In their quarterly update about new European venture capital funds, impact investor Stefano Bernardi and Yannick Roux of Semantic Ventures write that it has been “the wildest quarter in a long time”, with “33 new European funds closing almost €3bn in fresh new capital”.
That might sound a bit surprising in the context of COVID-19. Who would have thought that limited partners in European VC funds would be just as oddly bullish as US stock market investors given such a grim economic context? But what this all reflects, obviously, is more the optimistic mood of late 2019 than the apocalyptic one of 2020.
Indeed, there are reasons to think things will slow down in the future. One is that LPs will have their own wounds to lick. They’ll need to redeploy capital according to a multi-asset allocation strategy. In this context, it is likely that the tiny, marginal, and illiquid asset class that is venture capital will be rather low on the priority list, and so fund managers will have a much harder time raising money in the future than those who were lucky enough to close their new funds during the “wild” second quarter of 2020.
Another adverse trend is that there’s been a tendency to diversify a fund’s LP base from a geographic perspective over recent years, with more limited partners coming from abroad—including Asia and the US. But that trend could be reversed with what I call the “Great Fragmentation”. As we look to the East, the fast-growing rift between the Western world and China could lead outward-looking Chinese investors away from European VC funds. Further, as Danny Crichton writes in Venture Capital's Red Flags, there’s now a backlash against Chinese money being invested in US startups. If the Huawei ban can be taken as a precedent, then the European tech ecosystem will soon start asking if it’s wise to keep taking money from LPs connected to the People’s Republic of China.
Looking west across the Atlantic, the situation is hardly better. Sure, there has been interest from US investors in getting more exposure to European tech lately. But recent events, such as the European Higher Court striking down the US-EU Privacy Shield, could slow this trend down by widening the regulatory gap between the US and Europe. Likewise, the fact that the lower European General Court decided that Apple didn’t have to pay that €13bn in back corporate taxes after all will prompt member states to pursue unilateral measures such as France’s digital tax, further blurring the big European tech picture for foreign investors. Will US-based LPs be more confident when it comes to deploying capital in Europe given those developments? I bet not.
The rapid rise of remote work could also reshuffle the cards when it comes to getting exposure to Europe. Rather than deploying capital in local funds which in turn invest in local companies, why not focus investments in US startups with more room to grow on their domestic market and the ability to tap into Europe’s most distinctive asset—tech talent—through remote work?
This is all without mentioning the liquidity issue. Sure, there’s been a frenzy of initial public offerings in the US recently, with companies such as Lemonade and Agora surfing the bull market before the music stops. But the same does not exist in Europe, far from it, and the growing transatlantic rift will complicate things further for European companies seeking an exit in the US: antitrust, industrial policy, and national security considerations could stand in the way of European targets being acquired by US (or Chinese) giants. And, despite Spotify’s impressive success, other European companies could have a hard time following the same path to a great performance on US stock exchanges.
One trend, however, suggests we should be more optimistic about the European venture capital industry. Stefano and Yannick point to the rise of first-time funds in the latest fundraising waves, with “15 new funds and ~€770m in new capital”. It’s good news because it overturns the assumption that LPs are conservative by nature and always refuse to bet on newcomers. It’s also in line with the fact that venture capital as an asset class is now spilling out all over the place—more specialised, as explained by Stefano and Yannick, but also more focused on sectors, such as consumer goods or lifestyle businesses, where the risk/return trade offs might end up being very different from those in a pure software business.
To surf this wave of the “diffraction” of venture capital, LPs necessarily have to bet on new teams. Established firms don’t need more money, lest they risk degrading their returns; and the backgrounds of their more senior general partners make them ill-fitted to connect with the new opportunities that are currently rising. Finally, state-sponsored LPs, starting with the European Investment Fund, have a clear (if imperfect) policy of encouraging the formation of new firms and the rise of new investors.
This, I think, is the main takeaway. European venture capital doesn’t need to get bigger so much as it needs to get more diverse, deploying capital in more heterogeneous sectors, and become more able to chase the numerous opportunities across the complex geography that is Europe. For that, we need more new firms to emerge, and despite many headwinds, we can be confident the trend is here to stay.