Milo Yiannopoulos explains why European venture capital has not traditionally yielded returns.
European venture funds have performed poorly over the past three decades, lagging behind both their American counterparts and the public equities markets. In fact, an investor in the average European fund would have lost 1.9 per cent annually over the last decade, contrasted against gains of 8.4 per cent a year in a US fund.
This consistent lack of performance raises the question: why would anyone invest in Europe? It was no surprise to learn last week that funds here are increasingly relying on government subsidies.
So I did some asking around. The first thing I learned is that looking at average returns is misleading. Industry returns cluster in the top-quartile or top-decile of funds, meaning only a few funds generate the bulk of returns. That said, even the top tier doesn’t perform in Europe, does it?
Why is that? Why has no major European venture fund returned even a relatively modest 4x to its investors? Without meaning to rub European VCs’ noses in it, let’s just remind ourselves that Kleiner Perkins Fund VII returned 32x. Their Fund VIII returned 17x. Market rumour is that Accel Partners IX will return at least 14x.
The simple explanation is that the European market stinks: the ecosystem isn’t viable. That’s the conclusion of the European Investment Fund and NESTA in The Performance and Prospects of European Venture (PDF) and Venture Capital: Now and After the Dotcom Crash (PDF). Even American VCs who move to Europe perform poorly.
Then again, Europe has produced multiple $1 billion+ successes. There are more in the pipeline. The winners that sit inside funds, such as Skype, MySQL and Qliktech, are all large, even by American standards. Shouldn’t that mean the funds invested in these companies perform like the top-tier U.S. funds?
Well, no. The problem, according to the VCs I’ve been speaking to, is that the successful European funds are simply too large. Large venture funds are not a viable option on the continent.
For a large fund of, say, $400 million, returning 4.0x to investors means returning $1.6 billion to investors, before fees and expenses. Given that a VC rarely owns more than 20 per cent of a business at exit, that would require investing in a set of companies that collectively add up to $8 billion in market cap.
Europe’s technology industry has generated $66 billion of aggregate market cap in the last decade, $73 billion if you factor in Russia. Consider that funds invest over three to four years. Can any fund capture 10-12 per cent of a decade’s worth of market cap in three years? Of course not. It does beg the question: why don’t more investors in European venture firms perform this simple market share calculation?
The situation is very different in the US. The last decade in the US saw $600 billion of market cap created. In 1999 alone, the best ever year for VC-backed IPOs, nearly $70 billion was generated. So it’s much easier for a large fund to operate in the US, where one start-up like Google or Facebook can reach $100 billion of market cap.
The largest market cap created in Europe was the IPO of Russia’s Yandex, a geography European venture firms have historically shied away from. Only relatively recently has, for example, Balderton Capital been investing significant time and resources in that market.
So why run a large fund in Europe? Partly, it’s tradition: Most current European firms were established in the dot com days, when large funds were common. But mostly it’s the fees, the opiateof the venture industry. You need only query Duedil to find the current fee income of the large funds: here’s Index, Accel and Amadeus, for starters.
If the average venture fund gets paid 2 per cent on fees, shrinking a fund from $400 million to $100 million means giving up a guaranteed, risk-free $60 million in fee income over a decade. Even for performance-driven funds, that’s a big give.
Here’s the second reason European venture loses money, articulated well by Peter Thiel. Most European venture capitalists pride themselves on so-called “good value” investing. The motto is: “manage the downside and the upside will take care of itself.” It’s a great investment philosophy for many investment classes. Unfortunately, it doesn’t work at all in venture capital.
Trying not to lose money, which is the way European venture so often seems to operate, is a recipe for sub-par returns. In venture, you need absolutely colossal upsides to make money for your investors. The 1998 IPO of eBay contributed nearly 25 per cent of the total returns generated by the VC industry over the previous 20 years.
Research has consistently shown that 12-15 winners a year generate almost all the returns in venture. Catching these winners are what venture firms are paid to do. That’s harder if you’re constantly worrying about downside, judging punts according to how likely they are to fail.
Of course, the difficulty is knowing what these winners look like at inception. But it’s easier to know what they don’t look like. Simply put, if venture firms invest in a start-up that only ever has the potential for a mediocre outcome, investing only drags down end returns to the fund.
This seems counter-intuitive, but consider that venture funds are only able to make a finite number of investments. If firms have only a 10 per cent chance of finding a blockbuster, how many investments do they need to confidently return 4x to investors?
To reach a 90 per cent confidence interval, simple probability says they need to make about 22 investments. Waste one of these investments on something that never has the potential to become a winner, and you’ve just lowered your probability of reaching success.
Here’s an online calculator that demonstrates the problem visually. Assume you’re gunning for a 4x return overall. Since things always go wrong in start-up land, assume also that a few investments return nothing. Notice how returns deteriorate rapidly. To make up for the zeros, the winner has to be pretty darned large to have any hope of making the fund good.
It’s mathematics so simple even a journalist can understand it.
The third reason venture struggles here is that, until about 2007, it was almost impossible for a European (or, to be honest, any non-Californian) start-up to become really big. Europe had a fragmented market. Growth meant an expensive country-by-country rollout, often competing with an American competitor.
California didn’t just have all the money. It also had all the early adopters and the talent base to scale rapidly. Even in enterprise, start-ups traditionally had an easier time selling to the New York offices of banks than to their London offices.
It wasn’t a fair fight, so it’s no wonder that firms like Apax and 3i, who were some of the earliest venture firms in Europe, pulled out of the asset class entirely to focus on private equity.
With the advent of Facebook and Apple’s App Store, and with over 2 billion people now online, it’s possible like never before to launch a product and see it achieve rapid traction. It’s a broadly level playing field for European start-ups: Badoo penetrated Turkey with no marketing spend, and acquired 30,000 users from a single press mention.
Playfish acquired customers all over the world. Soundcloud became an Alexa Top 100 site in less than four years, and currently claims 25 per cent of its users from the US, where most would probably be surprised to learn it is based in Berlin and not Silicon Valley.
This level playing field has even affected American companies. Dwolla managed to get the Silicon Valley digerati on board even though the company is based in Iowa. Groupon came out of Chicago. New York has become the second most vibrant technology market, only a decade after the collapse of Silicon Alley.
What does all this mean? Well, it means that the future’s actually very bright in Europe, if companies of sufficient quality can be found to invest in. But – and this is a fairly big but – only if VCs can temper their love of the high management fees that go with big funds and if they retrain themselves to look for winners, instead of avoiding losers.