European venture’s reliance on public funding

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Since the bursting of the dotcom bubble, LPs have exercised caution when committing to European venture capital - and the statistics reflect that. In 2000, continental venture funds raised in excess of €34bn, according to unquote" data. Four years later, that number had plummeted to around €2.4bn.

Public funding bodies have played a large part in plugging the gap left by the institutional exodus from venture capital and now account for a large proportion of the commitments to European venture capitalists. But the relationship has not been entirely straightforward.

Fund managers bemoan bureaucracy, strategy restriction and an impact on terms. Yet, without public funding body support, the industry would have suffered an even more dramatic decline with far more depleted coffers.

It is within this context that unquote" conducted an exclusive study - commissioned by trade body EVCA - on the role of public funding bodies in European venture capital. unquote" consulted public and private LPs with more than 600 commitments between them, and fund managers holding more than 2,500 companies in their portfolio with upwards of 147 funds under their belts.

The largest such funding body is the European Investment Fund (EIF). Two-thirds of participants in the study had received a commitment from EIF. Its role in European venture is unparalleled. According to one UK-based VC: "If you took the EIF out of the equation in the European venture industry, you would have a major problem."

The relationship between public funding bodies and private fund managers may not be entirely harmonious, but it is essential: only 10% of participants in the study said they do not target public sources when fundraising, with almost 50% of GPs revealing they target them heavily.

Public endorsement
The appeal is more than purely financial. According to VCs across the board, a key benefit of securing a commitment from public funding bodies is the scale it allows them to achieve by attracting other sources of capital, such as high-net-worth individuals and family investors. Said one UK-based GP: "In terms of attracting private money, the reassurance of public money is very important. It is incredibly attractive to the private investors to have government money for them to invest alongside." A Spanish counterpart concurs, highlighting the role of public funding bodies in kick-starting the fundraising process: "It's much harder to start fundraising from private investors with 0% of the fund raised than with 30% already raised. That's what government bodies really change."

But perhaps most relevant in today's climate, which has seen the LP base for venture shrink, is the reassurance that public funding bodies provide to untapped sources of capital further afield. Given the strict due diligence processes VCs are required to pass - lamented by fund managers themselves - securing a commitment is often perceived by new investors as an endorsement of the VC's strategy and is an important accelerant in the sometimes arduous fundraising process.

Another player highlighted the EIF's warranties division and its unique convertible note initiative as a positive move to sustain the venture industry. "Under this scheme, EIF supports GPs through a warranty system that partially covers some of the write-offs a fund is bound to have in the first year of its life," the VC explained. "This helps to decrease the J-curve effect that funds often have in the first few years of their life, leading to negative IRRs. By using these warranties to return part of the write-off back to the LPs, the EIF is helping to improve the profitability of the fund."

Outside of financial support, the benefits of public funding commitments are clear. But are such bodies making full use of their influence? No, according to one VC: "Public funding bodies are the biggest investors in European venture and, as such, I think they should foster more synergies between the funds they back to encourage co-investment opportunities, sales, dealflow, and so on. They have an immense relationship network but they don't leverage it enough." Power could be better harnessed to support the ecosystem in ways that are more than merely financial.

From increased scale to reassuring private LPs, the benefits of public money are varied for both the single fund manager and the wider ecosystem. And this crucial component of the European industry is here to stay; more than 40% of venture players surveyed expect the proportion of money contributed by public funding bodies to increase in the next five years, with less than 20% anticipating a decline in commitments. The relationship is certainly long-term, but it comes at a cost.

The downside of public commitments
Perhaps unsurprisingly given public funding bodies' ties to nation states, bureaucracy emerged as a major downside of securing the support of such backers. Around 30% of venture capital fund managers complain of the limitation on operational abilities; they find their investment targets limited or the bureaucratic requirements of investment committees, reporting or auditing leaving precious little time for sourcing and backing companies - their very raison d'etre.

But perhaps the most potentially pernicious element is the regional demands of certain public funding bodies. In several European countries, venture capital fund managers are only able to secure commitments from regional public funding bodies if they agree to commit a certain amount to the region in question. Spain is a particularly good example, with one such body in most of the country's 17 regions.

Said one Spanish VC: "I don't mind getting money from the Catalan or Madrid body, because I invest there normally. But if you give me money from a region where not much is happening, I'll be investing in something I don't want to invest in, so I wouldn't accept that kind of money. Regional funds are fine, but don't accept money when it doesn't make sense because you won't raise the private contributions and it will be a disaster. Or you'll be selling half-truths to investors, which is a disaster too." Given the asset class's need to pursue improved returns if it is to entice more private LPs, accepting a commitment from a regional body that requires a substantial commitment to the region could be problematic.

Losing control
For private LPs, the loss of influence and control over LPA terms and the advisory board remained a sticking point. Qualitative interviews revealed this to be a particular problem when discussing the role of European Investment Fund (EIF). One German VC with commitments from public and private sources said: "The most important thing is the rigidity of their charter and their rules of operation. You either comply or you're out - not just at the beginning, but also further down the road. And other LPs don't like that, because it is not purely just about economic drivers."

The slow decision-making process also proved problematic for private investors. Said one UK-based LP: "The problem is the lack of decision-making power some of the public funding body representatives have. Whether it's the investment terms or fund extensions, they have to go back to an investment committee and this makes for a more inefficient process. And sometimes you get quite junior people in the process. That can be a big negative. Anything to do with advisory board decisions involves a time lag and that can impact the GPs' ability to operate quickly." However, with public funding bodies such as the EIF managing the money of the European taxpayer, the fine-tooth-comb approach seems a lesser evil than rash decision-making.

Despite some thorny issues, private LPs neither saw the presence of a public funding body as a reason not to invest in a venture fund, nor as likely to lead to lesser returns. Though the multi-tiered approval process in place at the largest public bodies - with lead times of up to 12 months from initial engagement to cash in the coffers - may have an impact on the negotiation of terms, the benefits appear to outweigh these disadvantages.

For many VCs, particularly those operating in less developed venture ecosystems, the severe shortage of institutional investors in local venture funds leads to a serious reliance on public funding. "When it comes to venture capital in Spain, many investors don't understand why they should have venture capital in their portfolio. We don't have Axa Private Equity in Spain, for example, but if we did, I couldn't fundraise with them because my fund is too small. That's a catch-22 situation."

Though the relationship between public sources of capital and venture managers may be challenging at times, it provides an essential crutch as the European venture ecosystem evolves in the shadow of its Silicon Valley counterpart.

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• Topics
• Fundraising
• Venture
• European Investment Fund
• Market Insight
• Venture