European VC: Weighing up the market’s health

As technology company valuations see sharp corrections, how will this affect European venture capital?

As technology company valuations see sharp corrections, how will this affect European venture capital? We present the positives and the negatives for the market as it stands today.

It’s clear that the technology sector’s bull market run is over. Public market technology valuations have taken a big tumble - the NYSE FANG index, for example, was down nearly 30% in early July 2022 versus the same period in 2021. Total shareholder returns (TSR) for publicly listed technology companies have also fallen hard, according to analysis by BCG. Following an annualised TSR of 30% from 2017 to 2021, the year-to-date median TSR for the sector to April 2022 stood at a negative 20%.

At times like these, it’s natural to look at past shocks for clues as to what may happen next. Some may be asking whether we could see a repeat of the wilderness years for European VC that played out after the dot.com bubble burst, while many will be hoping for something more akin to the post-financial crisis correction, which had a short and limited impact.

With many LPs and fund managers preparing for the worst, but hoping for the best, we’ve gathered a collection of expert opinions to take stock of where European VC is at in 2022 – and there are both positives and negatives.

At times like these, it’s natural to look at past shocks for clues as to
what may happen next.

Positives

The party is now over. Despite the pain many are expecting in portfolios, most investors believe the correction was overdue and that opportunities will stem from acquiring high quality technology companies at lower valuations a little further down the line. “We are seeing a more rational market now,” says David Thévenon, Partner at Balderton. “We’ve moved away from companies raising in a matter of days with little information to the process taking longer and with a lot more questions from investors.” Or, as Nino Marakovic, CEO & Partner at Sapphire Ventures, puts it: “I feel relieved. The party is over. And frankly, we didn’t want to party that hard.”

Marakovic adds that the demand for technology that underpinned the boom remains intact. “Funds with a traditional approach to portfolio construction and an active investment strategy will continue to raise capital,” he says. “There is no reason to believe that the opportunity is no longer there. On average, returns may not be as high as in the recent past, but there will be a much higher dispersion of returns.”

Overall, this should mean that capital can continue to be deployed in strong businesses. “I started my career as a VC in the early 2000s,” adds Beezer Clarkson, Partner at Sapphire Partners. “We were an emerging manager back then and we chose to return the un-committed capital we had raised to LPs, as many other VC funds did at the time. Today feels very different. We won’t see lots of funds return capital, but they will take longer to deploy it.”

The European VC landscape has matured. Many believe the growth and experience of Europe’s venture capital market and the entrepreneurs it backs put them in a much better position to weather the storm than in previous shocks. “Compared with the dot.com crash, I am confident about the ecosystem of European VC today,” says Bjorn Tremmerie, Head of Technology Investments, European Investment Fund. “It has evolved sufficiently that fund managers, although they may not have been through a crisis in that role, will have done so as a founder – that’s a big change for Europe. It’s no longer populated mainly by former investment bankers and consultants, but by operators who know what to do.”

Thomas Kristensen, Partner, LGT Capital Partners, agrees. “The European venture capital ecosystem has passed tipping points for entrepreneurial ecosystems and talent quality, and for capital,” he says. “The opportunity set is very attractive and there are still niches to be conquered and owned by new firms. There will be a few tough years ahead, but entrepreneurs will focus on building high quality sustainable businesses. High quality venture firms will recognise these companies and be willing to invest in their ambitious growth plans to become globally dominating players.”

The industry has been through a recent shock. Technology emerged a clear winner from the COVID crisis, but that wasn’t obvious when it first struck. VCs in the market today spent the initial phases of the pandemic triaging their portfolio companies, giving them valuable experience and a good insight into the resilience of their portfolio companies, both of which should assist them in a more bearish market. “In Q1 2020, all GPs were trying to figure out what Covid meant for their portfolio companies,” says Joe Schorge, Founder and Managing Partner at Isomer Capital. “They had to figure out how much cash they had and where they might need to cut back. They’ve just been through this exercise so they know how to triage a portfolio quickly, putting them in a good position to act quickly as we enter a different part of the market cycle.”

This also means that many companies should have good cash reserves. “Managers took stock during Covid,” explains a UK LP. “They were able to ensure the good companies raised cash during good times.”

European VC is in a good position compared to some other markets. European VC will face issues, but relative to other regions, it may well fare better. The fact that European public markets tend to be less enthusiastic about technology IPOs is a feature often bemoaned by GPs and policymakers, yet it may prove an advantage in today’s environment. “Europe’s markets don’t value growth as much as those in the US,” says Schorge. “So when there is a correction, Europe’s markets correct less. And while some of the biggest companies do go to US markets, there is more reliance on trade sales for exits. We’ve had exits recently that we’re really excited about - large technology companies are now buying European assets.”

European VC is also a beneficiary of US LPs rebalancing their portfolios away from the more challenging Chinese VC environment. “US LPs are looking more and more to European VC,” says Schorge. “They have seen the data, they can see it’s interesting and they see that Chinese VC is not so possible for them now, so they are switching allocations to Europe.”

Negatives

Late-stage may be hard hit since this is where much of the “tourist” capital flowed. The time lag between public and private markets reporting means that lower technology valuations will take some time to flow through, but most in the market are in little doubt that there will be pain in many portfolios, with later stage and growth funds particularly affected. “Later stage funds with publicly listed company exposure have already taken a hit,” says Holger Rossbach, Managing Director, Cambridge Associates. “They will have had lock-ups. However, the earlier you go, the less of an impact I expect there to be. There is a lag in private portfolios, so we won’t know the full picture for four to eight quarters from now.”

However, there is a sense that this means that US VC portfolios may well be harder hit. “Money was cheap for some of the very large technology companies,” says Schorge. “They raised a lot of capital at high valuations and there was an assumption that money would always be there. A lot of the late-stage money came from the US and those portfolios may well be in a lot of trouble. We’re seeing US portfolios correcting faster than those in Europe.”

Distributions will undoubtedly fall for a period. As with other regions, exits will become more challenging for European VC funds so that cash will take longer to come back to LPs. “There will be a meaningful slowdown in the investment pace and in IPOs through 2022 and 2023,” says Marakovic. “Companies need to have a certain market cap to go public and with lower multiples, they will need to be larger for this to happen. They will also need to be closer to profitability. Cash flowing back to LPs will be challenged through this period.”

There is more pain to come. The lower public markets exposure of European VC funds means that reported valuations may take longer to reflect declines than in other regions, such as the US. The full impact of the technology shock may therefore not be known for some time. Yet LPs and GPs alike are bracing themselves for a difficult time. “The next two years will be spent wading through a lot of company clean-ups,” says Toby Coppel, Co-founder and Partner, Mosaic Ventures. “There will be a defensive mindset and it will be hard to get as excited about deploying capital.”

And while Europe’s market is more mature and well capitalised, VCs without enough capital may face a difficult market. “It will be a difficult fundraising environment,” says Elina Berrebi, Founding Partner of Revaia. “The full excesses of 2020 and 2021 have still not been absorbed and the full force of markdowns are still not clear.”

Indeed, some are predicting a clear out of VCs that turn out not to have performed – when that finally becomes apparent. “The question mark hanging over every manager is their recent track record,” says LGT’s Kristensen. “Evaluating VC track records now is very difficult because they are based on the frothy valuations of the last 24 months. Even average companies have also benefited from the frothy market. In a normal market, some of these would not have survived, and it’s still uncertain that they will. There will be valuation declines ahead in many VC portfolios, but it can take several quarters to be reflected in fund track records.”

He adds: “We experienced a lack of discipline among many VC firms and for some it could be an existential threat. The big, top tier firms will continue to raise capital with relative ease, as will the strong niche players. But managers who backed second and third tier companies at inflated, tier one valuations, will suffer as it becomes apparent that their deal flow quality was weak and their due diligence superficial.”