SOET for LPs

As the ultimate source of capital that flows downstream via VCs to startups, Limited Partners (LPs) play a critical role in the healthy functioning and success of the European tech ecosystem. The scale and predictability of capital flowing from LPs is itself shaped by the appetite and willingness of these institutional investors to allocate to the venture asset class on a consistent basis. As a result, LP sentiment is a crucial barometer to understand current and future appetite to invest.

This year's survey highlights a notable jump in the share of LP respondents who reported a decreased appetite to invest in the European venture asset class compared to prior surveys - rising to 20% from 8% last year and just 2% in 2021.

In comparison, just 18% of LP respondents reported an increased appetite, while the majority 62% reported no change in appetite. This likely reflects the fact that many LPs understand the importance of investing consistently through all stages of the cycle and the fact that, perhaps counterintuitively, a market downturn may actually represent a more attractive phase to allocate to the asset class.

What really stands out, however, is the huge gulf in perception between LPs and VCs. As many as 71% of VC respondents to the survey stated that they have noticed a decreased appetite from LPs compared to 12 months ago, clearly reflecting the strong perception that there are challenging fundraising conditions. This represents an almost doubling in VC respondents highlighting decreased LP appetite since last year's survey and is more than 3x higher than the responses shared by LPs themselves.

Interestingly, there is much closer alignment in the perception of VCs and LPs when asked about the greatest potential challenges likely to be experienced by VC GPs over the next 12 months. There is clear agreement on the difficulties of navigating the fundraising environment and the impact of a muted exit landscape on finding liquidity and realising distributions back to LPs.

The most notable areas of divergence of perception here relate to follow-on capital management and the competitive landscape for investment. LP respondents ranked the challenge of follow-on capital management much higher than VC respondents, while VC respondents were much more likely to perceive competition as a challenge than LPs. This divergence reflects LP placing increased focus and value on investment discipline and experience of fund management through full market cycles.

Interestingly, there is much closer alignment in the perception of VCs and LPs when asked about the greatest potential challenges likely to be experienced by VC GPs over the next 12 months. There is clear agreement on the difficulties of navigating the fundraising environment and the impact of a muted exit landscape on finding liquidity and realising distributions back to LPs.

The most notable areas of divergence of perception here relate to follow-on capital management and the competitive landscape for investment. LP respondents ranked the challenge of follow-on capital management much higher than VC respondents, while VC respondents were much more likely to perceive competition as a challenge than LPs. This divergence reflects LP placing increased focus and value on investment discipline and experience of fund management through full market cycles.

The changing investment environment means that LPs have to review their portfolios and allocation targets to consider potential adjustments across all asset classes, not just VC. In this year's survey, the majority of LPs reported an intention to maintain their allocations across all asset classes.

Looking at responses for venture capital specifically, more LP respondents stated an intention to increase their allocation (35%) over the next 12 months compared to any other asset class. For comparison, 22% of LP respondents reported an intention to increase allocation to Credit, and 20% reported a planned increase for Private Equity.

Interestingly, however, 15% of LP respondents stated an intention to decrease allocation to venture capital over the next 12 months, which was the third-highest share of respondents, after cash (20%) and real estate (26%).

As highlighted by survey respondents, distributions are top of mind for both VCs and LPs. The key metric to assess this is DPI, a measure of distribution to paid-in capital, i.e., the multiple of capital returned to investors relative to their initial commitment size.

On average, VC funds take up to a decade to return the initial investment to LPs (i.e. hit a DPI of greater than one), while further distributions continue to follow in subsequent years. A comparison of European vs. US funds highlights an interesting divergence in the time to DPI, but over time shows that European funds closely align to, and in some cases exceed, US benchmarks. The divergence in time to initial DPI across both regions is likely a function of the maturity of the exit landscapes.

As it does in every major venture ecosystem, government funding plays an important role in Europe too. National and regional initiatives, such as the European Investment Fund, British Patient Capital, KFW Capital, and bpifrance, are amongst the most active LPs in the European tech ecosystem. While new initiatives, such as the European Tech Champions Initiative (ETCI) will going forward play an important role in improving access to growth capital at scale.

These agencies have consistently backed local fund managers with billions of dollars of capital each year. Contrary to perception, however, the scale of annual investment has not grown materially over the past five years. In fact, in 2022, government backing actually declined again compared to 2021 and the peak year of 2020.

But as more and more private institutional investors commit to the European venture asset class, the relative share of funds sourced from governments continues to decline rapidly as a percentage of total funds raised by European fund managers. This hit a record low of 11% of total funds raised in 2022, down from more than 16% in each year between 2018 and 2020.

Considering their scale, European pension funds have historically punched well below their weight as investors in the region's entrepreneurial and growth ecosystem. As the State of European Tech has called out over the years, when comparing the total assets under management (AUM) of European pension funds, the share from this dedicated to the venture asset class is minuscule. 

In 2022, just 0.010% of pension fund AUM was invested into European VCs, in line with the average of the last five years. This is based on the reported assets of European pension funds, standing at $7.8 trillion.

Positively, there has been a small number of notable developments across Europe this year. The UK government, for example, added flexibility earlier this year on a fee cap previously limiting pension funds to invest in VC funds. Furthermore, in October, the Venture Capital Investment Compact was signed by a number of leading UK and European venture firms pledging to work in collaboration with UK pension funds and insurers, with the goal of allocating increased capital to VC in order to support the growth of the UK economy. In Germany, meanwhile, the Ministry of Economy and Climate is in discussions to increase the commitment of German pension funds and insurers to invest in VC. France launched the successor to its Tibi initiative, Tibi 2, to attract up to €7 billion of institutional capital into early stage, deep tech and cleantech investments.

The scale of European pension funds means even a small increase in their share of AUM dedicated to VC would translate into significant volumes of investment flowing into the European tech ecosystem.

To better understand industry sentiment on the question of unlocking capital at scale for the European tech ecosystem, survey respondents were asked to share their perspective on whether European institutional investors should increase or decrease their allocation to venture capital. The response was, unsurprisingly, overwhelmingly skewed in support of increased allocation (76% of respondents), including a large share of respondents that felt that the increase should be significant (36% of respondents).

It's easy to challenge the premise of the question. Of course, most respondents are likely to be in favour of an increase in support. But what stood out to us is the strength and consistency of support across all stakeholder groups, from VCs (surprise!), to policymakers, to LPs themselves. Even 66% of those survey respondents working outside of the tech sector perceived the need for increased allocation to venture capital.

The survey results register a strong call to action.

While strong advocates for the importance of venture capital, survey respondents recognise that investing in VC comes with complexities. The most commonly cited reasons for pension funds to hold back in their investment levels was perceived to be a lack of relevant experience of investing in the asset class, the relative perceived risk to other asset classes, and regulatory/legislative constraints.

Beyond these challenges, a variety of other perceived barriers were also frequently cited by survey respondents, including institutional governance and approval processes, limited relationships and networks within the space, and the potential bias of entrenched advisor networks.

It's clear that a significant level of knowledge-sharing and education will be needed at an ecosystem level to work in collaboration with institutional investors, policymakers, advisors and other stakeholders in order to address these concerns and remove barriers to allocation at scale.