New vistas for Alternative Investments and Venture Capital in Luxembourg

To the point

• Luxembourg has emerged as a leading financial center for alternative asset management, including venture capital.

• Luxembourg's regulatory framework, such as the SICAR and RAIF, has been instrumental in facilitating the growth of the venture capital industry in the country.

• The high regulatory burden for small asset managers, including venture capital firms, is a significant challenge, particularly for those seeking to market their services within Europe.

• The growth of the venture capital industry in Europe has increased significantly over the last 20 years, with the number of venture capital managers increasing tenfold.

• Early-stage investments require substantial returns, and growth pressure can be problematic for venture capital firms.
  

Luxembourg has established itself as a leading player in the financial world, particularly in the realm of alternative asset management and venture capital. In this exclusive interview, Nick Tabone interviews Managing Partner of Mangrove, Hans-Jürgen Schmitz to talk about Luxembourg's venture capital industry. The regulatory framework of the country, which includes influential entities like SICAR and RAIF, has played a crucial role in nurturing the growth of venture capital, attracting numerous firms eager to leverage the region's advantageous financial climate. Hans-Jürgen Schmitz has a unique perspective on the world of venture capitals and uncovers which hurdles asset managers have to go through. Dig into our conversation, as we uncover the evolution and hurdles in Luxembourg's venture capital world.

Mangrove Capital Partner was born in Luxembourg and is a success story. While you have a presence all over the world, Israel, Berlin, London, Barcelona, you have chosen to remain headquartered in Luxembourg. What is it about Luxembourg that makes you want to stay?

Hans-Jürgen Schmitz [HJS]: When we started off in Luxembourg, VC in Europe was basically nowhere apart from a few players. Back then, we were in a market environment where we had maybe 20-30, maximum 50, venture capital managers. Today, there are over 500, so a tenfold increase in the last 20 years. Adding to this, the average fund volume has increased, which means that the amount of capital that can be deployed in European companies through venture capital has increased about 50 times. Today versus 20 years ago. So, we had a relatively open field at the time. To define who we wanted to be and what we wanted to do was relatively straightforward, there weren’t many benchmarks.

Why did we choose Luxembourg at the time? It was a combination of obvious personal reasons. My family and job was here. The founders left their jobs as partners at Arthur Andersen, and it was not an easy decision, so we did not want to change too many parameters.

The other reasons were more practical. We needed to know how to set up a fund, and what it meant for investors, depending on the way the funds were set up? While Luxembourg did not have the toolbox that we have today, the basic instruments that we could use were there, particularly the framework for Part II funds, which is what we used in the beginning. What was also given was the framework, the competency, and the fundamentals of investment management with tax, legal or any other services for that, so that was a relatively easy decision.

And fast forward to today, we never regretted that decision. In hindsight, that choice was probably the best we could have made. Given how Luxembourg has evolved as a financial center and the toolbox it has developed, such as the SICAR or the RAIF, these are all results of the recognition of the market opportunity in alternative asset management. In addition, we never had to second-guess if our fund or our fund structure is compatible with a European, U.S., or Asian investors, whether it's a family office or institutional. It's almost a one-size-fits-all, at least for venture capital.

From an investor perspective, you don't have to explain to them why Luxembourg. And that again takes a lot of friction out of the fundraising process.

What are the biggest challenges facing the VC industry today and how is Mangrove adapting to them?

Hans-Jürgen Schmitz: Small asset managers, including venture capital firms, have to face a significantly higher regulatory burden compared to larger entities, such as private equity houses. Today, this is a barrier to entrance for a VC especially if you want to market inside of Europe. It may also force VCs to grow disproportionately, which can be problematic, particularly for early-stage investments, where the need to produce for investors may conflict with certain investment strategies.

As we look at the VC landscape today, many are still micro or small funds, 30 - 50 million Euro — the size that we at Mangrove started with. Unless they find some creative way of maneuvering AIFMD, at least in Europe, compliance with regulation may prove to become a knock-out criterion. They do not usually have the resources that we have for example, with dedicated legal and compliance people. This was again a choice we made many years ago.
Outsourcing can be an option of course but you must monitor the performance and costs closely.
I see technology emerging as another solution here in the form of software for investor management, KYC/AML checks, portfolio reporting etc., but it is and remains a major challenge that burdens the VC industry in Europe (vs. the U.S. for example).

The other factor is that in Europe we have an abundance of funding capability for seed and early investments. On the flipside, money for the growth and scale up phase is at deficit now and, therefore, around 70% of that money comes from outside of Europe, mainly from the U.S. and increasingly from Asia.

Another challenging phenomenon are valuations. Not surprisingly, in the current market the late(r) stages valuations have dropped massively, at least 50% in tech. They track the value trends in the public markets. But the more you look to early stage, the less that drop became visible to the point where I saw some statistics showing that 2022 valuations were at least at the same level, if not higher than in 2021 in early stage, which is completely counterintuitive. As a result, entry valuations remain high, while the short to mid-term perspectives for funding and value creation are gloomy at this stage.
How is this going to play out? I'm not limiting myself to venture capital, but more broadly to the industry. When are we going to see a rebound in sentiment, in valuations, or in market values? To some extent we were all hoping that 2023 would mark a turnaround, but it’s likely that it won’t happen until 2024.

And then again, I predict this rebound will be slower than post the financial crisis. A few fundamentals are different. We have overriding political uncertainties and crises that we didn't have at that time. Next, the interest rate level (if it lasts) will lead to asset reallocation. Investors have the choice of balancing high(er) risk tech stocks with high alpha and more conservative investments including fixed-income options, which will likely redirect money away from alternative assets, and less money supply will affect asset prices.

Finally, higher interest rates will also weigh on valuations because it means higher discounts on future cash flows, thus lower valuations. To illustrate, one of the key valuation measurements in high-growth private companies is sales or revenue multiples. They used to be as high as 15 of 16 on average on listed stocks in 2021. Now we are at 5 to 7. We may not see these come back anytime soon.

The first signals of recovery are usually expected from the public markets, at least in the tech industry. With 2022 being one of the worst years in recent history the earnings announcements in the next quarters will set the sentiment here. Before it trickles down to growth and early-stage tech in terms of market sentiment, valuations, multiples, etc., 2024 could be the year of rebound. Provided interest rates ease, as some experts believe, assuming that on the political front, we start to see ways out of some of the current crisis.

Generative AI is the new hype – as avid investors into the tech sphere, what are your thoughts on this trend and the impact, not only from an investment perspective but even in your business as a venture capitalist?

HJS: AI is obviously the talk of the town. And used (sometimes abused) in every second pitch deck we see. Truth is, it’s being developed by experts for at least ten years. Without being noticed by the general public. Until last November, when ChatGPT3 hit the main stage and gave the public a tangible glimpse of what it could do and mean for everyday tasks.

From an industry point of view, we are likely at a seminal moment in (tech) history, comparable to the introduction of the internet. As this technology continues to develop, it is likely that we will see many new and innovative uses for it in the future. And investment opportunities abound. Examples span from content creation, product design, gaming, all the way to specialty application in robotics, healthcare, finance, mobility, legal profession, just to name a few. From an investment perspective, one of the key attributes we will look for are applications that develop and train models on proprietary training data sets (as opposed to those using publicly accessible data sets). K Health, again, is an excellent example as it develops its algorithms exclusively on proprietary medical data. As is edgify.ai, which develops visual recognition-based applications for the retail sector.

In the context of our own business, I think AI enabled applications could become very relevant in deal sourcing, due diligence, and portfolio tracking. There are already quite a few initiatives in this regard, certainly in private equity. AI can be used to identify and evaluate potential investment opportunities with higher accuracy and in less time. Once invested, AI based applications can be used for performance monitoring. On the investor side, identification of new capital sources and more broadly investor relations management could be an area of use. Not to forget, of course, compliance monitoring across the organization in alternative asset management.

Not many venture capital firms get to have unicorns in their portfolios and Mangrove Capital Partners have been involved as early investors in five unicorns, such as Skype, Wix, Walkme, K Health, and TBOL. What is the secret ingredient? (In the business industry, a unicorn is a privately held startup company valued at over US$1 billion)

HJS: The term unicorn is being used, abused and overly emphasized. Statistically out of 1.000 investments over a lifetime not even two would reach unicorn status. By just being long enough in the business or by deploying enough money into the ecosystem alone will not guarantee you will ever encounter one in your portfolio. The profile you create for your firm (VC) and how you position yourself is important in attracting the founders of these startups to take your money.

Firstly, our business is a people’s business. From the founders’ perspective, our experience shows that experienced entrepreneurs are more likely to succeed in reaching these levels. Examples for this in our portfolio are The Bank of London and K Health.

Second, it is our observation that many very successful products and companies were built by people with no prior experience in the industry they target. Oftentimes it is about challenging the status quo — free of legacy — to develop groundbreaking solutions. As an example, K Health was not built by doctors, Skype not by telco experts. And while not a rule per se, it has been a key ingredient in our history and success.

Third, it is about a relentless focus on execution and speed. Pursuing an ambitious goal goes hand in hand with building a team and organization that is fast and agile to master growth. A lot of trials, errors, and pivots to keep the focus and adjust your organization along the way, is a rare combination and oftentimes the point of failure. Our job as investors in the early days is to help foster that sense of urgency, the need for speed, the belief in the opportunity. Then help find the right people, help build the foundation of the organization. You will be able to see in a couple of years whether the leadership team is able to perpetuate that recipe and produce outsized business growth as a result.