David and Goliath: it is all about the (right) metrics.

16th February 2017  

Some thoughts regarding the European and American VC’s landscape. by Daniele Testa, Chief Analyst at U-Start

First, it was Sequoia’s pitch to support an early stage investment in YouTube. Then, it was “From 0 to 1” by Peter Theil, or Elon Musk’s new idea, be it Tesla or SpaceX. There has always been, and probably there will always be, a cool story to break the ice on the American venture capital industry.

About the U.S., we could say that “the market is 5 times bigger than the whole European landscape” and that “VC players close 3 times as many deals as the European ones”. We could also add that “the EU regulation, in the likes of Solvency II or AIFMD, has been too strict on Private Equity to allow a good return on capital”. Any side one looks at it, Europe seems to have a massive inferiority complex with respect to its stars-and-striped colleagues overseas. On several metrics, Europe is right when feeling like the little, unlucky brother of the VC family. One for all, Europe has a significant Series B gap with respect to the US, with a consequent and almost annihilating effect on Series D rounds.

Keeping in mind that launching a business in a new market is no different to the dining hall at school – first come, first served - it is easy to do the math: European companies need to cut growth, reduce expenses and become profitable. All this responsible, financially savvy management happens while their American competitors have deep pockets to invest in product and sales, enjoying market (world?) domination. The sad conclusion? Average M&A evaluation in Europe is less than half of that in the US, leaving on the table a significant amount of unrealized potential (and money).

Are we doomed? Brace yourself, Europe? No, not really. There is a light at the end of the tunnel, there is at least a metric on which Europe is outperforming the US. It is not precise and far from perfect, but still significant: from 2011 to 2015, the average ratio between venture fund exit value and capital commitments was higher in Europe than in the US! In practice, it looks like the unlucky brother, in the last 5 years, has delivered a significantly higher realized return on each dollar invested in VC, than the mature, developed, ecosystem-based US landscape.

Why so? Thinking as the unlucky brother of the VC family does, we could say it was just luck. Macro-economists instead will probably say that, given the extensive supply of cash in the US landscape, it is normal to have cycles of over-inflation that lead to lower-than-expected returns. Personally, I like to back Todd Hixon’s view of the VC environment in terms of waves. He underlined how the last wave of innovation was, and in part still is, around platforms: mobile device, social networking, peer-to-peer commerce. He also points out that new platforms drive innovation at the industry level, and Europeans are leaders in the industries where this innovation is likely to take place: car manufacturing, energy conservation and renewables, cyber-security, mobile technologies and pharma. For once, Europe seems to be in a good position to lead this new wave: it has the complementary technology, skill clusters, application experience and a critical mass of early adopters.

These new trends are showing in and have contributed to the KPI above, which pictures a 5 years period where European VCs have managed to master an art that comes from the very nature of their economic landscape: efficient management of a scarce resource, capital. It is possible that the European way to growth is not through a series B where profitability is two to three years away, but instead it is a way where growth is almost self-funded through healthy unit economics and wise use of proceeds. European VC players should learn from their more mature and developed US colleagues, but should not copy them blindly. Europe should embrace its differences and build an eco-system that is supportive of its own specific needs and features, for example, the scarce capital allocation to the VC asset class and the fragmentation of capital in smaller funds, as opposed to its polarization in bigger, late-stage oriented funds typical of the US. It is imperative to stop comparing the two environments on metrics where Europe will never lead, because of non-controllable, secular features like internal demand or structural financial allocation, and focus on the capability to produce liquid exits, the payday of the Venture Capital. There will always be an advantage of scale, but Europe have proven that returns can also be achieved through efficiency. And maybe, a track record of positive returns will lead to higher allocations that, if well managed, will bring a bigger share of Series B deals and so on, towards a more balanced landscape of funds, capable of unlocking growth at the global level for European companies, which will finally have the financial backing to stand American competitors, and a much healthier business model to beat them.

by Daniele Testa, chief analyst at U-Start