Friday, October 15, 2021

US VCs are becoming investment banks. What’s Europe to do?

These days, a closely watched phenomenon is the growth and diversification of Andreessen Horowitz, one of the most prominent venture capital firms in Silicon Valley. Not only is it hiring new partners and employees by the dozens, but it is also expanding its approach to the market, going well beyond the usual artisanal approach of early-day venture capitalists.

For a long time, such firms would simply sign a cheque in exchange for equity at a given stage — whether seed or Series A or beyond. Now some of them are doing much more than that: investing across various stages, exploring new geographies and designing new financial instruments to adjust their offering to the specific needs of startups in sectors such as crypto, real estate, healthcare, financial services and others. It makes sense because, more often than not, startups now need more than just equity: they also need debt financing, working capital, structured financial products, access to specific counterparties and more.

What if a single VC firm could provide all of that to its “clients”?

Hint: it already exists

If we look a bit more broadly, we see that this model already exists: it’s called an investment bank! Financial behemoths such as Goldman Sachs, Morgan Stanley and JPMorgan effectively act as one-stop shops for their clients. They provide equity capital, debt capital, asset management, liquidity, sophisticated risk management, market research and opportunities for mergers and acquisitions.

If a single firm can do it all for its clients, then there are economies of scale on both sides. The more capital providers you’re connected with, the more you can tailor your offer to your clients’ specific needs. In the other direction, the more clients you have, the more you can market your portfolio of opportunities to those who can provide capital. And you can already spot these networks at work in the tech world.

It is logical, then, that the most successful VC firms are slowly morphing into a new breed of investment banks — gatekeepers of the capital markets for tech startups and tech companies.

“The most successful VC firms are morphing into a new breed of investment banks — gatekeepers of the capital markets for tech startups”

What today’s startups need

Compared to the tech businesses of the past, today’s startups do have more diverse needs. For example, the rise of revenue-based financing, dominated by the likes of Pipe, Capchase, and Uplift1, has made startups offering SaaS products realise that they could fund part of their endeavour with non-dilutive debt capital rather than costly equity capital. Could the same investment firm provide the equity capital to kickstart the venture and then the debt capital to fund its growth once revenue flows? American VC General Catalyst sure thinks so.

On the other hand, those with capital on their hands feel that technology is where you can enjoy outsized returns over the long term; therefore, they’re seeking more exposure. As they realise it’s not always easy to access the best deals, maybe they’ll start thinking about trusting an investment bank with large amounts of money to be deployed across its client portfolio to generate the best returns.

It is no coincidence, then, that indexing, a concept long confined to the stock market, is becoming more visible in venture capital (see John Luttig here, and Tomasz Tunguz here). Instead of chasing a few deals a year, just trust a large, established firm with your money and let it index it on the entire tech market! A traditional VC firm can’t do that, but an investment bank does.

The trend of small VC firms turning into large one-stop shops is corroborated by traditional players, including investment banks themselves, jumping into venture capital.

With the tech sector snowballing and demanding more from the financial services industry, traditional financial powerhouses are realising they may have a competitive advantage. It was pointless to try and compete with VC firms back when venture capital was a small asset class dominated by a small group of craftspeople. But now that it’s joining the big leagues of the financial world, there is a clear spot waiting to be conquered: Goldman Sachs, but for the digital economy (which will soon become the entire economy).

Where does this leave Europe?

So what about Europe? Can the Old Continent grow its own Goldman Sachs for the Entrepreneurial Age? Suppose the global market for investment banking is of any indication. In that case, the future belongs to US firms operating at an international level, while European players are bound to be confined to tiers 2 and 3, focusing on their domestic market.

To be fair, every investment bank in the world has difficulties operating beyond its domestic market. Still, it’s somewhat easier for US-based players, who are backed by the US government from a regulatory perspective and can thus access much larger pools of capital and deploy resources at a larger scale without crossing critical risk thresholds. In this regard, Europe is too fragmented a market to give birth to its own financial behemoths. Regulations differ from one country to another, as do cultures, customs and best practices when making deals. Surely there will be some one-stop-shop firms in Europe, but they will never emulate their American counterparts and become global players.

“Surely there will be some one-stop-shop firms in Europe, but they will never emulate their American counterparts and become global players”

Why will that be a problem? In short, European tech companies will lose a lot in terms of information advantage and soft relationships in the process. For lack of a European global player, they will be bound to pick one of two options: either deal with US players with a worldwide footprint but without much skin in the European game, or with local players eager to take an overly parochial approach.

These past few years, there have been many talks about the US losing its edge to China and other emerging entrepreneurial ecosystems. What the scaling up of some US VC firms reminds us, however, is that the ability to grow big, diversified and tech-savvy financial firms able to serve clients all around the world is the surest ticket to long-term dominance.

Nicolas Colin is cofounder of VC firm The Family. He writes a regular column for Sifted.

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