Investing in start-ups is prone to survivorship bias. People are more likely to recall successes such as Facebook and Google, and typically overlook the failures. This bias leads to the idealisation of the Venture Capital (VC) industry, some of which may be undeserved.
One of the reasons for this flaw is the overall structure of the VC industry. Investors in start-ups are typically unlisted funds. These funds have no obligation to share their track record with the public. Consequently, the public rarely hears about the failures or average technology companies.
A recent report by the European Investment Fund (EIF) provides a rarely seen insight into the European VC landscape. By way of background, the European Investment Fund (EIF) is an EU agency that provides finance to small and medium-sized enterprises. It does this through investing in VC funds and private banks. It has been reported that investment activity backed by the EIF accounts for over 40% of European VC investments.
The report publishes the EIF’s investment results over the last 20 years. The sample size is significant and the report analyses nearly 3,000 start-ups backed by 355 funds. Data on this scale is rarely published, and the findings are insightful.
(Mostly) A Losing Game
The report highlights that nearly 70% of investments are written off or sold below cost. On the other hand, only 20% of investments are sold at a profit (the remainder are sold at cost).
Of note, 4% of the EIF’s exits have returned more than five times their investment. This has generated almost 50% of the total aggregated returns.
This undoubtedly highlights the importance of portfolio diversification in VC. Most investments lose money. The investment managers are, therefore, searching for the one or two investments which will offset these losses.
Scottish Equity Partners (SEP) is a fund which evidently understands this. The fund has invested in more than 150 companies over the last 20 years. One of their investments was Skyscanner, in which they were an early investor. In November last year, Skyscanner was acquired by Ctrip. This reportedly returned 52 times their investment.
IPOs: Above Average Returns, but Unlikely
The average return after an exit through an IPO was 4.3 times the investment. In comparison, the average EIF exit return was only 1.7 times the investment.
Unfortunately, IPOs represent less than 10% of the EIF exits to date.
This is an interesting point as it goes against common wisdom. Valuation concerns are often quoted as a reason for tech companies choosing to stay private. It is strange to see that the evidence from the EIF’s perspective does not agree with this line of thinking.
Annual Returns Vary Considerably
Exits in 2001 generated greater than four times their investment, on average. In comparison, exits in 2003 generated less than half their initial investment, on average.
Over an 18-year period, the EIF’s average return was only 1.2 times their investment. This is considerably below the 2001 average return. It does, however, exceed the eight years during which the average return was less than their investment.
This evidence illustrates the importance of investing over a long period. Deciding to pick and choose could be the difference between making a profit or a loss.
Time to Be Critical
Whilst the EIF’s report highlights some interesting findings, one cannot apply these to every VC fund.
One of the criticisms of the EIF is that it supports underperforming fund managers, who are unable to get money from private investors. Some would argue that these findings, therefore, are the result of underperforming funds.
Still, following the recent sale of Skyscanner, Scottish Equity Partners may have a word to say to these critics (the EIF have invested in four Scottish Equity Partners funds).