Pando

European Venture Capital: Do you want the good news or the bad news?

By Sarah Lacy , written on November 5, 2015

From The Europe Desk

OK, European boosters: Do you want the good news or the bad news?

The good news is that European startups just clocked a 19-quarter high in venture capital investments, according to CB Insights. 19 quarters! If that was a score during a college drinking game, your opponent would have alcohol poisoning!

The UK looked particularly strong – for a third quarter in a row it was home to more than €1 billion in venture capital spread across more than 90 deals. So far this year, close to €10 billion euros have been invested in startups across Europe. Wow-ee!

And unlike past years, when the UK and London in particular dominated, there are three strong centers of innovation – and exits – in Europe now: Germany, Sweden, and the UK.

With numbers that good, what could the bad news possibly be?

The number of deals is down dramatically. CB Insights’ stats didn’t show an extreme drop off, but Pitchbook’s numbers were more granular. According to Pitchbook, the deals dropped over 50% in Europe from the first quarter of 2014 to the third quarter of 2015. Quarter-over-quarter the decline in deals was more than 20%.

Check out the graph below:

Dollars up/deals down isn’t exactly a new story line in 2015. It is the same trend we’ve seen in the US and Asia this year. The culprit are mega deals, and sure enough there were six European mega-rounds for north of €100 million this past quarter, according to CB Insights. But if VCs were purely bullish you’d see continued mega rounds invested and a pipeline of early-stage deals at the same time. Instead, the divergence in these two stats, taken together, is a sign that VCs are very bullish on individual mature companies, but worried about what the ecosystem will be like to start a business in the next few years.

Only, in Europe, there’s more reason to worry. Because it’s a smaller, more fragmented market, farther away from the nexus of capital in Silicon Valley, the same trends are far more exaggerated. To boot: Europe is greying with non-stellar GDP growth. To some, it’s a counter-play on emerging markets. All the predictability you want but none of that crazy demographic growth. (That’s good or bad depending on your view of China right now.)

But one thing can’t be mistaken. The smaller size and fragmentation of Europe means every excess can feel a lot more pronounced. For instance, big deals that don’t represent a broader ecosystem can skew the numbers far more dramatically than in the US. A full €1.1 billion of the year’s total— more than 11% of the capital invested in all of Europe— went to just two companies: Spotify and Delivery Hero. According to CB Insights, twelve of the largest rounds this past quarter made up €1.5 billion of the capital invested, or 43% of the total funding. That doesn’t display a ton of depth. European VCs as a whole are betting incredibly deeply on a small number of unicorns.

Meantime, early-stage deal flow is suffering far more than it is stateside. In the third quarter there were only 176 seed and angel deals done continent wide, the lowest quarterly number since 2012. There were just 183 early-stage deals done continent-wide, the lowest in even longer.

And because there is a finite amount of local venture capital, more money going to late stages, can come at the expense of money going to other stages or other companies. If European investors are right on their bets, the continent could produce more stand-alone publicly traded companies worth north of a €1 billion than the continent has historically seen, particularly in the consumer Internet space. But if it’s wrong, and companies like yet-another-undifferentiated-meal-in-a-box player HelloFresh disappoint, they may have traded a robust pipeline for the next decade for a few future down round IPOs or acquisitions. Even Spotify – unquestionably the most popular global European startup – is in an unenviable space. Take a look at Pandora’s ride as a public company so far. And Pandora has been the “lucky” online music company out of thousands who even made it to that point.

Part of what’s driven this all-in approach to European investment is an overall global trend. But part of it is the rise of Germany as a powerhouse of investing. Characterized by a Samwer brother style of copy-fast, throw-huge-amounts-of-cash, and grab land even faster approach, its biggest companies are ones that are just like US versions, injected with hundreds of millions of dollars in growth steroids. In contrast, the UK is continuing to play a slow-and-steady game of big bets, medium bets, and diversified plays across different sectors.

It looked for exactly one quarter that Germany could overtake the UK as the center of startup investing in Europe, but Germany is far more skewed by these trends of mega deals causing havoc in overall numbers.

Take a look at these charts:

I’ve covered European venture capital for more than a decade. It’s not uncommon for it to be pulled into the same tidal orbits as the US. But this time around, Europe has had one big advantage: It’s far less dependent on Silicon Valley VCs than it was in the past. Several US firms that had UK offices when I first started covering the industry in the late 1990s – like Benchmark, for instance – have long since cut ties. One of the lone US names with an active UK franchise is Accel, and it’s worth noting the firms and partnerships are run completely separately. Index remains the most active investor in the UK, and, sure, it now has a strong Silicon Valley office. But while it might like to think of itself as a global firm, Index was started in the UK and that’s still where it’s the most dominant.

Meantime, quarter-after-quarter the most dominant firm throughout Europe is a group few US investors have heard of: High-Tech Grunderfonds out of Germany. Outside of Accel, nary a top five Silicon Valley name even makes the most active investor list for the entire continent.

That Europe is in such a crest of investing, without the Valley’s dollars leading the way, is a massive sign of the ecosystem’s maturity, and welcome news since the Valley tends to pull back home when times get tough. That said, European investors could be in danger of getting lulled into the Valley’s cherry-picker game, instead of doing the grunt work of funding and mentoring new deals, keeping pro-rata and keeping the upside should they hit big.

We’re going to be digging more into Europe’s place in the tech world all month for our new special report. Stay tuned.

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