 percent for Europe vs. 48 percent for America) than it was for younger VC firms (45 percent for Europe vs. 53 percent for America).16
Why these differences? The smaller percentage of early-stage investments in European VC firms may be due to a smaller appetite for risk and/or the relative paucity of skilled entrepreneurial talent in Europe. And the smaller difference for younger VC firms may be a signal that the gap with America is narrowing.17 As The Economist points out (June 12th 2010, p. 79):
Success breeds success: many American venture capitalists have run start-ups themselves. European ones tend to be bankers and lawyers with little operational experience and less appetite for risk. That is why they have focused on more mature companies rather than on young start-ups… And it is why Europe’s new angels are determined to focus on infant firms.
The survey just cited found other statistically significant differences. VC firms in Europe, when compared to their American counterparts, on average: (1) hold their investments for a longer period of time (3.6 years in Europe vs. 2.9 years in America), (2) use convertible securities—convertible debt and convertible preferred stock—less frequently (17 percent vs. 59 percent), (3) replace management less frequently (19 percent vs. 34 percent), (4) invest in their own region more frequently (60 percent vs. 46 percent), and (5) co-invest with other VCs less frequently (56 percent vs. 81 percent).18
This survey did not provide any statistical evidence on whether these differences are related to the differences in performance, because performance was not measured. However, the differences suggest that European VCs monitor their investments less and adopt a more hands-off approach than their American counterparts.19
Available theory predicts that these differences might lead to lower performance in Europe because: (1) longer holding periods for investments may signal a reluctance to cut unpromising ventures and “shoot the wounded”, (2) less use of convertible securities may indicate weaker control rights and less downside protection for the VCs, (3) less frequent replacement of management may imply greater patience with managers who are not performing, (4) a more regional focus may lead to missed opportunities elsewhere, and (5) less frequent co-investing may imply that the benefits from syndication are not being fully exploited.
We are aware of only one academic study that systematically measured the performance of VC investments in Europe vs. America and attempted to explain the difference in performance by analyzing a number of explanatory variables simultaneously in a statistically rigorous way.20 Using data for a sample of 147 European VC-backed companies and a comparable sample of 234 American VC-backed companies for the period 1997-2003, this study found that European VC firms strongly underperform their American peers because (1) they do not increase the funding flow to good performers in contrast to the Americans; (2) use syndication less effectively than American VCs, (3) are less specialized (not focused primarily on early-stage or later-stage investments), and (4) include fewer corporate investors.
Overall, these authors conclude, there is evidence that European VCs are less sophisticated than their American counterparts (in the sense that their behavior is not as closely aligned with what theory recommends) and that this at least partly explains the observed performance differential.
Our interviews with VCs in Europe along with the available academic research indicate that VC firms in Europe underperform their counterparts in America. Although they operate in a manner that is broadly similar to VC firms in America as described in our earlier article, there are important differences related to the different external environment in Europe vs. America and to the differences in culture and customs. VC firms in Europe perform poorly relative to their American peers because their skills and behavior are not as closely aligned with what theory posits is needed for high performance.
Younger VC firms in Europe have more in common with their American peers than do older European VC firms. This may signal that Europe is closing the gap in VC practice with America. And Europe has built-in advantages that could be leveraged to enhance VC performance. One such advantage is technology. For example, German Mittelstand companies manufacture a variety of precision-engineered products that command world-beating market shares, while the Swiss have leading edge chemical and food technology. Another advantage is diversity. As Danny Reimer of Index Ventures points out, “People from different countries are good in particular roles. Germans tend to excel at business development, Russians at developing software, the French at user interfaces.” As the Internet becomes dominated less by American tastes, he adds, European skills, for instance in design and branding, are becoming more valuable.21 European VCs should capitalize on these advantages even as they learn from their peers across the Atlantic.
- Andreas Oehler, Kuntara Pukthuanthong, Marco Rummer, and Thomas Walker, “Venture Capital in Europe: Closing the gap to the U.S.,” in Greg N. Gregoriou, Maher Kooli and Roman Kraeussl (editors), Venture Capital in Europe (Burlington, MA: Butterworth-Heinemann, 2007), Table 1.1, p. 6.
- For example, as Hege et al. point out, “…we obtain the same results when we calculate returns separately for the UK and for all other European countries. This ensures that the low performance of Europe, when compared with the US, is not driven by underperformance in a single country, the UK, that is so dominant in the European sample.” Reported in Ulrich Hege, Frederic Palomino and Armin Schwienbacher, “Venture Capital Performance: The Disparity Between Europe and the United States”, Revue de l’association francaise de finance, vol. 30, no. 1, 2009, p. 26.
- Oehler et al., op. cit., pp. 4-5.
- The figures reported by Oehler et al. (op. cit.) are much higher than those reported by Josh Lerner in Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed—and What to Do about It (Princeton, NJ: Princeton University Press, 2009), Figure 2.1, p. 26. According to Josh Lerner, “Often in Europe, the phrase venture capital is used to refer to growth equity and even buyouts as well. I suspect that this is the problem (the reason for the inconsistent findings). In my analysis, I did a very careful assessment to enable an “apples to apples” comparison globally” (email communication December 20, 2010).
- Consistent with Josh Lerner’s observation above, Hege et al. report that early-stage financing in Europe in 1999 at the height of the Internet bubble was 12 billion euros, roughly a quarter of what it was in the U. S. that year (op. cit., p. 1); and The Economist reports 2.2 billion euros in seed and start-up capital in Europe for all of 2009, roughly equal to what it was in just the first quarter of 2009 for the U. S. (June 12th 2010, p. 78).
- Lerner, op. cit., p. 123.
- Lerner, op. cit.
- Paul Gompers, “Optimal investment, monitoring, and the staging of venture capital,” Journal of Finance, Vol. 50, No. 5, 1995, pp. 1461-1489.
- Oehler et al., op. cit, p. 9.
- Hege et al., op. cit., found that VC returns in countries with more developed stock markets (higher ratio of stock market capitalization to GDP) were not greater than VC returns in countries with less developed stock markets (p. 29). They also state: “On the whole, our findings appear consistent with the notion that the underperformance in Europe is explained by much lower returns for poorly performing companies”, p. 34.
- One survey of 150 VC funds in Europe over the period 1998-2001 found that banks were investors in 44% of these funds: Laura Bottazzi, Marco Da Rin, and Thomas Hellmann, “The Changing Face of the European Venture Capital Industry: Facts and Analysis,” The Journal of Private Equity, Vol. 7, Issue 2, Spring 2004, pp. 26-53 (see Exhibit 8, p. 32).
- For America., see Dimo P. Dimov and Dean A. Shepherd, “Human capital theory and venture capital firms: exploring ‘‘home runs’’ and ‘‘strike outs’’, Journal of Business Venturing, Vol. 20, 2005, pp. 1–21. For Europe, see Bottazzi et al., op. cit.
- See “Briefing: Europe’s tech entrepreneurs” in The Economist, June 12th 2010, pp. 77-79.
- For a theory-based description of the influence of the institutional environment, see Garry D. Bruton, Vance H. Fried, and Sophie Manigart, “Institutional Influences on the Worldwide Expansion of Venture Capital,” Entrepreneurship Theory and Practice, November 2005, pp. 737-760.
- Hege et al., op. cit., p. 29.
- Armin Schwienbacher, “Venture capital investment practices in Europe and the United States,” Financial Markets and Portfolio Management, Vol. 22, 2008, pp. 195-217 (data on p. 203, 207).
- Bottazzi et al. also found that younger VC firms have more early-stage investments than older VC firms, and their investment styles more closely resemble peers in America (op. cit, p. 27).
- Schwienbacher, op. cit., Table 7, p. 210. These data provide a better apples-to-apples comparison than other data in this article because VC firms that had one-third or more of their investments in buyouts are excluded in Table 7.
- Based on their survey data, Bottazzi et al. question the view that VCs in Europe are less involved in monitoring their investments and more hands-off because 68% of the VCs sat on boards of directors of their portfolio companies, and 69% monitored the performance of their companies on a weekly or monthly basis (op. cit, p. 27). However, their survey did not include American VC firms so a comparison is not possible.
- Hege et al., op. cit.
- See “Briefing: Europe’s tech entrepreneurs” in The Economist, June 12th 2010, p. 77.