Euro VC: growth, value and the barbell strategy

Paul Fisher does not write often but what he does write is always interesting.  His latest post sees him mulling over the valuation extremes that can be seen in the European VC market, and wondering whether VC is a growth or value game.  The answer is, of course, both.  He is implicitly taking a stance that is beneficial to his entrepeneur-customers i.e. that really growth is what one should care about and that being too conservative on valuation is somehow missing the point.
<--- Dapper Geezer Paul Fisher from First Capital

My observations on this are as follows:

• Competition levels are still quite low in Europe, which should help ensure that the asset class as a whole offers some great return opportunities.  The "well respected VC" bragging that his last 9 deals were done with no competition whatsoever is obviously showing off (the market is really not that inefficient), but the generic point is certainly true; lower levels of competition means less price pressure and therefore better return profiles for Euro deals.
  
• Competition generally helps the better firms shine, which is why many of us are welcoming the entrance of Highland, Oak and others as strengthening the local scene.  But extreme levels of competition destroy returns for all involved.  I know from recent, direct experience that even Sequoia sometimes have to fight like dogs on their own turf, including on price, to get into a deal.  I certainly do not hope to see the insane levels of competition sometimes seen on the West Coast.  There are definitely examples of strong price pressure in early stage in Europe too, such as Rebtel recently, where only a significant exit will help deliver a meaningful return to investors.
• Valuation has to be in line with your upside potential.  The well-known example of MySQL should serve as a cautionary tale.  Here is a fantastic business that is so disruptive on price that, whilst being nicely profitable and a great success in its own right, it simply cannot grow beyond a certain scale.  Some of the VCs involved are pushing for this business to achieve a scale that its model simply does not seem to allow.
• Valuation is not everything.  Paul uses the example of CSR.  I
  do not know thee details of the CSR deal but I will bet that the deal
  came with some serious results-related valuation adjustment
  mechanisms.  The company performed well so everyone was happy, but
  beware looking only at the headline number.
• Momentum investing is agressively pursued in late stage companies to establish an early track record.  I will use Index as an example as it is the best know case.  Index appears to have a clearly defined strategy of getting into the European winners and being the last money in.  To achieve this they appear to be fairly valuation insensitive, but they are very careful to pick clear winners.  KVS and Skype are older examples.  More recently Index went into MidasPlayer (which regrettably we could not fund at Series A due to fund restrictions :-() after Apax had invested.  It also put money into a number of open source companies such as Zend or MySQL as identified winners in its target open source category. The benefit to them is that they achieve early exits with decent if slightly constrained multiples which helps them associate with winning companies and demonstrate to LPs that they can succesfully exit. 
  
• Many funds pursue the so-called Barbell strategy.  A Barbell comes from the world fixed income and refers to a portfolio strategy where you combine buying a short-term bond and a long-term bond to achieve the same duration as a mid-term bond but achieve a certain exposure to the shape of the interest rate curve.  In other words you can go long some 2 years and some 10 years fixed-rate bond and short some 5-year fixed-rate bond, thereby achieving duration neutrality but benefiting from an expected flattening of the interest rate curve between 2 and 10 years.  The expression is also now used in VC Land to describe mixed fund strategies where you both invest in Series A or Seed and in late stage companies, but not in the middle.  You tend to be very valuation and ownership sensitive for the early stage deals and willing to pay a lot for growth in the later stages.  It is in this context (dear Paul) that value and growth foci can both be reconciled in a VC portfolio.  Large ownership stakes to compensate for increased risk in early stage deals, momentum and cash-on-cash potential to compensate for high valuations in late stage deals.
• Larger fund sizes might lead to strategy drift ...  This is a question more than a comment.  I firmly believe that a good generalist investor who understands his market can indeed pursue some seed and late stage opportunities in parallel.  In fact I sometimes dream of building Atlas over time into a proper crossover fund where we can go from seed to public and back (for the best discussion on this topic go to the fantastic Peter Rip and is VC2.0 series).  But I also ponder comments about the efficiency of Barbell in efficient markets and recommend reading discussions on this from EJ Olson or Jeff Bussgang as well as Max, closer to home.  I also note that whenever VCs move to managing larger funds, they automatically start writing much bigger checks even in early stage.  This can lead to both valuation insensitivity (as in Rebtel) or more worryingly to a tendency to throw too much cash at a startup.  Most people who have been in this business for a long time will agree that overfunding companies is the best way to help them fail.  Necessity is the mother of invention and all that... 
• ... but strength of platform increasingly matters.  At some point I would like to talk about the bigger topic of the tectonic shifts in European venture capital, but for this post I will limit myself to noting that the best deals irrespective of countries have shown a tendency to move to the best international platforms, with Index, Benchmark, Atlas, Accel, Highland, Oak or 3i hovering up many world-class opportunities.
  

At the end of the day, I think many strategies are coherent and can work well provided they suit a team that is hell bent on doing world class deals and making money for its investors.   Like any strong entrepreneurial management team, a strong, motivated and intellectually honest team of investing partners will figure its way through the opportunities afforded by the European market and provide the type of returns that investors want.  I for one am convinced that the European venture market holds a lot of promise.  After an abortive start circa 1995 and a period of atonement, I firmly believe Euro Venture is coming into its own as an attractive asset class on a global basis.  I see it happening every day.


Technorati Tags: vc, europe, paulfisher, european, venturecapital

Comments

[Joao]

On the barbell strategy comment, it is interesting to note that the balanced VC funds in europe have consistently beaten all of the specialized VC funds over the last years, and the bigger the fund the better IRR. This contrasts with higher returns for the early stage VC funds in the US, where the market is much more specialized.

My hypothesis is that because continental European countries are still too inward focused, their VCs can not achieve the scale to sustain specialized early stage funds – the economics of a 20-50M fund make it very difficult to attract the best VC managers and nurture the full capital raising cycle of the best startups (you end up not having the reserves to follow-on invest in the D,E,F rounds, which sometimes are the best and truly global). And if you do not have the track record you can not raise larger funds. This vicious cycle is an impediment to creating the brands that characterizes US style top tier VC firms across most of the continental European countries, and it fosters the concentration of talent and money in a couple of UK-based firms. One other implication is that for these smaller funds, deal terms and series A valuations are key determinants of profitability because they efficiently protect the downside – pushing for a necessary focus on value AS WELL as in growth investing.

I am very interested in knowing whether some sort of formal or informal network affiliation system exist between continental European VCs to address these issues, as it could be a solution to foster the development of a solid pan-european VC community. Any thoughts?

Joao