Pink fluffy unicorns dancing on rainbows
Or how unequal returns in Venture Capital have influenced the industry
I have previously written frequently on the buoyant state of European Venture Capital. On the supply side all stats show a picture of health — rapidly increasing investment, more funding rounds, rising valuations, and expanding communities. Coupled with this an ever growing roll call of Unicorns (those businesses valued at over $1bn) do much to champion the cause.
Aggregate returns from the asset class also suggest, at least superficially, a similarly healthy picture. Venture backed exits in Europe have consistently delivered €25–35bn in Enterprise Value per annum over the last several years vs. €5–8bn invested per annum over the preceding period of 2006–2013. If we assume that VC funds held on average 50–60% ownership of these exited companies (€12.5–21bn returned to VC funds per annum), this gives us a rough indication that VC has been returning 2.5x invested capital, broadly what is targeted by the asset class. So far, so good.
Perhaps since leaving the industry in the summer of this year I am more interested in the nuance, so there are perhaps two principle challenges one could level at this headline conclusion. Firstly, substantial recent growth in European Venture Capital (to roughly €12–15bn invested p.a. over the period since 2013) means that we will need to see a sharp increase in exit value in the coming years to sustain this rolling 2.5x gross multiple. Whether the enhanced supply of capital drives continued sustained returns is a question that is currently being played out, and not one that we will examine here.
Secondly, and perhaps more examinable, is the fact that these returns have been, and continue to be, hyper-concentrated. Over the period 2014–2016, the top 3 European exits each year have represented c. 50% of total European VC backed exit value, the top 10 a massive 75%. In other words, the predominant portion of value created in European VC has been, and continues to be driven by a very small number of mega-successful, monster companies.
So what? Well the implications of this are profound. In 2014 the average European exit was c. €150m* as a consequence of some amazing high value IPOs/acquisitions from the likes of Supercell (€9.3bn), Trivago (€3.7bn) and Skyscanner (€1.7bn). However, the median valuation of the 256 VC backed exits in 2016 was only €65m. If we exclude all exits >€0.5bn (c 15 companies), then the average value of a European exit was just €21m.
Now, let’s consider this from the perspective of an average Series A VC with a fund of €100m. Typically such a fund will be investing in about 30 companies over the fund cycle, and as a general rule of thumb will see one third of these investments fail. Returns are thus typically generated from a set of 20 companies. Let’s firstly assume that the fund has no access to the larger exits — the average fund participates only at Series A and the future Unicorns are funded at this stage by a small set of VCs in highly competitive rounds. The Expected Return from each of the fund’s 20 exits is therefore just €21m, and assuming an average of 20% exit stake then this VC fund will be returning 20 x €4m = Eur 80m, a 0.8x multiple on invested capital and a very poor overall performance. Generating a 2.5x return requires a €65m Expected Return from each exit, and hence requires the fund to be competing for, and winning, funding rounds in “hot” Unicorn investment prospects. In reality, the chances of backing a Unicorn (only 15 of over 260 exits in Europe in 2016 were at a value north of €0.5bn) are small, without perfect deal flow visibility at relevant points of inflexion. Anecdotally therefore we have in the past seen an industry of polarised returns, with few funds establishing leading positions and generating the lion’s share of returns.
To counter this dynamic we have recently seen many funds adopt earlier stage strategies, taking greater risk on lower cheque sizes to increase their chances of finding and backing ultimate Unicorns. The resulting increased competition at the earlier stages has had a dramatic impact on valuations, which according to Pitchbook doubled over the period 2009–2015 to $5m. This weight of capital has also driven a dramatic increase in the rate of failure of seed funded companies from 67% in 2009 to nearly 80% in 2013. In other words more companies are funded at an earlier stage with more competition driving higher valuations, and these companies are failing more readily when later stage capital is required.
So, it seems Unicorns create significant distortion in the market for early stage finance. Everybody across the industry is focused on them. Without competing for one, a fund is (generally) unlikely to generate competitive returns. Many funds have thus adopted their investment strategies, seeing their most likely chance of participating in a future Unicorn by making smaller bets in more companies at an earlier stage. And this competition has driven early stage valuations, perhaps creating some degree of false expectation which is ultimately resolved in higher failure rates for follow on funding. The impact of Unicorns is definitely not positive for all.
How this fascinating, and complex industry adapts to these dynamics over the next 5 years will be interesting to observe.
*€150m represents the simple average of €37.1bn exit returns from 256 exits in 2016. Dealroom.co suggest that the average value in 2016 was €771m (a number I quoted in the first draft of this article), but it is not clear how this is calculated.
Sources for all figures: