European VC market: dramatic adjustment ahead?

The current edition of the Go4Venture Monthly European Venture & Growth Equity Market Bulletin covers November. In the world of growth equity and venture capital, November is typically a busy month as transactions are wrapped up ahead of the Christmas season. This year was no exception, with November ending up some 20% ahead of last year (by both volume and value), and year-to-date figures showing a near 40% value increase and some 20% volume contraction.

Regarding the investment cycle the authors writhe that “we are getting to a new phase where everybody understands these are frothy market conditions. In the ‘up-the-ante’ part of the cycle, we are starting to see silly rounds, for silly reasons, with silly numbers, and of course everybody jumping on the bandwagon.”

What is different this time round, though, is that everybody knows about the impending market correction. However, common wisdom is that when the burst comes it won’t be that bad. The rationale? Public markets are overvalued, but not by as much as in 2000 (tech is only on a 23x forward-looking P/E, rather than 100x). In private markets, valuations may be crazy but at least businesses are real, i.e. with actual revenues, profits and scale. And many (just like Uber) are marketplaces which are disrupting ‘brick-and-mortar’ competitors and are inherently more profitable, with wonderful digital scalability. And past purchases like Facebook buying Instagram for $1bn in 2012 now seem, with hindsight, not that expensive (Instagram has since passed 300mn users, is doubling every year and its (photo) ads sell for 20x that of its parent).

However the authors add: “the more this cycle to price absurdity continues, the less we are certain that the contraction will not be as dramatic as in 2001.” Although the over-valuation doesn’t seem as bad as last time, and more contained to (certain parts of) tech, one of the drivers is excess liquidity in the economy driven by quantitative easing policies, suggesting that all markets are probably overpriced. And this is in the context of an awful macro environment, dramatic geopolitical conditions and general indebtedness. For a rehearsal of how dramatic market changes can be, we only have to look at the sudden fall in oil prices – in short, a market correction could easily turn into a rout encouraged by systemic weaknesses. And if we roll back five years (to 2008-09), we know that a 30-40% market correction feels like a trip to the abyss.

On the plus side, the general optimism is spreading investment beyond just internet and latestage, which have been the two constants of the past five years, and is clearly bringing private equity funds into the realm of growth investing. If we look at November:

• Internet is of course very present, with niche e-commerce and fintech plays well represented (three each of our of fourteen Large HTI investments – defined as financings of £5mn / €7.5mn / $10mn or more), but we also see three medtech investments and a variety of transactions in enterprise software, telecom software and cleantech.
• Of the fourteen Large HTI investments, nearly half are led by pre-IPO or private equity investors, even if most are Series C or late-stage situations.

It is difficult to predict whether these positive developments will survive a market adjustment. One of the reasons for optimism is that the root cause of the malaise is indebtedness. Only growth will allow value creation, which will hopefully create a lasting environment where growth stories (including venture) are seen as the way forward rather than an evil to avoid.