The European Union confronts a significant challenge in its bid to match the United States economically. Economists at the International Monetary Fund (IMF) assert that Europeans invest insufficiently in venture capital, rendering the sector underdeveloped in this region.
Since the turn of the century, the United States has enjoyed an average annual growth rate of 2.03 per cent in real GDP. In stark contrast, the European Union manages just over half that rate, at 1.16 per cent.
The IMF attributes this disparity almost entirely to differences in average annual labour productivity growth. To boost productivity, greater investment in venture capital is essential, argue IMF economists in a recent report.
Currently, productivity per hour in the EU is 26 per cent lower than it would be if it had matched the productivity growth of the United States since 2000.
Economist Nathaniel Arnold highlights that institutional players in the EU invest too little, leaving the continent lagging in the development of «superstar» companies that significantly contribute to employment and economic growth.
A gaping hole
The statistics are striking. Over the past decade, venture capital investment in the EU has averaged a mere 0.3 per cent of gross domestic product (GDP) annually, approximately $130 billion. By comparison, US venture capital funds raised $924 billion during the same period.
«Institutional investors such as pension funds and insurers are a vital potential source of private capital that currently invests relatively little in venture capital,» Arnold told Investment Officer.
See also: Stepping Up Venture Capital to Finance Innovation in Europe
This deficit of large venture capital funds in Europe is a ‹costly weakness,› according to the IMF. When European startups reach the stage where they require substantial funds to scale rapidly, they often turn to US funds. Many startups relocate to the US to benefit from a better-funded ecosystem.
In the past decade, fewer than 35 funds have been established in the EU with more than €500 million in funding. Consequently, few funds can provide individual startups with €30-50 million in growth funding per round.
Although data from Invest Europe shows that new venture capital funds raised from insurers and pension funds have increased in recent years, Arnold attributes this to a rise in total funds raised. «Funds raised by insurers and pension funds remain a small share of the total, around 10 per cent,» Arnold noted.
Banks pose obstacle
The report’s three authors, including economists Jan Frie and Guillaume Glaveres, point to Europe’s bank-led financial system.
The tendency for companies to turn to banks for investment is an «unfortunate reality» for startups, according to the IMF.
High-tech startups often develop new technologies and business models, which are risky and difficult for banks to assess.
Furthermore, the value of startups frequently lies in their personnel, ideas, and other intangible assets, making it challenging to use as collateral for a bank loan.
Banks are also constrained by regulations that rightly limit loans to risky companies without collateral, even if they are fast-growing and likely to yield substantial profits later.
Returns
Nevertheless, the fact that America boasts the world’s best-funded startup ecosystem does not necessarily mean US investors always achieve higher returns from their investments, according to a report by industry body Invest Europe.
Since 2002, European venture capital funds have achieved a net annual return of 12.65 per cent, surpassing the 12.25 per cent earned by US investors, Invest Europe stated. European funds have also outperformed their US counterparts over five- and ten-year periods.
However, data from PitchBook contradicts Invest Europe’s analysis. Internal rate of return (IRR) data from 1,709 venture capital funds indicates that US vehicles have outperformed their European counterparts over nearly all time periods until the past year.
Detailed data on EU insurers› and pension funds› allocations to venture capital is not readily available. Data on their private equity investments can be downloaded from EIOPA, with venture capital included but not separately reported. Industry reports, such as the Atomico 2023 State of European Tech report, reveal that venture capital constitutes a very small portion of EU institutional investors› portfolios.