09 Jun 2011   |   Viewpoint

Explaining the venture capital performance gap

Venture capital is the driving force of much entrepreneurial activity and Europe needs to look to the US role model to understand how it can promote and develop its venture capital sector, says a new report

Governments worldwide are making efforts to promote venture capital but development of the sector is hampered by the low returns being delivered to investors, with the result that growth has been slow and uneven.

The first VC fund was set up in the US in 1946 and although 3i in the UK was founded in the same year, it was not until the 1990s that venture capital took root in Europe. The US remains home to the largest VC industry, with $20 billion invested in 2010, next to a (relatively) paltry $5 billion in Europe. Within Europe, UK market was the most active, with UK funds investing $1 billion.

Exploring the reasons for the huge disparity will be the first step to understanding this poor performance and starting to improve things, says a new report from NESTA, the UK public investment fund. The report looks in particular at the gap between the US and the UK, but it contains much that is instructive for attempts elsewhere in Europe to harness venture capital in support of growth. The creation of a single and stronger venture capital industry is also a key objective of the European Commission’s long term economic strategy, Europe 2020.  

“Atlantic Drift: Venture Capital Performance in the UK and the US,” draws its conclusions from a database combining information on venture capital fund performance and their investments in the US and the UK for 791 funds raised between 1990 and 2005. This allows the authors to tease out differences in aggregate performance across countries and also to compare like-for-like funds specialising in the same sectors and set up in the same year.

This provides useful insights for investors and fund managers, and also policy makers aiming to promote development the venture capital sector.

Shortcoming of public venture capital funds

One particular tool that governments have deployed is to set up public venture capital funds to bridge what are seen as significant funding gaps for start-ups and early-stage companies that are not being addressed by the market. Attempts to use public money to stimulate new sources of finance have followed a number of approaches, but the report says they have had the common shortcomings of trying to achieve too much, being sub-scale, limiting the pool of potential investments and having unrealistic time horizons.

As a result, publicly-backed funds have delivered lower returns than private funds, though the performance gap is narrowing, according to the report.

While the report points to some progress such as this improvement in the relative performance of public funds, it also highlights problems ahead, setting out three key recommendations for policy makers:

1. Don’t make policy as if venture capital activity exists in a vacuum - venture capitalists are tremendously dependent on other players - entrepreneurs with ideas, lawyers negotiating agreements, marketing experts, engineers and customers, being willing to take a chance on a new company. This means more effort should be directed to creating an ecosystem in which start-ups can flourish.

2. Resist the temptation to over-engineer public support schemes - too many rules about public venture funds, such as the locations in which companies can operate and the type of securities investors can use, limit the flexibility and usefulness of public funds.

3. Avoid initiatives that are too small - public venture capital schemes must have critical mass. Small programmes do little to help entrepreneurs and are also likely to lead to poor financial returns, because small funds tend to underperform and cannot stay with their companies as they grow and their capital requirements increase. And too often in the past such failure has generated a backlash that has impeded future attempts to deploy public funds.

Atlantic Drift: Venture capital performance in the UK and the US

Josh Lerner, Yannis Pierrakis, Liam Collins and Albert Bravo Biosca

Nesta Research Report 31; June 2011. www.nesta.org.uk

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