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Participation of Institutional Investors in European Venture Capital
CONTENTS
Section 1: Introduction 1
Section 2: Methodology 4
Section 3: Analysis 5
3.1. Risk/Return Profile 7
3.1.1. The perception that Buyout outperforms Venture Capital 7
3.1.2. Return dispersion 9
3.1.3. Perceived attractiveness of U.S. over European VC 11
3.2. Internal Limitations 17
3.3. Public Policy and Regulation 22
Section 4: Conclusions 25
1
Section 1: INTRODUCTION
Private Equity refers to investments in companies which are not listed on the stock exchanges, or in other words, private companies. As of June 2017, overall Private Equity Assets Under Management (AUM) reached $2.8tr. Within Private Equity, two strategies comprise around 80% of the asset class, Buyout with 58% and Venture Capital with 22% ($621bn in VC AUM in June 2017).1
As shown in Figure 1.2, fundraising in VC has grown consistently in the last few years reaching circa $90bn in 2018, an all-time record.2 This significant growth goes hand in hand with two main factors: a great performance of the Tech Sector, which can even be seen looking at public markets (74.04% return by NASDAQ compared to 44.66% return by S&P 500 in the last 5 years), and an increasing allocation from investors to alternative assets (due to the low correlation to public markets and the potential to enhance returns).
1 Source: “Global Venture Capital and Private Equity 2018”, Preqin
2 Source: “Venture Pulse: Q1’2019 Global analysis of venture funding”, KPMG
Buyout
Figure 1.1:
Private Equity AUM by Strategy,
June 2017 (%)
Venture Capital
Growth
Others
58%22%
14%
6%
Figure 1.2:
Global Aggregate Annual VC
Fundraising ($bn)
80706050403020100
2010 2011 2012 2013 2014 2015 2016 2017 2018
90
2
Despite high growth in AUM, the capital raised is not evenly distributed amongst all regions. When comparing Europe to the United States, areas with similar economic size, we see that between 2010 and 2018, European Venture Capital funds received on average three and a half times less capital than their counterparts in the U.S. (Figure 1.3).3
There are several factors contributing to the significantly lower VC fundraising in Europe. In this paper we will concentrate on one: the low participation of European Long-Term Financial Investors4 (LTFI) when compared to the American peers.
Figure 1.4 provides a breakdown of the contribution of different investor types to the total fundraising in the U.S. during the 2012 - 2016 period ($158bn). Over half of the capital (55%, $87bn) was committed by Long Term Financial Investors. The remaining $71bn came primarily from High Net Worth Individuals (HNWIs) (17%, $27bn) and Government related Agencies (10%, $16bn).
3 Source: “Venture Pulse: Q1’2019 Global analysis of venture funding”, KPMG
4 Long Term Financial Investors include Pension Funds, academic institutions, endowments, banks, insurance companies and sovereign wealth funds
Long-Term Financial Investors
Figure 1.4:
LP base composition in the U.S.
2012-2016 ($bn)
Family Offices & Private Individuals
Government Agencies
Other
55%17%
10%
18%
60
50
40
30
20
10
02010 2011 2012 2013 2014 2015 2016 2017 2018
Figure 1.3:
Annual Fundraising in US, Europe
and Asia ($bn)
US Europe Asia
3
The situation is very different in Europe. As shown in Figure 1.5, Long-Term Financial Investors provided only 27% ($13bn) of the total $48bn raised. In absolute terms, this represents a contribution of LTFI to European VC of only 15% of what was committed to U.S. VC. This gap has been partially covered by the relatively larger participation from Government Agencies in Europe (23% vs. 10% in the U.S.). Nevertheless, in absolute terms, Government related Agencies in Europe contributed close to 69% of what it was in the US.5
To further illustrate this difference, we may consider Pension Funds, which are the largest investors considered in this category. Figures 1.6 and 1.7 illustrate the assets under management of U.S. and European Pension Funds and their respective commitments to VC Funds.6 As seen, U.S. Pension Funds manage ~2.7 times more capital than the Europeans, while the difference in VC commitments is more than 11 times.7
5 Source: “The State of European Tech 2017”, Atomico
6 Pension Funds’ assets under management are based on the data from OECD (as of 9 May 2019)
7 Calculated based on information from Figure 1.3, 1.4 & 1.5. For U.S., $158bn raised out of which 20% came from Pension Funds. For Europe, $48bn raised out of which 8% came from Pension Funds
Long-Term Financial Investors
Family Offices & Private Individuals
Government Agencies
Other
Figure 1.5:
LP Base Composition in Europe
2012-2016 ($bn)18%
27%
23%
32%
US Europe
10
20
5
10
0
0
15
30
20
40
US Europe
Figure 1.6:
Pension Funds’ AUMs,
Europe vs. U.S. (2017, OECD) ($tr)
Figure 1.7:
Aggregate amount of committed
capital to VC by Pension Funds,
Europe vs. U.S. 2012-2016 ($bn)
4
Section 2: METHODOLOGY
This report is based on publicly available information combined with both the direct experience of Axon Partners Group and primary research conducted specifically for this paper. Primary research was performed in two phases:
The first phase consisted of a large-scale survey, distributed to three key stakeholder groups in Europe: Long Term Financial Investors (primarily Pension Funds, Insurance Companies and Asset Managers), General Partners across Europe, and Placement Agents. The purpose of the survey was to collect basic information from LPs regarding their participation in VC, such as: allocation to PE, allocation to VC, allocation to European VC and their attitude towards the asset class.
In the second phase, we conducted a series of interviews with some of the participants to gain insights into the reasoning behind each survey response. As a result, we were able to deconstruct the limitations into specific concerns faced by investors when considering allocating capital to VC funds.
During the final step of our process, we revisited each of the underlying issues to verify their validity based on our findings and publicly available information.
5
The survey performed by Axon Partners Group has confirmed that European Long-Term Financial Investors are not highly active in Venture Capital, or even Private Equity as a whole. Specifically, the survey found that among the European institutional investor respondents, less than 10% had an allocation to Private Equity of 5% or more. Our findings are consistent with both the data collected in our Fund of Funds experience, as well as with the information presented by Preqin regarding the median allocations of Institutional Investors to PE asset class.
As shown in Figure 3.1, the median allocation to Private Equity in the U.S. is 6.1%, which is significantly higher than 3.9% in Europe.8 If we consider median target allocations in Europe and the U.S., we are also able to see investor sentiment towards the asset class. Both regions are looking to increase their investments into the asset class, but on a different scale. In the U.S., the median target allocation is 10% of the overall AUM, while in Europe it is only 5%.
In the survey, participants were also asked to specify their allocation to VC as a percentage of their overall PE allocation. We found that more than 1/3rd of the participants currently have an allocation to Venture Capital of less than 1% of their PE Allocation. To put these numbers in perspective, we may
8 Source: “2019 Preqin Global Private Equity and Venture Capital Report”, Preqin
No. of Investors
Median Current Allocation
Median Target Allocation
Figure 3.1:
Institutional Investors in PE:
Number and Median Current and
Target Allocations
(as % of Total AUM)
Section 3: ANALYSIS
6
consider a hypothetical case of a pension fund with €50bn in Assets Under Management. If we consider the European average provided by Preqin for the PE allocation (3.9%), this hypothetical pension fund would have an allocation to PE of ~€1.95bn. To estimate the VC allocation, we may take the 1% allocation to VC as a percentage of PE allocation provided in the survey, resulting in a €19.5m allocation to venture capital. Thus, such allocation (€19.5m to VC out of €50bn AUM) can hardly be considered as a long-term strategic and systematic investment plan, but rather as a sporadic internal initiative. As it will be explained in later sections of this report, such a negligible proportion of investment in VC is not only suboptimal but also incorrect due to the inherit need for diversification that is necessary to make the asset class investable for LTFIs.
In addition to the quantitative allocation data collected in the survey, the respondents were asked to specify the main reasons behind their low allocation in VC. The two main problems stated by investors were the perceived low risk/return profile of VC, and Internal limitations (Figure 3.2). Regulation, also covered in this paper with a contribution from Invest Europe, was another relevant topic mentioned by some institutional investors, but to a lower extent and mostly in the case for insurance companies.
These findings were validated and further deconstructed through interviews with the respondents. During the interviews, each respondent was asked to provide reasons for their answers to the survey, as well as some basic information about their firm. In addition, each interviewee was invited to share their thoughts about Venture Capital as an asset class and the current opportunity in Europe.
Despite a generally increasingly positive outlook on the asset class and the recognition of the current relevance of the technology sector, when asked to elaborate on the reasoning behind their perception of an inadequate “Risk/Return Profile” for VC, investors typically mentioned that VC returns were lower than in Buyout and that VC had a much higher dispersion of returns.
Risk/Return Profile
Internal Limitations
Regulations
Other
Figure 3.2:
Survey response Distribution
10 20 30 40 500
7
Some investors also manifested that in their view, the U.S. represented a better investment opportunity than Europe. In terms of “Internal Limitations”, investors responses mostly referred to the fund size/minimum ticket size problem. Moreover, when GPs were asked about their experience approaching institutional investors, they answered that these institutions in Europe currently did not have an active allocation to the asset class and that normally their proposals were discarded without getting into the analysis. Investors did not consider regulation to be a strong factor limiting their ability to invest in VC at this time (probably due to the low investment levels). However, several participants, especially insurance companies, mentioned that regulation also presents some limitation related to the capital consumption required to invest in VC. Each of these topics will be further broken down in the following sections.
3.1. RISK/RETURN PROFILE
The perceived low risk/return profile was the number one reason among all survey responses and represents the biggest concern institutional investors have when considering investments into the asset class. To understand whether the Risk/Return profile is as unfavorable as perceived by the investors, we take a deeper look at the historical of returns and dispersion.
3.1.1. The perception that Buyout outperforms Venture Capital
The first point may be summarized by a quote from one of the interview participants: “On average Buyout funds outperform VC funds”. To validate the overall perception that buyout outperforms VC, as a first step, we analyzed the returns data provided by Pitchbook illustrated in Figure 3.3 and 3.4.9
9 Source: “PitchBook Benchmarks private markets data (as of 2Q 2018)”, PitchBook
0%
5%
10%
15%
20%
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Figure 3.3:
Median Returns
(IRRs by Vintage) Buyout vs. VC
Buyout VC
8
Looking at the data, it is evident that Buyout, on average, has indeed provided slightly higher median returns than VC during the 2005-2016 period (11.49% vs. 9.91% respectively). Nevertheless, it is important to mention that on average the difference between the two was only 158bps and that the main difference was observed in the period 2005-2009.
Although median return is an important indicator of general performance of any asset class, it does not tell the full story for VC. As seen on Figure 3.4, top quartile VC funds indeed outperformed buyout funds over the same period (18.51% and 17.79% respectively). This is even more evident when considering top decile returns, where VC funds achieved 282bps higher average returns than buyout (28.09% and 25.26% respectively).
Considering that the market has always been skeptical of performance statistics published by data providers (as they rely on information provided by the fund managers), we decided to validate performance using and additional source.
In a recently published paper by Brown, Harris, Jenkinson, Kaplan, Robinson and Hu titled “Can Investors Time Their Exposure to Private Equity?”, the authors explored the effect of various Private Equity capital allocation strategies on returns. To perform this analysis, the researchers used data from the portfolio management software Burgis, which collects real data directly from Limited Partners investing in PE funds (net cash flows to investors). Using this data, the authors were able to perform retrospective analysis of VC and Buyout performance with different simulated investment strategies, such as “Fixed Annual Commitment”. In this strategy a hypothetical investor commits a fixed amount to either purely VC or Buyout funds on an annual basis between 1987 and 2013 (data through 2016 on 3000 funds). Interestingly, with a fixed allocation and based on real returns obtained by investors who use Burgis, the
Buyout VC
30%
25%
20%
15%
10%
5%
0%
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Figure 3.4:
Top Quartile Hurdle Rate
(IRRs by Vintage) Buyout vs. VC
9
VC simulated portfolio would have achieved significantly higher returns than a Buyout one (29.1% IRR and 16.5% respectively).10
Based on the performance presented by both sources (data providers and real LP data from Burgis) it is fair to conclude that the perception of LPs regarding VC underperformance when compared to Buyout is not well supported. In fact, according to the data provided by Burgis, an investor with a well-diversified VC portfolio built with a fixed annual allocation between 1987 and 2013 would have obtained a significantly higher return than with a Buyout portfolio. As we will describe in the following section, diversification is a key consideration when investing in VC.
3.1.2. Return dispersion
Return dispersion was the second major concern referred to by many investors in the context of VC risk/return profile. To validate this point, once again, we analyzed publicly available data from PitchBook Benchmarks. As seen in Figure 3.5, VC standard deviation of returns is larger than in Buyout (15.84 and 13.64 respectively).11 Considering the limitation described in section 3.1.1. that data is provided discretionarily by fund managers, the return dispersion in VC might be underestimated (since underperforming funds do not have incentives to disclose track record and considering that losses of not performing VC funds are larger than in buyout).
To further understand the nature of VC return dispersion, it is interesting to see the upside potential mentioned in the previous section. Research performed by Cambridge Associates, illustrated in Figure 3.6, shows that Venture Capital has
10 Source: “Can Investors Time Their Exposure to Private Equity?” (Brown, Harris, Hu, Jenkinson, Kaplan, Robinson)
11 Source: “PitchBook Benchmarks private markets data (as of 2Q 2018)”, PitchBook
Figure 3.5:
Standard deviation of returns,
VC and Buyout5%
10%
0%
15%
20%
25%
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Std Buyout Std VC
2016
10
a 33% average return dispersion from median to the 5th percentile, higher than any other Alternative Strategy. It is also apparent that returns are not distributed evenly across the spectrum. The chart shows that the top 5% of funds are significantly further from the median than the bottom 5%. This may be explained by the fact that VC asset class is heavily reliant on the right-hand tail of the distribution to boost returns, even more so on the individual fund level.12
Furthermore, a simulation performed by Brown, Harris, Jenkinson, Kaplan, Robinson and Hu shows the effect of diversification on a portfolio of randomly selected funds (N=1,3,5,7,15,30) of different vintages for Buyout and VC, as well as their respective return distribution in terms of PMEs. The results of the study are presented in Figure 3.7.13
12 Source: “Private Investing for private investors”, Cambridge Associates
13 Source: “Can Investors Time Their Exposure to Private Equity?” (Brown, Harris, Hu, Jenkinson, Kaplan, Robinson)
0%
10%
20%
30%
40%
50%
Absolute Returns
-10%Hedge Funds
Global Real Estate
Global PE Global VC
Q4 Q3 Q2 Q1
Figure 3.6:
Alternative Asset Strategies
dispersion from median to 5th
percentile (%)
1.00.8
Figure 3.7:
Distribution of portfolio PMEs,
Buyout vs. VC
0
00.4 0.6 1.2
5
10
15
Dens
ityDe
nsity
VC
Buyout
1
2
3
4
5
1.4 1.6 1.8 2.0 2.2 2.4
1.00.80.4 0.6 1.2 1.4 1.6 1.8 2.0 2.2 2.4
1 fund 3 funds5 funds15 funds 30 funds
7 funds
1 fund 3 funds5 funds15 funds 30 funds
7 funds
11
As seen, simulated buyout portfolios have a significantly lower dispersion of returns than VC portfolios. In Buyout, adding funds to the portfolio does not significantly improve the median performance but rather increases the density of the distribution. Notwithstanding, adding funds in a VC portfolio improves the median performance, as well as lowers the return dispersion.
From this analysis, it is clear that return dispersion is a major challenge when investing in VC. However, the diversification benefit is significantly higher in VC than in Buyout, concluding that a well-diversified portfolio is essential to invest in VC in a professional manner.
3.1.3. Perceived attractiveness of U.S. over European VC
“Whenever we have considered the idea of increasing our allocation to VC, the U.S. market has been our target geography as it has the most mature VC industry. However, in the U.S. it is very challenging to access top tier funds. This situation has limited our appetite for the asset class”, said one investor when asked for the reasons for their current low allocation to VC.
It is true that historically the U.S. has been the reference market for Venture Capital; able to create the first generation of successful global tech companies and to attract the largest proportion of VC funding in the world. As of today, despite the increasing relevance of the Asia-Pacific region, U.S.-based companies are still receiving over half of the total VC financing (Figure 3.8).14
The American market has seen very successful tech companies such as Microsoft, Apple, Google and Facebook; all of them initially VC-backed and now tech leaders delivering strong returns to investors. The robust performance of the U.S. VC market can be observed in Figure 3.9.15 As shown, the U.S.
14 Source: “Venture Pulse: Q1’2019 Global analysis of venture funding”, KPMG
15 Source: Cambridge Associates for 30/06/2017
0%
20%
40%
60%
80%
100%
2014 2015 2016 2017 2018
Figure 3.8:
Financing of VC-Backed
companies by region
Americas Europe Asia
12
has delivered higher returns than Europe looking at 20-, 15- and even 10-year horizons.
This pattern, however, has changed with time. Considering the horizon returns for the last 5-, 3- and 1-year time periods, it is evident that European Funds have catch-up and even outperform the U.S.
One of the key drivers that has supported this strong performance of European VC funds is the undeniable growth of the European VC ecosystem. European VC funding increased at a compound annual growth rate of 25.6% over the last 5 years, and annual funding reached an all-time record of €27.8bn in 2018 (Figure 3.10).16
This consistent funding growth has allowed European tech companies to grow and develop faster and bigger than ever before. Now and for the first time in history, Europe is home to some of the world’s current leading tech companies. Skype, Spotify, Skyscanner, Just Eat, and Asos are only some of Europe’s biggest success cases that revolutionized their respective industries at a global level.
16 Source: “2019 Preqin Global Private Equity and Venture Capital Report”, Preqin
0%
10%
20%
30%
1 year 3 year 5 year 10 year 15 year 20 year
US VC Index ($) European Developed VC Index (€)
Figure 3.9:
Pooled Median IRR VC Index
30%
25%
20%
15%
10%
5%
0%2013 2014 2015 2016 2017 2018
8.9
12.9
18.5 19.9
25.827.8
Figure 3.10:
Venture Capital Investments in
Europe by year (€bn)
13
The success of European VC is not limited to these select companies. In fact, the number of $1bn-companies in Europe increased exponentially in the past years with an average 40% annual growth. Similarly, since 2010, the number of tech companies has grown 16 times, from 7 companies to more than 110 in 2018 (Figure 3.11).
The growth of VC investment in Europe along with the resulting success of European startup companies (illustrated by the number of new +$1bn companies in Europe), provides an interesting insight into the relationship between availability of financing and startup success.
Nonetheless, despite delivering superior returns compared to U.S., the significant growth in funding, and the increasing capacity to create successful tech companies, Europe still attracts less than 15% of global VC funding (Figure 3.8).
In Axon’s view, there is still a large an obvious financing gap in Europe, which can be quantified by comparing VC investments in relation to GDP in the U.S. and Europe.
0
20
Up to 2010
40
60
80
100
120
Up to 2014 Up to 2018
Figure 3.11:
Number of tech companies with
valuation over $1bn
US Europe
10
8060
5
4020
0
0
15
120100
20
US Europe
Figure 3.12:
GDP per Region in 2018 (€tn)
Figure 3.13:
Financing per Region in 2018
(€bn)
25
140
14
As seen in Figures 3.12 and 3.13, despite the similarity in size of the European and the U.S. economies in terms of GDP (€21.0tr and €20.5tr respectively), the amount of funding received by European tech companies is significantly lower.17 In fact, European tech companies received only €28bn in financing during 2018, whereas in the U.S. based companies have attracted nearly €131bn.18 This represents a 4.7x difference in capital available to tech companies between the two regions of several size.
In our view, this funding gap is directly related to the superior performance of European VC funds versus U.S. ones, and should be considered as an opportunity in the medium/long-term. Moreover, important socioeconomic changes such as the closing experience gap between U.S. and European managers, important support from the public sector, high level of talent and rise of European serial entrepreneurs, as well as the slow but increasing acceptance of the asset class by European investors, contribute to Europe’s superior performance. We believe that the current opportunity for Europe will prevail in the coming years, as the conditions are becoming only more favorable for investors.
To understand the current funding gap in more detail, we analyzed two major VC sectors, ultimately comparing the situation in the U.S. and in Europe: Life Sciences and DeepTech.
Example 1: Life Sciences Funding
With the world population growing consistently and the life expectancy increasing every year, Life Sciences became a vertical attracting much attention from Venture Capital funds globally. Despite many of the global MedTech and Pharmaceutical companies being based in the U.S., Europe is well known to be on forefront of medical innovation.
As seen in Figure 3.14 and 3.1519, Europe and the U.S. generate very similar number of patents related to Life Sciences; nevertheless, the amount of capital raised by Life Sciences funds in Europe is significantly lower. Even though the number of new patents is increasing consistently in both regions, the capital raised in Europe has not seen much growth. Life Science funds in the U.S. received on average twice as much committed capital as their European peers between 2010 and 2013, in fact, the gap widened significantly between 2014 and 2016.
17 Source: OECD Data
18 Source: Dealroom data as of 10/04/2019
19 Source: EY, World Intellectual Property Database, IATI report 2018, OECD
15
20
0
10
30
40
50
2010 2011 2012 2013 2014 2015 2016
EuropeUS
Figure 3.14:
Life Sciences related patents by
region (thousands of Patents)
4
0
2
6
8
10
2010 2011 2012 2013 2014 2015 2016
EuropeUS
Figure 3.15:
Amount raised by funds in Life
Sciences by region (€bn)
Example 2: Deeptech
The U.S. has historically been more active in the field of deep technology innovation, creating a higher number of companies per year when compared to the European region. Nevertheless, it can be observed that in recent years, Europe has thrived with DeepTech companies, closing the gap with the U.S. in terms of the number of companies created every year.20 Concretely, the number of European DeepTech startups founded between 2014-2016 almost doubled compared to the 2011-2013 period (Figure 3.16).
20 Source: “The state of European Tech”, Atomico
Europe US
490
950
687
125294% increase
Figure 3.16:
DeepTech start-ups founded
since 2011 (Cumulative # of
Companies)
16
Nonetheless, notwithstanding the growth and quite similar amount of DeepTech companies created yearly in Europe and U.S., funding in both regions again looks very different.
Figure 3.17 shows how DeepTech funding in Europe is still far below the U.S. In 2018, U.S. DeepTech companies raised €28.3bn, while European peers only manage to raise €6.7bn, 4.2 times less capital.21
Interestingly, even with lower funding, European DeepTech companies were able to achieve an aggregate value of VC-backed exits of €19.4bn while the U.S. companies generated an exit value of €32.1bn in 2018. This represents only 1.7x difference in created value, despite the 4.2x difference in funding (Figure 3.18).22
21 Source: Dealroom
22 Source: Dealroom
Figure 3.18:
DeepTech Exits in Europe & U.S.
in 2018 (€bn, %)
Europe Exit Value
US Exit Value32.1, 62%
19.4, 38%
Figure 3.17:
DeepTech Funding in Europe &
U.S. (€bn, # of Deals)
0
5
10
2013
15
20
25
30
0
500
1000
1500
2000
2500
3000
2014 2015 2016 2017 2018
Europe FundingUS Funding
Europe # of DealsUS # of Deals
17
3.2. INTERNAL LIMITATIONS
Internal Limitations was the second largest restriction mentioned by the respondents when addressing the ability of investors to increase their allocation to VC. This restriction refers to limitations that institutional investors face when considering investments in VC. During the interview stage we were able to further break down this restriction into two highly connected limitations: first, the minimum ticket size requirement that most large institutions have, and second, the resulting lack of dedicated allocation and teams focused on the analysis of VC opportunities.
“We have seen a couple of good VC opportunities before; however, it generally doesn’t make sense for us to invest much time into looking at them in detail. Most of the time the VC funds are around 100-150 million and, at most, we would be able to invest in a fund like this is 10-15 million. These opportunities take just as much, if not more, time than traditional Buyout funds we typically invest in, where we can put a 50-100 million ticket. How you manage your resources really becomes a problem when you need to manage a 20 billion portfolio”, shared with us a Portfolio Manager at a large LTFI.
18
The concern described above, is the first major internal limitation mentioned by several respondents during the interview stage. More precisely, it refers to the lack of scale normally observed in VC opportunities, making it harder to meet the standard requirements of large institutional investors. This limitation comes from two interconnected required conditions: first, the minimum ticket size that these institutions have which typically prevents any investment below 30-50 million; and second, is the maximum stake these institutions can take in any given fund (typically ~10%). The combination of these constraints excludes any potential investment in any VC fund bellow € 300-500 million and thus excludes the vast majority of European VC funds which typically are in the € 100-200m range.
The second internal limitation was mentioned by several VC fund managers during the interview stage and was later also confirmed by LTFIs. One fund manager summarized the current situation as follows: “Most European Institutional Investors don’t have a dedicated allocation to VC and don’t generally invest in the asset class. Even when they begin to consider the opportunity, it is often clear that investing in VC is not a priority. For them it is much easier to keep on investing large tickets in well-known Buyout funds instead of searching for the good VC funds to invest 5-10 million at a time.”
For many years, fixed income and public equity assets were the main investment options for institutional investors, comprising approximately 90% of AUM in 2000. However, after the financial crisis, institutional investors started to invest more in non-traditional asset classes such as private equity and real assets, largely due to decreasing yields on fixed income and high volatility of the public markets at the time. In the U.S. this has caused a significant increase in both Buyout and VC investments, in Europe on the other hand, most of the capital went into the buyout funds due to the much lower relative maturity of the European VC in 2008-2009. Between 2009 and 2018 buyout funds were able to produce great returns for their investors, aided among other factors, by the low interest rate environment. Consequently, over the last 10 years European Institutions continued to increase their allocation to buyout, build specialized teams and gain expertise in the asset class. This allowed them to further boost their buyout portfolio returns through more sophisticated investment techniques such as co-investments, and even some direct investments. However, as time and resources are limited, such a strong focus on one strategy has led many institutional investors to neglect other alternatives such as VC (Figure 3.19).23
23 Source: “The State of European Tech 2018”, Atomico
19
0
40
80
120
Buyout
104
2
Figure 3.19:
Pension Fund investments in
European Buyout and VC,
2013 – 2017 ($bn)
VC
Looking at the two limitations addressed by the survey and interview respondents, it is clear that both are a result of LTFI’s need for effective use of time and resources. However, as it became clear through the interviews with VC fund managers, current low LTFI allocation to VC in not only driven by administrative and efficiency related reasons, but also reflects investor’s view on the asset class. As covered in Sections 3.1.1 and 3.1.2., the view of European LTFIs on the asset class is based largely on outdated assessments of VC performance, return dispersion and lower relative maturity of European VC versus the U.S.
It is undeniable that after the financial crisis an increase in buyout allocation over VC was a logical choice in Europe based on the market reality at the time. Nevertheless, it is important to note that these decisions were made 10 years ago, and the European VC ecosystem has changed drastically since then. Moreover, as explained in Section 3.1., European VC currently presents a great opportunity for investors and in fact European returns are outperforming the US in the last years. As such it is fair to say that the current approach of analysts toward the asset class, although justified by internal policies and limitations, do not fully reflect the current opportunity and state of European VC.
To conclude, the internal limitations described above are indeed a serious factor negatively affecting investor’s ability to increase their VC allocation, primarily due to the small size of European VC funds. This is now changing as some of the most experienced and best performing European VCs are able to raise larger funds one generation to the next. However, the gain in scale is a gradual process that requires some time due to the long lifecycle of VC funds. On the investor side, it was promising that many of the interviewed LTFIs recognized the importance of gaining exposure to the tech sector as it is essential for the long-term success of the overall portfolio in the 21st century. Nevertheless, it is clear that the only way to increase the allocation of LTFIs to VC is with the conviction
20
2013
10.0%
13.7%
16.3% 16.2% 17.1% 18.0%
2014 2015 2016 2017 2018
Figure 3.20:
VC as a percentage of Yale
Endowment Portfolio
of top management needed to implement specialized investment programs and to construct dedicated teams to analyze this opportunity.
As shown in the case study below, large LTFIs in the U.S., such as the Yale Endowment, already have a significant allocation to VC. Having a dedicated allocation to VC and a specialized team has allowed them to excel in the asset class by managing it in a professional way. In the case of Yale, it has allowed the endowment to significantly outperform all of their direct peers, such as MIT and Stanford.
Example 3: The Yale Endowment
The Yale endowment is among the most active VC investors in the world, especially relative to its size. In 2018, their allocation to VC has reached 18% of the overall AUM, or $5.22bn out of $29bn (Figure 3.20). VC has also significantly outperformed the rest of the portfolio, delivering 24.6% 20-year time weighted return.24
Yale wasn’t always as active in Venture Capital as it is now. Although first investments into VC funds were made as early as 1976, they were nothing more than opportunistic bets. However, in 1985, when David F. Swensen took over the fund’s management, building a VC portfolio became a strategic decision passed from the very top. In 2015, VC even became a separate line in Strategic Asset Allocation (SAA) of the Endowment (Figure 3.21).25
24 Source: Bloomberg
25 Source: Yale Annual Reports
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As seen in Figure 3.22, the Yale Endowment has indirectly supported some of the largest tech success stories in the world through its VC fund investments.
Furthermore, in June 2018, the Endowment has further increased its allocation to VC to 19% as a part of their tactical allocation aimed to decrease the impact of market fluctuations on the overall portfolio.
Direct Investment Indirect Investment
Figure 3.22:
Sample of Yale endowment
investments
Absolute Return 26% Real Estate 9.5%
Venture Capital 18% Bonds and Cash 6.5%
Foreign Equities 15.5% Commodities 6.5%
Leveraged Buyout 15% Domestic Equities 3%
Figure 3.21:
Yale Strategic Asset Allocation
targets for 2015
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3.3. PUBLIC POLICY AND REGULATION (By Michael Collins, CEO of Invest Europe)
All investment strategies and all methods of business finance and development are shaped by public policy. While several factors are driving change in VC (the growing preference of investors for all forms of alternative assets; the realized returns that European VC is able to demonstrate) it is clear that public policy has also played an important part.
Under the Capital Markets Union (CMU) banner, the European Commission has explicitly recognized the contribution that private capital, including venture capital, can make to financing European businesses, and particularly those start-ups and SMEs that are at the heart of the EU economy.
The CMU initiative recognized from the outset the need to improve cross-border flows of capital, to provide European businesses with a more diverse range of funding options - reducing their reliance on banks – and to promote a greater use of equity finance.
Consistent with this, a number of the initiatives that have been put in place to deliver the goals of the CMU have explicitly been directed towards the encouragement of greater VC activity in Europe and in particular towards promoting an increase in the commitment of private capital to the sector.
Foremost amongst these initiatives is VentureEU – a scheme conceived with the specific intention of using public money to attract private investment. By appointing private sector fund-of-funds managers and providing them with
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significant cornerstone investment to support additional fundraising from private sources, the European Commission has shown a welcome willingness to innovate.
As a complement to the intelligent use of public money, the encouragement of private (and cross-border) investment into European venture capital funds also depends heavily on the regulatory regimes under which both venture capital fund managers and prospective limited partners operate.
In order to facilitate fund managers in their cross-border fundraising within Europe, two initiatives have been pursued during this mandate:
• Cross-border distribution of funds:
- Introduced a new, harmonized definition of and conditions for pre-marketing under both AIFMD and EuVECA, recognizing the specific VC fundraising model
- Streamlined conditions for de-notification, making it easier and cheaper for a manager to stop marketing in a country
- Limitations on host fees and charges levied on AIFMD-authorized managers
• EuVECA - review of the passport regime:
- More flexible eligibility requirements: 70% of investments in companies with up to 499 employees
- Opportunity for AIFMD-authorized managers to market qualifying funds under the EuVECA label
- Prohibition of unjustified host fees and charges
While it is still too early to assess the impact that these measures will have on the appetite of European VC managers to increase their cross-border fundraising, they provide an encouraging indication of the willingness of the EU institutions to promote such activity.
The next European Commission is expected to return to these issues as it reviews the Alternative Investment Fund Managers Directive (AIFMD), the EU Venture Capital Regulation (EUVECA), and the European Long-Term Investment Fund (ELTIF) Regulation. In their different ways, all three of these measures will determine whether European venture capital can continue in its efforts to become more cross-border in its scope and it is to be hoped that the Commission (and the Council and Parliament) will see these reviews primarily as instruments to facilitate more of such activity.
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EU (and to some extent member state-level) regulation also impacts heavily on the supply of private sector capital to venture capital funds.
Large institutional investors such as insurance companies or Pension Funds are subject to an extensive set of regulatory obligations, often designed to ensure the long-term health of the business (particularly if its failure could have financial stability implications) and to protect customers.
These rules influence the asset allocation decisions that such investors make. By ascribing a certain level of risk to investments and requiring volumes of prudential capital to be held against those risks, such regulation can shape investment decisions.
Given the scale of the capital managed and allocated by these institutional investors, changes to the regulatory regimes under which they operate have the potential to impact significantly on their interest in supporting venture capital.
During the mandate of this European Commission, investor regulation has been broadly positive for institutional investors’ appetite for venture capital:
- Insurers (Solvency II): reduced risk charges for investments in equities held in EuVECA, ELTIF and any closed-ended and unleveraged funds (39% instead of 49%); and significantly reduced risk charges for investments in portfolio meeting the conditions to be deemed long-term (22%)
- Pension Funds (IORPD): no capital requirements introduced as part of 2015 review
- Banks: no ban on banks’ investments in VC (Banking Structure Regulation (BSR) withdrawn); a clear distinction has been introduced between investments in “VC firms” and investments in funds (including VC funds)
At the same time, there remains a concern that regulatory requirements and supervisory interpretation and application of those requirements still does not accurately capture the risk that institutional investors face when investing in venture capital (or other forms of private equity), with the risk that the sector is denied access to capital.
The next Commission is likely to return to this debate, not least with the comprehensive review of Solvency II that is scheduled in next couple of years. Without jeopardizing financial stability or consumer protection, the EU Institutions can – and should – approach this review with the express intention of encouraging insurance companies to increase their allocations to venture capital.
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Throughout this paper we have investigated, described and challenged some of the key reasons behind the low participation of European LTFIs in the European VC asset class. It can be said with certainty that European institutional investors are far less active than their US peers not only in Venture Capital but in Private Equity as a whole. According to the data provided by Preqin, the overall PE allocation is not expected to increase significantly in the medium/long term, as target allocation in Europe is only 5% of the overall AUM of institutional investors, which assumes a 28% increase from today’s current allocation. In the U.S. on the other hand, the overall PE target allocation is set at 10%, which represents a 64% increase of LTFIs investments. When it comes to VC, this difference is even larger as US LTFIs are far more active than their European peers.
By conducting surveys, interviews, and research based on public information, we were able to better understand such a significant difference in the participation of European long-term financial investors in VC compared to their US peers. As a result, we have found that the factors influencing investors’ decision/ability to invest in VC are mainly related to the perceived risk/return profile of the asset class, and a combination of internal limitations.
Section 4: CONCLUSIONS
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In the context of risk return profile, in Section 3.1 we have addressed three major concerns stated by long-term financial investors: a) performance of VC when compared to buyout, b) return dispersion in VC, and c) relative underperformance of European VC when compared to the U.S. VC. Overall, our conclusion is that the perception of LTFIs in reference to the non-attractive risk/return profile of European VC as an asset class is not justified:
a) In terms of the performance of VC versus Buyout, according to the data provided by Pitchbook, the median returns are indeed slightly higher in Buyout. However, this is not the case when looking at the top quartile performing funds, in which VC outperforms Buyout. Furthermore, using real data from Burgis and considering a continuous and stable investment strategy (described in detail in Section 3.1.1) we were able to show that in the long-term and under such conditions, a VC portfolio would have significantly outperformed a Buyout one.
b) Referring to returns dispersion, we verified that in fact VC does have a higher dispersion of returns than buyout, or any other alternative asset class. Thus, we conclude that in VC it is essential to have a well-diversified exposure and a professional selection process in order to obtain higher returns. As described in Section 3.1.2, the diversification benefits in VC do not only decrease return dispersion, but also significantly improve median returns.
c) While considering the opportunity in Europe versus the U.S., it became clear that investor sentiment is not justified based on today´s reality. U.S. VC Funds definitely were a dominant force 20 years ago, when they were able to produce significantly higher returns than European VC Funds. However, as described in detail in Section 3.1.3, this is no longer the case, at least since the end of the financial crisis. The fast-growing entrepreneurial mentality, the unparallel European talent pool, the current maturity of European VC fund managers, and the support of the public sector, have created a perfect environment for European startups and VCs to succeed. On top of that, as described in Section 3.1, the funding gap is still large and undeniable, and represents a huge opportunity for investors, not only at present but for the coming years, as investment opportunities only get better and valuations remain reasonable.
The need for professional approach to the asset class leads us to the second major consideration faced by the long-term financial investors, internal limitations. Within internal limitations we have addressed two major topics: the minimum ticket/fund size problem, and the fact that currently most long-term financial investors in Europe do not have a target allocation to the asset class and therefore do not have specialized teams dedicated to the analysis
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of such opportunities. As a consequence, most of the VC opportunities are simply disregarded by LTFIs before they may be analyzed. To change this paradigm, high conviction and commitment from the top management is needed to prioritize a defined VC allocation, as it requires a long-term strategic view rather than a pragmatic approach usually employed in such organizations. On the positive side, it was encouraging to see that the general attitude of institutional investors towards the asset class is changing. Many of the interviewed investors have admitted that recent European VC developments, such as the high-profile success stories of Spotify or Farfetch, have not gone unnoticed and are making them more open to potentially include tech opportunities in their portfolio.
We have also found that the current scale of European VC is still too small for most institutional investors. Although the size of the European funds is definitely increasing, it will take a while until European VC reaches the scale necessary to organically attract a large allocation from European LTFIs (due to the reasons described in Section 3.2). Having said this, we recognize that the only way for such investors to increase their participation in the asset class is through the establishment of specialized investment programs and teams needed to analyze VC opportunities.
In Axon’s view, initiatives such as VentureEU offer a real solution to all the constraints and limitations described throughout this paper. A fund of funds provides a professional fund selection and diversification by vintage year, investment stage, geography and sector, and as such, solves all the concerns outlined in Sections 3.1.1 and 3.1.2. As well as that, it solves the size and team problem described in 3.2 by providing a vehicle of sufficient size to satisfy internal requirements of most institutions and offering a specialized team able to effectively navigate the asset class. With this, a VC fund of funds is able to deploy a more sophisticated investment strategy that includes the use of co-investments and secondaries which help to boost portfolio returns and flatten the J-Curve.
In the coming years we should expect the European VC industry to continue evolving at a faster pace as the market has gained traction and scale, the asset class has delivered solid returns, and European companies proved to be able to become global leaders. However, this new scenario requires larger funding levels in order to fuel the current exponential growth path. For this reason, the engagement of European LTFIs has become crucial, as the VC industry has to reduce its reliance on the public agencies in order to create sustainable and organic growth in the long term.
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