VCM0002

Written evidence submitted by Dr Keith Arundale

1 Introduction

1.1 I am a Senior Visiting Fellow at the ICMA Centre, Henley Business School, University of Reading where I teach Private Equity & Venture Capital modules to both undergraduates and postgraduates. I am also a Non-Executive Director of Henley Business Angels, a Visiting Professor at the University of Chester Business School and a former doctoral researcher at the Adam Smith Business School, University of Glasgow. I am the author of “Raising Venture Capital Finance in Europe” (Kogan Page, 2007) and “Venture Capital Performance: A comparative study of investment practices in Europe and the USA” (Routledge: Taylor & Francis Group, 2020). I also authored the BVCA’s “Guide to Private Equity”.

1.2 For the past 12 years I have been researching the investment practices of venture capital (VC) funds in UK, continental Europe and USA (and also recently, China). This research and my findings were published in my book “Venture Capital Performance: A Comparative Study of Investment Practices in Europe and the USA” as noted in 1.1 above. My research was predicated on my desire to investigate the reasons for the historic weaker financial performance of UK and European VC funds compared to their counterparts in the USA. Both the BVCA’s and Invest Europe’s data has consistently revealed an overall underperformance of VC funds in the UK and Europe compared to their counterparts in the USA, although returns have significantly improved in recent years and are now largely commensurate with returns achieved by US venture funds. For example the 10 year VC returns to 2013 were 0.84% pa compared to 5.03% pa for USA whilst 10 year VC returns to 2019 were 16.8% pa for Europe compared to 17.5% pa for USA, with UK returns for this latter period of 11.6% pa overall (Invest Europe / BVCA data).

1.3 The historic underperformance of UK and European VC funds has had significant economic implications, notably reduced allocations of finance to the VC component of the European private equity asset class by the traditional institutional investors which has resulted in a shortage of funds going forward for investment into young, innovative, potentially high-growth European companies. This has necessitated government institutions, principally the European Investment Fund (pre-Brexit) and the British Business Bank to fill this funding shortfall.

1.4 Unlike previous largely quantitative studies into the performance differential which involved quantitative analysis of large datasets, in my research I conducted a series of in-depth interviews with venture capitalists from 64 different VC firms from both sides of the Atlantic, including VCs based in the UK, various continental European countries and Silicon Valley, Boston and the mid-Atlantic regions of the USA. I supplemented my VC interviews with 40 further interviews with people in the wider VC ecosystem, including limited partner investors, entrepreneurs, VC-related individuals, advisors to the sector and corporate venture capital firms. Establishing a unique dataset from a thematic analysis of the transcribed interviews my study found structural and operational differences and contrasts in the approach to investing between US and European funds and differences in the wider environments in which the funds operate. These differences are summarised below and are particularly relevant to the Committee’s request for international comparisons and examples of international best practice. I have developed best practice guidelines for VC investing, derived from my research into UK, European and US VC funds, which are included in the appendix to this letter.

2 Structural differences

2.1 Concerning the structural aspects of VC funds, US funds in the sample (average size $282m) were considerably larger than UK ($168m) and continental European ($128m) funds. The larger size funds in the US allow VCs to follow-through with their initial investments which, in turn, better permits investee companies to scale. US VC firms have proportionately more partners with operational and entrepreneurial backgrounds than European firms which may well assist in the screening and value-adding capabilities of US VCs.  The research also revealed that US firms share responsibility for deals more than UK and continental European firms, often having two partners working together throughout the life of an investment. Additional knowledge and experience gained by two partners working together reduces information asymmetries which could lead to better investment and consequent better fund performance. There was also evidence of US VCs clubbing together to make relatively small investments in very early, seed stage investments in order to “test the water” and thereby reduce the risk of missing out on potential outlier investments which have the potential to contribute disproportionately to the overall returns of a fund. 

3 Operational differences

3.1 For the sample of VC firms included in the study there were a number of operational areas where the investment practices of European VC firms differ from those of US firms. These areas include a theme approach to identifying “hot” future areas for potential investment adopted more by US VCs than by European VCs, with the latter tending to follow the trend. US VCs put considerable resource into researching and developing innovative new areas for investment. Getting ahead of the competition in this way and investing at the earliest stages of new technologies could contribute to the better performance of US VC funds. In addition more US VCs pursue a home run, “1 in 10”, investment strategy than European VCs. This is a high risk approach but can lead to outlier returns for the funds as a whole. Other findings from the research include the impact that the brand strength of US VCs has on attracting quality deal flow whereas European VCs have more of a proprietary approach to generating deals. A senior partner can force the approval of investments at some US VCs against the wishes of other partners. This can lead to outlier performance as the more usual consensus approach can remove potential outlier deals. It was also found that more US VCs, particularly the West Coast based VCs, have “entrepreneurially friendly” terms in their term sheets as opposed to the “investor friendly” terms found with European VCs and with some East Coast based US VCs. This again demonstrates US VCs’ focus on the upside of investment growth and the European concern to protect the downside risk.  

3.2 European VCs appear to keep poor performing investments going for longer than US VCs which can clearly impact on performance. On the other hand, more US VCs wait for the best exit than European VCs who tend to exit early, perhaps due to fund raising pressures from their investors. US VCs appear more able to achieve optimal exits for their investments as a result of their wealth of contacts with potential trade buyers, such as large technology companies, and an overall easier exit process in the US including a stock market that is more receptive to technology companies. European VCs achieve less than optimal realisations for their investments which result in less profitable exits and lower returns for their funds.

4 Wider environmental differences
 

4.1 European VCs have a lower propensity for risk and do not “think big enough” with their investments. US VCs’ risk approach is exemplified in their “1 in 10”, home run investment strategy. There is also more of a willingness to share contacts, talents and information in the US, particularly in the unique environment of Silicon Valley, versus more of a proprietary system in Europe. 

5. Summary

5.1 These structural, operational and wider environmental factors all impact on the performance of individual investments and therefore on overall fund performance and therefore contribute to the historical difference in performance between US and European VC funds. In general the findings from VC firm executives’ views on the differences between the European and US environments were in accordance with the views of the other stakeholders interviewed.

5.2 The implication of this research is that the solution to the well-known funding gap in the UK is not simply a matter of increasing the supply of finance. Rather, there is a need for quite fundamental changes in both the practice of UK investors and in the wider ecosystem. First, there is a need for the UK VC community to adopt a variety of best practices, including the adoption of more of a higher risk, “home run” investment strategy where considered practical and rational, the pursuit of outlier deals championed by senior, experienced partners, the use of “entrepreneurially friendly” terms and less focus on the downside, a “theme” approach to identifying hot areas for investment, raising larger funds, where practical, for follow-on funding and scaling,  hiring more partners with operational and entrepreneurial backgrounds, exiting from investments when the most value can be achieved depending on market conditions and scaling potential, a less proprietary approach, more networking and sharing of information including dissemination of best practices, building collegiate syndicates and a focus on data and metrics that drive investment decisions. Second, there is the need for more receptive public markets for technology companies together with a ready supply of good CEOs and entrepreneurs willing to form serial ventures.

5.3 UK VC is at a pivotal moment. There are many excellent features about the venture capital sector in the UK. These include much technological innovation from the universities, centres of excellence in fintech, AI and other areas, more people studying entrepreneurship at our universities and joining entrepreneurial companies. Moreover, it is notable that a number of new UK VC firms that have been formed in the past decade have adopted more of a US Silicon Valley style of investing. This, in turn, might be expected to encourage increased institutional funding for the sector. However, there is more the UK VC sector needs to learn from the US VC sector and apply to raise its overall performance. US firms are more aggressive, they’re looking at the “Babe Ruth” approach. UK / European firms are far more timid and that comes out in everything that entrepreneurs say. This is not a cultural issue. It is due to real economic factors, including a more competitive environment in the US and issues with scaling, fragmented markets and a general lack of finance in Europe for starting up and scaling companies. 

5.4 As a follow up to this research I am now currently researching the investment practices of Chinese VC firms, in comparison to UK, Europe and USA, and I would be pleased to present preliminary findings of this China research to the Committee if this is of interest. For example, Chinese investors and their portfolio companies exhibit a pragmatic, “get up and go” approach, perhaps similar in some ways to the drive, ambition and “thinking big” approach demonstrated by US VCs, more so than European VCs. Chinese VCs are looking to make the best returns as quickly as possible.
 

5.5 If I can be of assistance to the Committee’s review process please do not hesitate to contact me. I would welcome the opportunity to be interviewed by the Committee.

Appendix:

Guidelines for best practice VC investing

Keith Arundale, PhD

These best practice guidelines for venture capital investing are derived from my recent research into venture capital fund performance and the investment practices of VC firms in Europe and USA. The research is the most up to date, complete and extensive qualitative review of the entire VC investment process featuring interviews with 70 VC investment executives from 64 separate venture capital firms in Europe and USA supplemented by interviews with 40 other stakeholders (limited partner investors, entrepreneurs, advisors and corporate VCs).

The best practices for setting up and running a VC firm, which may help to improve performance if appropriately adopted, are categorised into structural, operational and wider environmental headings below. Full details on the research on which the guidelines are based can be found at:  
http://theses.gla.ac.uk/view/creators/Arundale=3AKeith=3A=3A.default.html
 

Structural
 

• Funds should be of adequate size to provide initial and follow-on finance in order to allow young, high-growth businesses to grow and scale.
• Sector expertise of investment partners permits better deal sourcing, in-house due diligence and value adding activities.
• Taking the risk and investing early at the seed stage, maybe in syndicate with other VCs, may result in investments with outlier performance.
• Investing in the local geographic area may help better overall fund performance because of tighter networks and in-depth knowledge of local opportunities.
• Partners with entrepreneurial / operational backgrounds help facilitate the investment process through knowledgeable deal sourcing and adding value to portfolio companies post investment.
• Partners working together on deals facilitates the sharing of information and expertise.
• Venture partners, additional to the main investment team can bring additional resource to deals with specialist skills and knowledge.

Operational

• Pursuit of a higher risk, “1 in 10” investment strategy can lead to outlier returns through “home runs” and contribute to superior performance.
• Use of milestone financing, or “drip-feeding” investments, can help minimise risk exposure on an investment (if competitive terms permit), but care required as the presence of milestones can lead to suboptimising behavior in the face of market changes with which milestones have not kept up.
• Following a theme-based approach to investment trends may contribute to superior performance as may a focus on disruption in terms of technology, market or business model.
• Brand name, profile and track record help to attract better quality deals which can lead to better fund performance.
• Due diligence carried out in-house by sector specialist investment executives may be more effective, and less costly, than due diligence carried out by external advisers.
• Investment decisions should be made by the investment team, not by people external to the process. Use of consensus in decision making can remove the outlier investments and depress returns; deals “railroaded” through by senior partners may enhance returns.
• Investment terms should be as entrepreneurially friendly as the local competitive environment permits.
• Syndicating with VCs who are known to the investor aids better alignment of interests and less conflict between syndicate members. Effective collaboration with other VCs in pooling of expertise and knowledge about a deal can lead to better outcomes with due diligence and improved value add.
• Use of a metrics based approach to monitoring portfolio companies and weeding out poorer performing investments soonest contributes to better investment outcomes and improved fund performance.
• The in-house resources that VCs can bring to bear on their investments through value adding activities should contribute to overall improved performance, although the best investments may be where VCs have to add the least value because the companies are well-performing.
• Exiting too early from an investment should be avoided if at all possible; waiting for the best exit can help achieve optimal gains.

Wider environmental

• A “thinking big”, ambitious culture, combined with a higher propensity for risk, can lead to outstanding returns.
• Open networks encourage information sharing and hence better knowledge of new technology developments and markets in contrast with a more closed and proprietary approach. Regulatory and legal environments, including copyright laws, need to be conducive to innovation.
• Extensive networks between VCs, entrepreneurs, large technology companies and other stakeholders, and a non-proprietary willingness to share time and resource in a “giving back” culture, help achieve better overall performance.
• A good supply of experienced CEOs, repeat entrepreneurs and effective sales people are needed to run high growth potential venture backed businesses. 
• Luck is an ingredient of success in VC investing; however a major component of VC success can be attributed to skill in recognising a serendipitous opportunity and capitalising on it.

Incorporating these guidelines into the structure of VC firms, their operational activities in terms of investment practices and the environments in which they operate may help to improve performance, although this is of course not guaranteed!     

About the researcher: Dr Keith Arundale is a university lecturer, author, executive trainer and consultant in private equity and venture capital. He is a Senior Visiting Fellow at Henley Business School, University of Reading, a Visiting Professor at the University of Chester Business Research Institute / China Centre and a former doctoral researcher at the Adam Smith Business School, University of Glasgow. Keith was awarded an Adam Smith Business School prize for PhD excellence for his research work into VC fund performance and investment practices in Europe and USA. Keith is the author of “Raising Venture Capital Finance in Europe” (Kogan Page, 2007) and “Venture Capital Performance: A comparative study of investment practices in Europe and the USA” (Routledge: Taylor & Francis Group, 2020). He also authored the BVCA’s “Guide to Private Equity”.

Disclaimer: The above guidelines are based on the author’s research into venture capital investment practices and fund performance in UK, continental Europe and USA. This research engaged a purposive sample of some 70 VC firm investment executives from 64 separate VC firms and 40 other stakeholders. The findings are specific to this sample and not necessarily representative of the wider population of VC firms. The information included in the guidelines has been prepared for general interest only and does not constitute professional advice. You should not act upon the information contained herein without obtaining specific professional advice. The information reflects the views of the author and does not necessarily represent the current or past practices or beliefs of any organization. The author is not engaged in rendering accounting, business, financial, investment, legal, tax or other professional advice or services whatsoever to the readers of these guidelines. Accordingly, to the extent permitted by law, the author accepts no liability, and disclaims all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained herein or for any decision based on it.

May 2022