Why PE Firms Are Abandoning Early-Stage VC in UK and Europe

Introduction: The Business of Venture Capital

"The business of business is business."
— Milton Friedman [1912–2006; recipient of the 1976 Nobel Memorial Prize for Economic Science] (Cogman & Oppenheim, 2002; "Milton Friedman," 2008)

This reportedly famous quote by Milton Friedman — a senior research fellow at the Hoover Institution from 1977 to 2006 — routinely proved true in the past. In today's world, however, according to Cogman and Oppenheim (2002), as companies seek to grow and expand, their business ventures regularly reach into controversial areas where the rules regulating the business "game" may not be so precisely defined.

In the business game, one major financial player — the venture capital (VC) firm — is a small financial services organization that primarily positions itself to: assess business opportunities; provide capital; and monitor, advise, and assist the firms in its portfolio (Kenney, Haemmig, and Goe, 2007).

VC funding may evolve from multiple sources. Traditionally, however, large institutions — including universities, insurance companies, and other grouped investment sources — invest the bulk of the funds. By investing in start-up businesses not yet publicly listed, the venture capitalist accepts a substantial tranche of illiquid equity, converting their status to something like a partner to the entrepreneur (Kenney, Haemmig, and Goe, 2007; "How Venture Capital Works," 2008).

During 1993, venture capitalists debated what to call themselves. Purists contended that the term "venture" ought to denote only early-stage investment. Private equity, investment capital, and development capital served as preferred alternatives. (Eadie, 1994.) Venture capitalists — typically former executives or investment bankers who turned to raising private funds for targeted investments — remained "stuck" with the name. The venture capitalist not only aims to increase a targeted company's equity value, but also, in time, to monetize the investment through a liquidity event such as an initial public offering (IPO) or sale to another investor, ultimately reaping financial rewards (Kenney, Haemmig, and Goe, 2007; "How Venture Capital Works," 2008).

In addition, the VC firm receives a management fee, which frequently totals 2% of the total fund, as well as a percentage of the upside — usually 20% — for making profitable deals. VCs may also realize returns, albeit unwelcomely, from firm failure and bankruptcy when their targeted company does not perform as anticipated (Kenney, Haemmig, and Goe, 2007).

The average lifespan of a venture fund is approximately one decade; however, the VC process is not complete until the firm "exits" the investment. In an environment where exit is not possible, investment by venture capitalists is similarly not viable. Ideally, the investee company moves to an IPO or a buyout, at which point the VC investor hopes the stake proves worth more than its original assessed value. Not all VC deals, however, produce positive returns. Kenney, Haemmig, and Goe (2007) note that in spite of the growth in VC operations, investors repeatedly faced "a continuing lack of high-quality deals in Europe."

The repeated theme of low returns for VC investing in Europe demonstrates that "the long-run returns for early-stage investing in Europe have been far lower than in the U.S." (Kenney, Haemmig, and Goe, 2007). Contributing factors include: the relative weakness of European universities; the relative weakness of European corporations; and the relative weakness of European nations in information technologies (Kenney, Haemmig, and Goe, 2007).

European VC Performance and Industry Data

European Venture Capital Association (EVCA) figures for 1993 show that technology-based investments represented 17% by value of total investments that year — a 20% decline relative to 1988 (European Venture Capital Association [EVCA], 1994). In the UK, the largest venture capital industry in Europe, the proportion of funds allocated to technology-based enterprises more than halved in the seven years to 1992, when only 9% of the value of all investments made were in technology-based sectors (British Venture Capital Association [BVCA], 1994). These European figures stand in stark contrast to U.S. venture capital activity, where approximately 80% of venture capital investments were targeted at technology-based enterprises in recent years (Murray, 1996).

Analysis of 2006 VC deal data (Figures 1–3, adapted from Guthrie, 2007) shows that the number of VC deals in France and the UK were below those in other countries. While the value of VC deals in France remained relatively low, the value in the UK was higher than in other listed countries and regions.

Analysis reports that the UK public sector supports start-up companies more than any other European country. In May 2007, Franklin and Hugo (2007, p. 2) report that the United Kingdom hosted 1,668 venture-capital-backed companies. In 2006, 3i Group was the top investor in VC companies, raising approximately £1.4 billion — an increase of 27% from 2005. Noteworthy increases in activity in information technology, services, and retail reportedly fueled this striking financial increase.

Stimulating the demand for venture capital — that is, increasing the pool of investable companies — Franklin and Hugo (2007, p. 2) stress, is as vital as stimulating the supply of capital. Even though the UK attracts more than double the venture capital per capita compared to other European countries, it attracts only about one-third the amount of VC drawn by the U.S. Ideally, a pool of companies capable of delivering returns to venture capitalists comparable with those obtainable from other private equity asset classes would be developed, contributing to the possibility that UK and European venture capital could eventually match U.S. ventures.

Performance data from PricewaterhouseCoopers (2008) illustrates the divergence between early-stage and buyout fund performance. Among pre-1996 vintage funds, the since-inception IRR for early-stage funds stood at approximately 9.0–9.3%, compared to 15.8–16.1% for mid-MBO funds and 18.1–18.7% for large-MBO funds. Among 1996-vintage-onwards funds, venture funds recorded a deeply negative since-inception IRR ranging from -1.6% to as low as -86.7% in the most recent period, while mid-MBO and large-MBO funds retained positive returns overall. Technology funds across all vintages showed since-inception IRRs ranging from -0.1% to -12.8%, consistently underperforming non-technology funds, which recorded 14.2% to 18.7% over comparable periods (PricewaterhouseCoopers, 2008).

Vintage-year data further underscores this underperformance. Funds raised from 1999 through 2002 — coinciding with the dot-com bubble and its aftermath — recorded particularly severe negative returns. The 1999 vintage showed IRRs declining from -15.8% to -2.0% across measurement windows, while 2001 vintage funds recorded -29.1% to -23.4%. More recent vintages from 2004 to 2007 showed mixed results, with the 2006 cohort showing a positive 100.6% over three years, though with only six funds in the sample (PricewaterhouseCoopers, 2008).