A Comparison of the Venture Capital Industries

in the USA, Japan and Germany by Dr. Martin H. Hager, MBA

Desautels Faculty of Management MBA Practicum

EXECUTIVE SUMMARY

his comparative analysis is motivated by the question why the leading economic nations of the United States, Japan and Germany

have developed such significantly different venture capital industries. The report identifies government regulations in Japan and corporatist influences in Germany at the beginning of the 20th century as key factors that led to a bank-based financial structure with constraints imposed on institutional investors and stock markets. Over the same time period, the United States developed a different financial structure in favor of market-based intermediation with significant involvement of institutional investors creating strong demand for marketable securities and venture capital. The report goes on to identify key factors in bank-based financial systems that are incompatible with the concept of equity financing and effectively prevent a thriving national venture capital ecosystem. Among these factors is the issue of information asymmetry which cannot be overcome in bank-based economies, but also the lack of vibrant exit markets which are the result of persistently low demand for venture capital. As a result, the national venture capital industry of the United States has dwarfed those of Japan and Germany in size and profitability over the last 20 years. Yet, recent developments have created complementarities in the global fundraising and investment landscape which have led to an unprecedented convergence of global venture capital markets.

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Table of Contents

1. INTRODUCTION ....................................................................................................................1

2. THE DEFINITION OF VENTURE CAPITAL .........................................................................2

3. THE IMPORTANCE OF VENTURE CAPITAL ......................................................................4

4. DEVELOPMENT OF THE VENTURE CAPITAL INDUSTRY ..............................................7

5. THE GLOBAL VENTURE CAPITAL LANDSCAPE ........................................................... 11

6. FACTORS INFLUENCING THE VENTURE CAPITAL INDUSTRY ................................. 13

FINANCIAL SYSTEMS AND THEIR STRUCTURE ............................................................................................. 13

INFORMATION ASYMMETRIES........................................................................................................................ 15

DEPTH OF CAPITAL MARKETS ....................................................................................................................... 16

IPO QUALITY ..................................................................................................................................................... 19

TYPES OF INVESTORS ...................................................................................................................................... 21

7. FUND PERFORMANCE ...................................................................................................... 24

PERFORMANCE MEASURES............................................................................................................................ 24

COMPARISON OF PROFITABILITY .................................................................................................................. 25

8. CONVERGING VENTURE CAPITAL MARKETS .............................................................. 30

9. SUMMARY ............................................................................................................................ 38

BIBLIOGRAPHY ............................................................................................................................ 41

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1. INTRODUCTION

he importance of venture capital is universally recognized, not only as an indicator of innovation but also as an engine for future

economic growth. Over the last two decades, venture capital has increased in global importance but has taken radically different development paths in the different regions of the world. Today, we observe dramatic differences in the global venture capital landscape: The United States has arguably the longest history and continues to be at the forefront of this global industry whereas venture capital in Europe and Asia only started to develop in the mid-1990s. All venture capital markets around the world have matured over the last 20 years, yet there are remarkable global differences regarding the availability of venture capital and the performance of investment funds. Against the backdrop of historical developments in North America, Europe and Asia, this report seeks to examine the differences in structure and performance of financial markets in these 3 regions of the world and will focus specifically on the United States, Japan and Germany. The direct comparison not only aims to highlight commonalities and opportunities of the three selected markets but also helps to illustrate recent industry trends that mark the first steps towards a truly global venture capital industry.

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2. THE DEFINITION OF VENTURE CAPITAL

Translating newly acquired know-how and

the development of novel technologies into a

commercially viable product lies at the core of

the venture capital concept. Investments in

newly established enterprises that are built on

untested technology are generally not

supported by banks due to high risk and a

general lack of collateral. Venture capitalists,

however, are willing to take such risk and

provide risk capital in exchange for equity or

an ownership stake in the company they

finance. This characteristic identifies venture

capital as a type of private equity. It means

that investments are made over a longer

period of time during which the company is

not public, i.e. cannot be traded on a public

exchange like the NYSE or the NASDAQ.

In some cases, the investment comes from a

wealthy individual or a group of wealthy

individuals that use their own capital to

support businesses in a very early stage based

on their personal interest. These individuals

are not acting in the interest of a venture fund

and are called angel investors.

The motivation of angel investors can either

be purely personal to help friends or relatives

to start a company or it can be based on an

interest to provide capital for a specific

promising technology or industry. As private

individuals, these angels generally support

various very young companies and make a

number of small investments in exchange for

an equity stake in the company [1]. This very

early stage is referred to as a pre-seed stage or

seed-stage (Figure 1) where angel investment

supports development of an initial concept

before the business has reached the start-up

phase.

3

Subsequently, the seed-stage company attracts

interest from venture capital funds that

provide financing for product development.

The company is now in the start-up phase and

tasked with commercializing its product,

including manufacturing and marketing. From

here, further injection of cash by venture

funds is used to support the private company’s

growth. During this expansion phase,

investments are used to provide additional

working capital and increase production

capacity (Figure 1). A company in expansion

phase is able to consider alternatives to

venture capital financing and can receive

capital through private equity investments or

debt financing. Finally, companies that have

expanded and become profitable leave the

venture capital phase and will start to

approach an exit phase, either through an

initial public offering (IPO) or through an

acquisition by a key player in the industry. Any

investment at this late stage is meant to serve

as a bridge to prepare the company for exit

and is also referred to as mezzanine financing

(Figure 1). Venture capital is usually provided

according to these different stages and the

company only receives enough funding to

reach the next stage.

With these investment options in mind,

venture capitalists act as an intermediary with

the mandate to make prudent equity

investments in portfolio companies using

capital funds provided by investors. Even

though this concept bears some resemblance

to banks, the financial return for investors does

not come in form of interest rates. Instead, the

venture capital firm’s investment strategy must

compensate the investor for taking on risk

without collateral. As the risk of loss is very

high but also the potential for profit is

considerable, a venture capitalist’s primary

goal is to identify an exit strategy that will

maximize the financial return for the fund and

its investors. To identify the best exit strategy

requires careful planning and is frequently

guided by investment banks. One of the most

lucrative and hence most desirable exits occurs

through an IPO, in which shares are offered to

the public for the first time, effectively marking

the transition to a public company.

Subsequently, the venture capital firm

gradually sells its stake and returns the

proceeds to the investors. Other exits are

realized by selling the company, either to

another investor or to a larger company.

But the provision of funding is only one aspect

of the important contributions of venture

capital and it is frequently overlooked that

experienced venture capitalists and angel

investors support entrepreneurs with advice

and management expertise. The venture

capital firm will also try to maximize the

likelihood of success and actively participate in

the management of the startup company by

taking a seat on the board of directors. At this

level, experienced venture capitalist can

directly guide the company’s development,

build a strong management team and support

the first growth phase [2]. In the event that

performance objectives are not met, investors

are in a strong position and can change

strategies and even members of the

management team to ensure that

performance will improve. This arrangement

results in increased competitiveness of venture

capital-backed companies and evidence

suggests that it also produces more and

stronger intellectual property [3].

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3. THE IMPORTANCE OF VENTURE CAPITAL

The importance of a thriving venture capital

industry for the future wellbeing of an entire

nation cannot be underestimated. Without

any doubt, research and development plays

an essential role for long-term growth as it is

generating new knowledge and commercially

relevant technologies. But despite spending

more on R&D than the United States (Japan

3.4%, Germany 2.9%, USA 2.8% of GDP [4])

and being ahead in patent filing (Figure 2),

the stagnating economies of Japan and

Germany have been unable to translate these

remarkable investments in tangible advances

such as GDP growth (Figure 3). In 2014, Japan

reported a year-on-year contraction of its GDP

by 0.1%; Germany’s growth was only 1.4% [5].

One of the contributing factors is that the

majority of research and development

activities are concentrated in a few large-sized

enterprises (LSEs) that dominate based on

their ability to generate economies of scale

and minimize risk. Such companies focus

research activities on product and process

improvement as opposed to introduction of

risky technologies [6]. In these economies,

small and medium-sized enterprises (SMEs) are

at a disadvantage. However, LSE-dominated

systems are able to operate in equilibrium and

cannot respond to restructuring, recession,

changing competition or accelerated product

life cycles. An economy that relies to a great

extent on a static population of LSEs is

exposing itself to high risk of creating an

Source: WIPO [74]

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economic vacuum if one of them fails.

SMEs are greatly important for the long-term

stability and vitality of an economy because

they are able to replenish lost jobs and

restructure industries. Compared to LSEs, SMEs

have a higher degree of flexibility, are faster in

responding to a shift in global and national

opportunities and consequently create a level

of competition that is indispensable for

innovation. Many studies carried out in the

United States, Japan and Germany have also

demonstrated a link between the number of

high-growth SMEs, the creation of new jobs

and national economic growth [7]. However,

intensifying research and development in

SMEs through public funding of R&D activities,

e.g. the Small Business Act in Europe [8] has

frequently not resulted in the desired effect on

the creation of a vibrant SME ecosystem [9].

Instead, the creation of sustainable spin-offs

likely relies on supporting their growth phase

to enable commercialization of technological

opportunities.

In order to create favorable conditions for

innovative and growth-oriented SMEs, venture

capital must play a central role in a country’s

innovation ecosystem by providing young

firms with early-stage financing such as

pre-seed, seed and start-up funding but also

later-stage financing. This risk capital gives

SMEs the financial resources they need to

invest in further research and development,

manufacturing and marketing before they

reach a stage that will allow them to generate

Source: Business Insider [75]

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revenues. Consequently, venture capital is

fostering innovative activity and

entrepreneurial talent and is a vital

component to drive growth in mature

economies that suffer under prevailing

industrial and institutional structures.

This point is further underscored by the

finding that venture capital investments are

three times more effective in generating

industrial innovation than are R&D

expenditures [3]. Additionally, venture capital

is an important source of managerial

experience — a key ingredient in successful

innovation. Along with financing, venture

capitalists bring entrepreneurial experience,

industry knowledge, and networks of

customers, which many young entrepreneurs

lack. Interestingly, higher levels of GDP growth

correlate well with amount of total venture

capital investments per capita of a given

country, which may indicate that venture

capital is an important source of

macroeconomic growth (Figure 4). This is

supported by studies of the European Venture

Capital Association (EVCA) demonstrating that

venture-backed companies impact economic

growth by stimulating innovation, productivity

and competitiveness [10].

Source: [76], OECD [77]; MHH analysis

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4. DEVELOPMENT OF THE VENTURE CAPITAL INDUSTRY

The beginnings of the venture capital industry

in the United States can be traced back to the

years after World War II when the American

Research and Development Corporation

(ARD) was formed [11]. It was the first venture

capital firm that was able to raise money from

institutional investors like the Massachusetts

Institute of Technology (MIT) instead of relying

on wealthy families [12].

ARD started operating in 1946 during a time

when government subcontracting had

created a strong network with industries and

universities that facilitated technology transfer

to small firms [13]. Over the following decades,

venture capital grew from its beginnings on

the East Coast of the United States to a mature

industry with its largest cluster of venture

capital firms in the southern part of the San

Francisco Bay Area (Figure 5). Even today, the

majority of investments continue to be

concentrated in these two hotspots and with

this critical mass the venture capital industry in

the United States has consolidated its global

Source: The Atlantic [78]

Source: Prequin [79]

8

leadership position as the country with the

largest number and the highest volume of

venture capital funding (Figure 6). As of 2014,

venture capital investments in the U.S. reached

$50 billion and with that the highest level

since the year 2000 (Figure 7).

The venture capital industry in Japan was

shaped by a different economic, political and

social environment and consequently took a

completely different development path [14].

The first venture capital firm in Japan was

established in 1972 after a Japanese

delegation had traveled to Boston and studied

ARD’s experience and approach. That year,

Kyoto Enterprise Development Co. Ltd. (KED)

began operating and used the investments of

prominent Kyoto corporations to invest in

small businesses in the region. Just one year

later, Nomura Securities together with other

financial institutions and insurance companies

invested ¥500 million to create the Japan

Associated Finance Co. Ltd. (JAFCO) which is

still operating today [15].

Since its inception, JAFCO has been a pioneer

of the Japanese venture capital industry and

over the last 40 years the company invested

globally in over 3,800 unlisted companies,

backed more than 950 IPOs and has currently

¥495 billion under management [16]. In 2000,

at the height of the global internet boom,

Source: NVCA [80]

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venture capital investments in Japan

approached ¥300 billion for the first time but

have since declined and as of 2014 total a

mere ¥117 billion (Figure 8).

In Germany, the first steps towards creation of

a venture capital industry took even longer.

The WFG, Germany’s first venture capital fund,

was only established in 1975 as a consortium

of leading German financial institutions with

involvement of the federal government [17].

This unusual alliance was short-lived as it

became apparent that the various parties

pursued objectives that could not be

reconciled: rapid commercialization of new

technologies was the primary objective for the

federal government, whereas the financial

institutions were concerned with minimizing

risk. Endowed with DM50 million over its short

lifetime, the WFG failed after only 9 years of

operation and cumulative losses amounted to

DM38 million [17].

Over the same time period, U.S. venture

capital had increased from $400 million to $5

billion [18]. In Germany, private equity

investments were only able to break through

the DM1 billion mark in 1992 and remained

stagnant until 1996. In 1998 investments

reached DM4 billion [19], of which only DM1

billion was true early phase venture capital

[20]. This investment pattern did not change

Source: VEC [66]

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over the following years: Seed, start-up and

later-stage venture capital investments in

Germany only received €650 million in 2014

and with 9% continue to represent only a

fraction of the €7 billion total private equity

investment volume. Buyouts on the other

hand represented 79% or €5.6 billion [21].

Figure 9 further illustrates total investments for

the DACH region (Germany, Austria and

Switzerland) in comparisons with other

European countries.

Source: EVCA [68]

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5. THE GLOBAL VENTURE CAPITAL LANDSCAPE

Looking at the historical development of the

venture capital industry in each of the

described countries, it is immediately evident

that the venture capital industries in Japan

and Germany have never been able to play a

significant role in the national economies. The

industries have become more similar over the

last decade, in particular the factors which

determine vibrant markets and attract

investors all seem to be abundant.

The recent venture capital and private equity

country attractiveness index summarizes

factors that shape national venture capital and

private equity markets including economic

activity, depth of capital markets, taxation,

investor protection, corporate governance,

human & social environment, entrepreneurial

culture and deal opportunities [22]. According

to the 2015 ranking of 120 countries in 8

different geographic regions of the world, the

United States is the most attractive country for

venture capital and private equity allocations,

followed by the United Kingdom and Canada

[22]. The report ranks Japan on 5th place,

citing market-leading technology, good

entrepreneurial culture and opportunities but

also criticizes high corporate tax burden,

decreasing stock market liquidity and IPO

activity [22]. In particular, Japan’s market

liquidity has recently been impacted by the

massive quantitative easing (QE) program of

the Bank of Japan. The asset purchase

program of Japanese Government Bonds

(JGB) has effectively tightened supply and

demand and together with the rapid decline

in long-term yields has resulted in reduced

market liquidity [23]. Germany on rank 7 still

faces high hurdles for starting and running a

business and is limited by the size of its stock

market but opportunities exist due to a large

number of investment targets in a diverse

portfolio of industries [22].

Source: OECD [77]

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Despite the significant convergences between

the national markets of the United States,

Japan and Germany and the resulting highly

attractive investment opportunities, major

differences in the national structures are still

observable. In 2014, the United States raised

$29.9 billion in venture capital and invested

$49.3 billion in venture capital. Japan raised

$0.89 billion and invested $1.15 billion 1 in

venture capital. Germany raised $0.41 billion

and invested $0.88 billion2 in venture capital.

Figure 10 gives an overview of the global

venture capital investment volumes in 2014.

When put into perspective as the amount of

venture capital invested as a percentage of

national gross domestic product (GDP), the

differences between these three countries

become evident (Figure 11). The United States

with a GDP of $17.4 trillion in 2014 invested

0.28% of its GDP in venture capital, Japan with

a GDP of $4.6 trillion invested 0.04% in 2013

(Figure 11) or 0.025% based on the 2014

numbers, and Germany with a GDP of $3.8

1 based on historical exchange rate 101.75 ¥/$ 2 based on historical exchange rate 0.732 €/$

trillion invested 0.023% [5]. Consequently, the

United States is 3.8-times larger than Japan on

the basis of GDP but invests 43-times more in

venture capital than Japan does. The United

States produces a GDP which is 4.6-times

larger than that of Germany, yet American

investments in venture capital were 56-times

higher.

The large developmental gaps between the

venture capital industries of the United States,

Japan and Germany cannot simply be

explained by the fact that venture capital has a

much longer history in the United States.

Economic context, institutional environment

and culture all have played an important role

in each country and have uniquely shaped the

way in which venture capital has developed.

In the following chapter, we will take a closer

look at the structure of the venture capital

industries in the United States, Japan and

Germany and the forces that have shaped

them over the last two decades.

Source: OECD [77]

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6. FACTORS INFLUENCING THE VENTURE CAPITAL INDUSTRY

FINANCIAL SYSTEMS AND THEIR STRUCTURE

The introduction of venture capital in Japan

and Germany occurred three decades later

than in the United States and resulted in a

completely different outcome. From the very

beginning, venture capital in Japan and

Germany was based in and reflected a

fundamentally different financial system and

structure unlike that of the United States.

Figure 12 illustrates a comparison of the

financial structure of the three countries from

1991 to 2000 (diamond) and 2001-2011 (bar).

The relative importance of banks and markets,

respectively, is shown as the ratio of bank

credit to the sum of bank credit plus total

equity and bond market capitalization [24].

The higher the ratio, the higher the

importance of banks in a given country. Large

differences in the financial structure of the

three countries are immediately evident. The

financial systems of Japan and Germany

feature large banking sectors which dominate

all aspects of financing, drive industrial

development and traditionally control

ownership [25]. In this environment, banks

focus on tangible assets and cash flows as

collateral for granting loans and favorable

options are presented to established stable

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companies. Young, innovative companies with

little collateral or intangible assets are

considered less attractive and generally face

many issues in a bank-based system, e.g.

absence of competition and transparency

make it impossible to use price signals as

guidance for decisions. Absence of market

signals and lack of information about

profitability is less of a problem for physical

asset-rich companies, which is why such

industries do generally well in bank-based

systems. Interestingly, both Japan and

Germany have been criticized for having

underdeveloped stock markets that play

limited roles in the support of funding (Figure

13). But whereas Japan’s banking system has

evolved over the last 15 years and shifted to a

more market-based financial structure,

Germany did not progress and has not

changed its bank-oriented system since the

reunification (Figure 12).

On the other hand, in the United States the

relative importance of the banking system is

less than 20% (Figure 12). In contrast to

bank-based systems that can only support

incremental innovation, its market-based

system is generally better suited to support

innovative high-risk companies with

revolutionary innovation. Due to information

transparency, which will be discussed below in

more detail, a company will be able to choose

from a larger number of potential lenders and

the competition amongst lenders produces a

number of independent assessments of

borrowing costs. Reliable disclosure also

assures investors that they pay an adequate

price for shares. And finally deep and liquid

stock markets guarantee attractive exit

strategies, provide the foundation for

financing through capital markets and allow

dispersed ownership. Consequently, the

American market-based systems provide ideal

conditions for venture capital financing of

young companies.

Source: IESE [81]

15

INFORMATION ASYMMETRIES

It is becoming obvious that a country’s

financial environment determines if a venture

capital culture is able to take hold and develop

into a vibrant industry. In a recent publication,

Christian Schröder argues that venture capital

investments are negatively affected by the

characteristics of a bank-based financial system

whereas market-based systems provide

incentives in form of attractive liquid markets

for lucrative exits via IPO [26]. Why would a

bank-based system have such a negative

impact and why is debt provided by banks

simply not suitable for high-tech startups?

According to the assumptions in the

Modigliani and Miller theorem [27], it does not

matter how a company is financed and

theoretically it should not matter if a company

is financed via debt by a bank or via equity by

venture capital. Yet, in reality the factor of

information asymmetry plays an important

role and determines why venture capital

investments use preferred equity rather than

debt [28]. High-tech startups in the software

and biotech industry display a high probability

of asymmetric information due to the

non-transparent nature of initial phases of

research & development which are only fully

accessible and certifiable by the entrepreneur.

Later phases are more easily observable by

outside parties due to the involvement of

official evaluation institutions (e.g. the FDA).

The high degree of information asymmetry

risk between entrepreneur and venture

capitalist leaves investors with uncertainty

about project quality and presents investors

with extreme monitoring difficulties that could

be exploited under a debt financing

arrangement. Under the provision of debt, the

foreclosure option may create an incentive for

the entrepreneur to accept defaulting on debt

and a bank would not be able to capture the

expected cost of debt via interest rates under

such conditions [29]. Consequently, a bank

will refuse to provide debt in a situation where

information asymmetry is too high.

On the other hand, equity financing has

unique characteristics that are able to mitigate

some of the risk associated with information

asymmetry. For example, investments can be

made in stages which allows investors to

closely monitor the entrepreneur and control

potential information asymmetries as the

startup company develops [30]. Moreover,

entrepreneurs will compensate investors with

the issuance of a powerful type of equity

called “preferred stock” that endows the

holder with specific rights and privileges [31].

Preferred stock has two main features that can

equalize information asymmetry and

incentivize the entrepreneur to align his

interests with those of the investor. One

feature is referred to as ‘liquidation preference’,

i.e. preferred equity ensures that investors are

protected if the company is sold below

valuation and that investors can participate in

the upside potential according to their

percentage ownership in the company if the

company is sold above valuation. This

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arrangement shifts risk away from investors to

the entrepreneur and reduces the risk of

opportunistic behavior and moral hazard.

The second feature is that investors have

freedom to use preferred stock as a hybrid

between debt and equity and they can

emphasize the debt-like qualities or the

equity-like qualities depending on the funding

situation. If performance of the entrepreneur is

poor, investors can take control of the firm. If

the start-up does well, investors can use

preferred stock like equity and give control to

the entrepreneur [32]. Successful exit through

IPO is triggering conversion of the investors’

preferred stock into common stock, effectively

rewarding the entrepreneur with full control

of the company and further aligning the

interests of investors and entrepreneurs [33].

DEPTH OF CAPITAL MARKETS

As banks would not participate in the high

returns that are associated with a successful

IPO, bank-based systems have generally a

much lower demand for liquid and deep

financial markets which in return has an

impact on stock market performance and

leads to decreased incentives for venture

capitalists to exit companies in such an

environment. In the absence of a high

probability of a profitable exit via IPO, the

assessment of the net present value (NPV) of a

portfolio company will also be considerably

lower. And finally, the absence of an IPO is the

ultimate disincentive for the entrepreneur

because there will be no opportunity to

re-acquire the control rights that were ceded

to the venture capitalists during the start-up

phase. Consequently, well-developed stock

markets allow attractive IPOs and the size of

the IPO market indicates the potential for

successful exits to the entrepreneur. These

characteristics make stock markets

indispensable in the interaction between

venture capitalists and entrepreneurs.

A direct comparison of the stock markets in

the USA, Japan and Germany further supports

the observation that the bank-based systems

of Japan and Germany generally have

underdeveloped capital markets whereas a

key source of the U.S. competitive advantage

in venture capital is the existence of a robust

market for IPOs.

The New York Stock Exchange (NYSE) is the

world’s largest and most liquid equities

marketplace and by far the most important. It

is considered the “gold standard” among all

stock exchanges and listed 2,423 companies in

2014, including many of the most prestigious

blue-chip companies in the world [34]. With a

market capitalization of $19 trillion, the NYSE is

roughly three times larger than the National

Association of Securities Dealers Automated

Quotations (NASDAQ) with a market

capitalization of $6.8 trillion. Together, these

two American stock exchanges dwarf the

market capitalizations of other stock markets

around the world (Figure 14). NASDAQ is the

world’s oldest and largest electronic stock

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market. It is a benchmark for U.S. technology

stocks, has the highest trading volume of any

exchange in the world and listed a staggering

3,395 companies in 2013 [35]. As an

electronic stock market, it has no central

trading location or exchange floor but instead

uses fully automated trading technology with

speeds of less than one millisecond.

The largest stock exchange in Japan is the

Tokyo Stock Exchange which was established

in 1878. In 2013, the Tokyo Stock Exchange

(TSE) and the Osaka Securities Exchange

merged to form the Japan Exchange Group

(JPX) with a combined market capitalization of

$4.67 trillion, making it the third largest in

world (Figure 14). The exchange is home to

the largest global Japanese corporations like

Toyota, Honda, Mitsubishi, Sony and Softbank

[36] and listed 3,416 companies in 2013.

Despite being situated in one of the largest

economies in Europe, the Deutsche Börse

Group was only founded in 1993. As the

successor of the once provincial and

fragmented Frankfurt Stock Exchange, it has

since aspired to become one of the world’s

leading exchange organizations

headquartered in Frankfurt. However, with

$1.8 trillion market capitalization it is only the

10th largest stock exchange in the world

(Figure 14) and listed only 720 companies in

2014. The Deutsche Börse Group has an

integrated business model that offers a larger

Source: Business Insider [82]

18

number of products and services covering the

entire process chain from the execution of

trading orders to post-trade services. It also

operates the Xetra electronic securities trading

platform [37] and the largest European

derivatives exchange Eurex [38].

A closer look at historical performance data for

these three exchange organizations supports

the notion that well-developed IPO markets

are indispensable to build a strong and vibrant

venture capital industry. Several key measures

of performance reveal pronounced differences

between the stock exchanges of the USA,

Japan and Germany. The number of IPOs and

capital raised in the period 2002-2006

(predating the global financial crisis) clearly

shows that the market-based financial system

of the United States is able to provide more

lucrative exits via IPO (Figure 15). Over the

measured time period, the NYSE hosted 232

IPOs with a remarkable $270 million as the

median amount raised in a company’s first

offering of equity to the public whereas the

NASDAQ hosted a larger number of exits

(488) with lower transaction size ($83 million).

Interestingly, the TSE and the Deutsche Börse

counted similar numbers of IPOs but the total

amount of capital raised at the TSE was twice

that of the Deutsche Börse whereas the

median valuation of an IPO at the Deutsche

Börse was even higher than those at the

NASDAQ ($95.6 million vs. $82.8 million)

indicating that a large number of IPOs

achieved only very low public valuations at the

Deutsche Börse (Figure 15).

19

IPO QUALITY

In general, the absence of liquid primary

equity markets poses an enormous problem

for bank-based financial systems and is a major

contributing factor why a healthy venture

capital industry is not able to develop and

grow. But it is not only the depth, size and

strength of the financial markets that is

determining a successful exit. It is also the

quality of an IPO itself which again is

determined by the quality of the company that

is going public and the quality standards of

the stock exchange, i.e. the IPO requirements.

Evidently, sound financials and strong

performance of companies will create a

well-functioning IPO market and it has been

generally accepted that pre-IPO profitability is

a good predictor of a company’s ability to

survive as a public company in the time

following the IPO [39]. Consequently, if

pre-IPO profitability is high, companies are

able to meet the extremely strict quality

standards, i.e. listing requirements of the

world’s leading stock exchanges (e.g. the

NYSE) which has the potential to produce a

high valuation at IPO and generally produces

a higher quality of public companies with

higher success rates.

Formal listing requirements ensure that these

quality standards do not erode by stipulating a

minimum number of shareholders, market

capitalization, years of business conduct,

amount of net assets and scale of income. Not

surprisingly, the bank-based financial systems

of Japan and Germany are home to stock

markets with considerably less stringent IPO

Source: EY [40], PwC [83]

20

listing requirements as compared to NYSE or

NASDAQ [40]. Due to the complexity of

regional listing requirements (e.g. the TSE

operates six different markets, each with

different listing requirements), the comparison

is not meant to provide a detailed and

comprehensive understanding of quantitative

differences but rather a generalized and

averaged overview of the four stock markets

and their IPO requirements (Figure 16).

Despite these simplifications, it is easily

observable that IPO requirements at TSE and

Deutsche Börse are considerably less stringent

when compared to NYSE or NASDAQ. In fact,

the Deutsche Börse simply has no stipulations

at all regarding a required minimum in

revenue, profit or assets (Figure 16). In a

striking similarity to the previously described

IPO patterns at the Deutsche Börse in

Germany (Figure 15), the low IPO listing

standards at the TSE produce a characteristic

IPO market in Japan that features many

small-scale public offerings with small market

capitalizations [41].

Categorizing the amount raised in IPOs at TSE

and NASDAQ reveals that 39% of IPOs at the

TSE had a volume of less than $10 million and

only 4% were in a range of $50 to $100

million. IPOs with a volume of less than $10

million represented only 2% of all IPOs at the

NASDAQ and the largest percentage (32%)

was in the range between $50 and $100

million (Figure 17). Consequently, poorly

developed exit markets in Japan and Germany

lack the required liquidity which makes exits

more difficult and ultimately represents a

significant disincentive for investors.

21

TYPES OF INVESTORS

The different characteristics of bank-based

financial systems and market-based financial

systems are also reflected on the level of

venture capital fundraising and the types of

investors that become actively involved.

Taking a closer look at venture capital

fundraising in the United States, Japan and

Germany and the type of investors that

provide funds reveals remarkably different

contribution patterns (Figure 18).

In Germany, the government and financial

institutions such as investment banks play

central roles in the venture capital fundraising

process, whereas pension funds have virtually

no significance in Germany. The less favorable

legal framework presents a huge disincentive

for pension funds and insurance companies to

invest in venture capital and severely limits

options for investment opportunities. Pension

funds in Germany are restricted to invest in

shares and bonds but have recently shown

signs of increased interest in hedge funds and

buyout funds due to continued quantitative

easing in the Eurozone [42]. Despite the

realization that pension funds represent an

important cornerstone in the fundraising and

investment process and despite the widely

accepted notion that pension funds and

insurance companies must be deregulated,

the German Federal Cabinet adopted a bizarre

policy in March 2015 of effectively banning

German insurance companies and German

pension funds from investing in private equity

funds that are managed outside the European

economic area (EEA) [43].

In the United States, pension funds are a far

more important source of venture capital

funding due to changes in the Employee

Retirement Income Security Act (ERISA) in

1979, which relaxed certain restrictions and

allowed pension fund assets to be allocated to

riskier investments [44]. Another landmark

decision was the 1980 ERISA ‘Safe Harbor’

regulation, which removed risk exposure that

was associated with accepting pension funds

as investors [45]. As a result, pension funds

have become the largest source of venture

capital in the United States (Figure 18).

The liquidity of venture capital investments

was further increased by the

Gramm-Leach-Bliley act of 1999, which

permitted banks to expand their venture

capital and private equity investments.

Another important source of venture capital in

the U.S. are research foundations and

endowments. As an example, Harvard

University alone invested $6.5 billion or 18% of

its $36.4 billion endowment in private equity.

Venture capital investments made up $2.16

billion of the private equity portfolio and

produced a return of 32.8% in fiscal year 2014

[46]. The endowment is directly supporting

innovations that are generated by the

Harvard/MIT community and has made critical

contributions to the venture capital industry

on the East Coast of the United States as

22

discussed earlier (Figure 5). In this context, an

important contributing factor that

revolutionized university entrepreneurship

was the Bayh-Dole Act of 1980 which allows

universities to retain ownership and

commercialize inventions generated from

federally-funded research [47]. The capacity of

American universities to directly invest in

venture capital and also directly support

commercially oriented research represents a

decisive advantage that produces start-up

companies which are able to withstand

commercial pressures early in their

development phase [48].

In Japan, the venture capital industry relies to

a large extent on government agencies. Just

like in Germany, involvement of the public

sector brings all kinds of complications to the

investment process due to the pursuit of

non-financial objectives. The result is often

poor performance of the venture capital funds

as we will see in more detail in the following

chapter. Pension fund investment in venture

capital as we have seen it in the USA does not

exist in Japan (Figure 18). However, in 2014

an interesting policy shift of Japan’s

Government Pension Investment Fund (GPIF)

attracted a lot of attention from investors [49].

As the world’s largest retirement fund, the

GPIF manages assets worth $1.2 trillion which

is the equivalent of the national GDP of

Mexico. Over the last decade, the fund

pursued a government bond-focused strategy

and had a 60% allocation in low-yield bonds

that offered only 0.6% return. In 2014, the

investment advisory committee of the GPIF

reviewed the asset allocation and

recommended the adoption of a new policy

Source: BvK [21], VEC [66], EVCA [68], NVCA [80], DJ [84]; MHH analysis

23

asset mix in favor of more rewarding areas

such as venture capital. Reducing its exposure

to Japanese government bonds and

transitioning to higher return assets was

expected to help realize a greater nominal

yield than the past average 1.8%. After its shift

to a more aggressive portfolio, the GPIF

reported in March 2015 a return of 12.3% in

its annual report, the highest return in its

history [50]. These are encouraging

developments and hopefully will inspire

smaller public pension funds in Japan to

match the GPIF shift with an ultimately

positive impact on Japan’s venture capital

industry.

In summary, bank-based and market-based

financial systems represent frameworks which

influence inception and growth of a venture

capital ecosystem in very different ways. In the

market-based financial system of the United

States, liquid and deep stock markets

complement venture capital and stimulate

investments. In the bank-dominated financial

systems of Japan and Germany, bank

financing is substituting venture capital,

resulting in a lack of demand for venture

capital financing and a lack of investment in

venture capital. Eventually, this has created a

situation where inadequate access to venture

capital funding produced smaller companies

with less sound financial standing.

Consequently, these companies realize lower

valuations at IPO and generally do not show

strong performance in the aftermarket making

investments in venture capital and financing

with venture capital in Japan and Germany

even less attractive.

24

7. FUND PERFORMANCE

PERFORMANCE MEASURES

As outlined in the previous chapter, many

factors influence the regional emergence of a

venture capital ecosystem and determine size

and strength of venture capital markets. The

financial systems of Japan and Germany

create a much less favorable economic,

financial and legal framework for venture

capital investments when compared to the

United States and these limitations strongly

affect fund performance as we will see in this

chapter.

Investors provide venture capital to achieve

their commercial objectives and consequently

a premium is attached to satisfactory returns,

i.e. returns which compensate investors for

taking on a high degree of risk. Long-lasting

lack of competitive returns has a profound

negative impact and will prompt investors to

shy away from venture capital investments.

Even though returns are of central importance,

the evaluation of venture capital fund

performance is difficult and complicated by

the fact that these investments are not traded

on secondary markets and pricing of trades

remains undisclosed.

To determine the return of a fund investment

or divestment, the only available information is

the cash flow history which serves to calculate

the annualized effective compounded return

rate that is often referred to as the Internal

Rate of Return (IRR) [51]. With cash flows in

and out of an investment and cash injections

at different time points, a simple percentage

change or total return calculation would not

reflect the true Return on Investment (ROI) as

it is based on a buy-and-hold assumption. As a

result, determining the IRR plays an important

role in venture capital fund performance

reporting but it cannot be directly compared

to annualized returns which weigh each year

equally in the calculation.

A fund’s profitability is measured as the yield it

produces on an investment and so the IRR can

be defined as the discount rate at which the

present value of all future cash flows equals

the initial investment [52]. Attempts to

estimate returns before a fund reaches

maturity are sometimes expressed as “Interim

IRR” which tries to factor in unrealized IRRs.

However, an objective evaluation of portfolio

companies is only possible through an IPO, a

trade sale or additional financing rounds.

Since the calculation of unrealized portfolio

returns is based on various and potentially

biased assumptions, the interim IRR is not very

informative.

Venture capital funds are typically set up with

an intended lifetime of 10-12 years. The year

the fund begins operating and the venture

capital firm starts to make the first investments

marks the so-called “vintage year” of the fund

and profitability can only be reliably

25

determined when the fund reaches its

late-stage period of exiting investments. A

fund’s annualized IRR is then recorded within

this time span, e.g. the “IRR Since Inception”

calculates the return of a fund since it began

operations, or the “Investment Horizon IRR”

calculates the return generated by a fund

during a fixed period up to the most recent

date. The “Pooled IRR” represents all cash

flows since inception together with the

residual value for all funds as if it was a single

aggregated fund [53].

COMPARISON OF PROFITABILITY

A comparison of the pooled IRRs since

inception by vintage year starting from 1982

clearly shows consistently better returns for

funds in the United States (gray) as compared

to funds in Japan (red) or Germany (black)

that commenced operations during the same

period (Figure 19). The profitability difference

is visible for most of the time period and is

particularly pronounced for vintage years in

the 1990s which reflect the famous

technology boom that culminated in the

dot-com speculative bubble in the years 1997

to 2000 [54]. In line with above outlined

characteristics of the venture capital industries

Source: Cambridge Associates [55], VEC [56], TR&EVCA [85]; MHH analysis

26

in three major world economies, it appears

that venture capital funds in Japan and

Germany have not benefited from the boom

phase as much as funds in the United States

and have displayed very poor performance

since (Figure 19). However, further indicators

are needed to support this observation.

The IRR alone is not an adequate measure of

performance of venture capital funds and

must be complemented by other measures of

performance that reflect the return of venture

capital funds as a multiple of the original

investment. These investment multiples are

indicators that can distinguish between the

realized and unrealized portions of a total

return or an investment. The realized portion

of the fund return is calculated on the basis of

cash-out/cash-in and is called the distributions

to paid-in capital (DPI) or the realized multiple.

It is a ratio that divides all distributions (i.e.

cash, stock return to investors) by all invested

capital, the “paid-in”. The unrealized portion of

the fund is the residual value of investments

that have not been exited.

In a comparison of DPI ratios for the United

States, Japan and Germany, the same pattern

that was previously observed for IRRs is

recapitulated on the level of investment

multiples. Distribution to paid-in capital has

been consistently higher for funds in the

United States but more importantly the DPI

ratio has been greater than 1 in all vintages

Source: Cambridge Associates [55], VEC [56], TR&EVCA [85], EC [86]; MHH analysis

27

until 2004 (Figure 20). This indicates that fund

investors were able to realize cash returns that

consistently exceeded the cash amount that

was paid in. In contrast, the distant vintage

groups since 1999 in Japan and even 1996 in

Germany have not been able to realize

enough cash to return the capital that was

paid in which manifests in DPI ratios smaller

than 1 (Figure 20). An interesting detail is that

American and Japanese funds of vintages

before 2000 have no unrealized portion, i.e.

are fully liquidated [55], [56]. However, even

after more than 20 years of operation, many

German venture capital funds have not

managed to exit all their investments [57].

This trend seems to be especially severe in

earlier stage investments. In a simplified

comparison of venture capital fund

performance between the United States and

Europe, it is evident that venture capital funds

in Europe were making distributions to their

investors that total just 59% of the total

investment volume (Figure 21). This is in stark

contrast to venture funds in the United States

which were able to distribute 117% of the

moneys that were paid into the fund.

Remarkably, the DPI investment multiple of

American funds does not change significantly

across different investment stages and the DPI

ratio remains 1.16 even for the very risky early

stage investments (Figure 21). In Europe,

investments in development stage companies

returned only 77% of the originally injected

cash and returns are reduced to a mere 41%

when only early stage investments are

28

considered (Figure 21). The observed pattern

on investment multiples is again reflected in

the IRRs: Early stage investments have the

lowest returns in Europe (-0.8%), whereas they

produce the highest returns in the United

States (20.2%) (Figure 21).

Finally, investment horizon returns are able to

capture the aggregate performance of all

funds in a dataset and allow the direct

comparison among the three countries of

interest (due to the lack of reported

performance data for German venture capital

funds, the comparison is based on European

venture fund performance records). Figure 22

presents the IRRs of venture capital funds in

the United States, Japan and Europe over a

range of investment horizons at the end of

2008. In agreement with the previously

discussed performance data, venture capital

funds in the United States display overall

strong performance, in particular for the

10-year and 20-year horizon reflecting very

high exit prices during the technology boom.

For example, an investor who held an equal

proportionate share in all venture funds that

started operations between 1999 and 2008

would have had an IRR of 21% by the end of

2008.

Investment returns in Japan benefited from

the technology boom to a lesser extent but

European fund returns appear particularly

poor possibly reflecting the fact that Europe

expanded its venture investment in

technology at a very late stage of the

Source: JVC [87]

29

technology bubble when high prices had to

be paid for investments [58].

As outlined in this chapter, the large

differences in the historic development and

the current significance of the venture capital

industry in the United States, Japan and

Germany have manifested in considerably

different fund performances. Venture capital

investments in the United States on average

yield much higher returns compared to their

Japanese and German counterparts and this

profitability gap is consistently reflected on the

level of internal rates of return since inception,

investment multiples and investment horizon

IRRs (Figure 19, Figure 20, Figure 22). Even

though fund performance is inherently

difficult to capture and even more difficult to

compare across countries [59], the

observations in this chapter are consistent

with the conclusions of chapter 6 which

outlined how less favorably financial systems

have created a general lack of demand for

venture capital and have led to a lack of access

to venture capital in Japan and Germany.

With the negative impact of the dotcom

bubble on fund performance slowly fading

and with the recovery of economies after the

global financial crisis, profitability measures

begin to show improving fund performance.

In the long run, this development will further

accelerate the converging of venture capital

markets as we will see in the next chapter.

30

8. CONVERGING VENTURE CAPITAL MARKETS

The large differences in access to venture

capital financing in the three discussed

countries have persisted over the last 15 years

in which the global venture capital industries

went through times of financial turmoil. Two

major disruptions caused a setback in the

expansion of venture capital investments

around the world and stood in the way of a

true global convergence of venture capital

markets: The dotcom equity market bubble of

the late 1990s saw investments soaring and

then plunging, wiping out $5 trillion in market

value in the United States alone (Figure 23).

Many of the investments during the boom

turned out to be costly mistakes and the

ramifications still reverberate throughout the

venture capital industry. Even today, the

long-term negative effects of those years at

the turn of the millennium on fund returns

and profitability are still visible in the DPI ratios

of investment funds, especially those

belonging to the 1998-2000 vintage series

(Figure 20).

Source: Bain & Co [88]

31

In the following years, markets consolidated

and the world economy and global private

equity recovered. Venture capital fundraising

and investments around the world began to

pick up again and reached record heights in

the years 2007 and 2008 (Figure 23, Figure

24). For the first time it seemed as if the

superiority of the American venture capital

industry was decreasing and investments in

venture capital in the rest of the world would

finally start to catch up (Figure 24). However,

the subprime credit bubble which triggered

the Global Financial Crisis of 2008 and the

subsequent global recession that lasted until

2012 caused venture capital investments to

plummet (Figure 24). Even though deal

making in most private equity markets was

reviving in the years following 2010, it took

until 2013 for investments to reach 2008 levels

[60]. Finally, in 2014, annual global venture

capital investments hit a record $88 billion and

set the highest mark since 2000. Since then,

venture capital investment has started to

thrive around the world: in just the first half of

2015, venture capital investments have

already reached $60 billion and the year 2015

is likely to surpass the $88 billion mark [61].

Source: EY [65]

32

Interestingly, even though the global

recession had a dramatic negative impact on

venture capital fundraising and investments,

the recent developments are fueled in part by

low interest rates as the result of a continued

QE program in Japan (Chapter 5), the

renewed commitment of the European Union

to intensify QE and extend it until 2017 [62],

and the United States liquidity trap, i.e. the

reluctance of the Federal Reserve System to

end quantitative easing [63].

Venture capital-focused investment capital

around the globe is now more available than

ever before and the sector is finally

experiencing the gradual convergence of

venture capital markets that was interrupted

twice by the macroeconomic forces of the last

decade. An overview of the worldwide

venture capital internationalization trends

(Figure 25) shows the domestic, intra- and

intercontinental links between venture capital

firms (VC) and their portfolio companies (PC)

analyzed over the time period 2000-2008 and

reveals that venture capital was already

strongly interconnected during this

challenging time period [64]. As expected,

domestic links within North America are most

frequent, followed by domestic links within

Europe and intracontinental links with Europe

(Figure 25). The intercontinental investment

flows that drive venture capital market

convergence are most frequent for European

investments in North American portfolio

33

companies (2,627 links) and North American

investments in European portfolio companies

(1,559 links) Asia has 1,155 links with portfolio

companies in North America and 771 in the

opposite direction (Figure 25).

However, the interaction between the United

States and Asia has changed dramatically over

recent years. A comparison of today’s global

investments reveals a major shift in the

geographic pattern and substantial growth in

newly emerging venture capital hotbeds.

While the United States continues to dominate

global venture capital investments, Asia has

pulled ahead of Europe with an overall

investment volume of over $10 billion during

the second quarter of 2015 (Figure 26). These

new trends in the globalization of venture

capital are also the result of significant foreign

venture capital investments in Asia. In

particular China has been a key target of

venture capital investments from the United

States with the result that Beijing became the

second-most preferred venture capital

destination behind the San Francisco Bay Area

in 2014 (Figure 27). This represents a

significant shift as in the past decades, the top

four regions in the world with the highest

venture capital investment activity have

always been all in the United States: Silicon

Valley of the San Francisco Bay Area, the New

England area around Boston, New York and

Southern California (Figure 5). Further

convergence of venture capital markets is also

34

visible outside Asia where foreign funds play

an ever more important role in national

markets and cross-border investment flows

contribute to the realization of a fully

integrated venture capital market. According

to a survey by the National Venture Capital

Association (NVCA), more than 49% of

venture capital firms in the United States

invested internationally in 2012, in Japan 60%

invested internationally in 2013 and in

Germany 92% invested outside their home

country [65], [66]. This is a remarkable

development considering that until very

recently the vast majority of venture capital

firms invested just in their own local home

markets. These are only the first steps but

venture capital markets are gradually

becoming more international and offer

venture capitalists greater opportunities to

diversify their portfolios. The ability to attract

international investments but also to invest

internationally depends on the development

state of national venture capital markets but

generally cross-border investors and portfolio

companies are equally attracted to the

concept of international venture capital

35

syndication. According to a recent study by

Bertoni & Groh (2014), international

syndicates have a strong advantage as they

can leverage capital market activity of their

home countries to enhance exit options for

portfolio companies [67]. Consequently,

investors are increasingly providing capital

across their national borders, and national

markets increasingly try to attract international

investors. One of the best documented

examples of this recent development is the

European Union and its integration in global

cross-border venture capital investment flows.

In 2014, global venture capital investments in

European portfolio companies reached new

heights: investments from private equity firms

outside the European Union (e.g. Canada,

Israel, Australia, United States etc.) totaled

€391 million, of which €326 million were

contributed by the United States and 55

million were invested by private equity firms in

Asia & Australia (Figure 28). Foreign venture

capital investments from outside the EU have

been constantly increasing since 2009 not

only in terms of total non-European

investment volume (bars) but also as

36

percentage of total (domestic + foreign)

investment volume (diamonds, Figure 29).

Asian investments in Europe expanded in the

wake of the global recession from €9 million to

€55 million but have since hovered around 1%

of total investments in the EU [68], [69].

European private equity firms also invested

venture capital in portfolio companies outside

the EU. Investments were up by 9% in 2014

and increased from €323 million to €352

million (Figure 28), [70].

This is a particularly interesting development

as it highlights an important factor that drives

the convergence of global venture capital

markets: complementarity. Europe’s lack of

follow-on funding in the mid stage after

successful seed and early stage investment

(Figure 1) is attracting investments from all

over the world. As outlined above for

Germany, government agencies play an

important role and try to provide venture

capital for early stage financing (Figure 18) but

beyond this early stage there is a general lack

of financing, in Germany but also in all of

Europe. As shown in Figure 30, while investors

in the United States have similar interest in

early and mid -stage investments, European

investors shy away from follow-on financing

after government support and prefer less risky

37

late-stage deals. This provides an interesting

opportunity for venture capitalists in the

United States to source new investments away

from the intense competition and high

valuations of their home market [71].

European portfolio companies benefit from

this development and the resulting stronger

ties to the U.S. market: Within the past four

years, 24 European venture capital-backed

companies exited at valuations beyond $1

billion [72].

As outlined in this chapter, venture capital

activity in the various markets around the

world has fully recovered and has started to

converge. This dawn of a true globalization of

venture capital is unprecedented and ranges

from cross-border investments and foreign

acquisitions to exits on foreign stock

exchanges. Of course 2015 marks just the

beginning of the global integration of venture

capital industries and the increasing

participation of North Africa, South America,

the Middle East and Southeast Asia in

fundraising, investments and divestments will

create a powerful global venture capital

universe with unprecedented growth

opportunities.

38

9. SUMMARY

Despite having ranked as the countries with

the first, second and third largest world

economies for almost 40 years (1972-2009),

the development of the national venture

capital industries of the United States, Japan

and Germany could not have been more

different. This comparative analysis sought to

trace back the roots of this development on

the national level and understand which

factors influenced supply of and demand for

venture capital that eventually resulted in the

remarkable disparity among the three

countries. Even though frequently used when

comparing nations and national cultures,

special attention was given not to analyze this

question from a behavioral finance perspective

or reduce observed differences to cultural

stereotypes.

The power of a thriving venture capital

industry in driving economic growth and the

capability to adapt to macroeconomic

changes is undisputed and yet not all nations

have been able to grow a productive venture

capital ecosystem. Especially in the wake of

the recent financial crises and the resulting

global attempts to revive economies, venture

capital and its support of SMEs has become an

important political, legal and regulatory

objective and many nations try to stimulate

venture capital investments and seek to

improve its access to emerging growth

companies. However, looking back at the past

twenty years, it is not immediately obvious

why success has been limited in Japan and

Germany whereas the United States is

providing 70% of the total amount globally

invested in venture capital.

This comparative analysis argues that by the

early 20th century, financial systems in the

three countries were very similar. However,

during the industrialization process, Japan and

Germany were set on a path different from

that of the United States and developed

autonomous financial systems and institutional

arrangements with strong regulatory

intervention by the state. In these two

countries, the bulk of financial assets and

liabilities such as bank deposits and direct

loans has been managed by commercial banks.

On the other hand, the United States

developed a system that has relied on tradable

securities as the dominant form of financial

assets. These two major characteristics serve to

broadly categorize the financial system of the

United States as a market-based system and

that of Japan and Germany as a bank-based

system. The bank-based system is able to

provide financial stability and is a powerful

national resource to achieve economic goals.

The market-based system is more volatile but

has a higher degree of flexibility and is better

suited to allocate funds.

39

Of these two structures, only the market-based

financial system creates a climate that is

conducive to the inception and growth of a

venture capital industry.

Among the plethora of factors affecting

venture capital industries, this report examined

the interesting phenomenon of information

asymmetry which represents an

insurmountable obstacle during early

development stages of companies in

bank-based financial systems. In such a

high-risk environment, only market-based

systems can help to equalize potential

information asymmetries between the venture

capitalist and the entrepreneur and it explains

why venture capitalists resort to equity but not

debt to finance entrepreneurial projects.

Interestingly, the issue of information

asymmetry (Chapter 6) is related to the recent

convergence of venture capital markets

(Chapter 8) in that it explains why German

and Japanese investors have a strong appetite

for late stage and buy-out deals where

information asymmetries are virtually absent

and bank-based systems are able to provide

debt financing.

Immediately connected to the concept of

equity financing in market-based financial

systems is the requirement for a strong and

vibrant stock market that incentivizes investors

with lucrative exits. As outlined in Chapter 6,

deep and liquid stock markets are important

factors which stimulate venture capital

investments in the United States whereas in

bank-based financial systems investors are

reluctant due to poorly developed exit markets.

The complex question of whether lack of

venture capital investments results in poorly

developed exit markets or poorly developed

exit markets result in low interest from venture

capitalists has not been addressed in this

report. Yet, the comparison clearly shows that

Germany’s corporation-dominated bank-based

system has resulted in remarkably

underdeveloped exit markets and Japan’s

stock market – albeit being the third largest in

the world – predominantly produces IPOs

with low valuations. Additionally, regulations

of financial structures in the United States,

Japan and Germany have further contributed

to the striking differences between these

countries. The full-capitalization pension

system of the United States allows pension

funds to invest in venture capital as an asset

class, resulting in a higher demand for

marketable securities and greater provision of

venture capital driven by the attractivity of exit

markets. Until recently, pension funds in

Germany and Japan were strictly regulated

and mainly investing in government bonds.

However, new movements in the liberalization

of regulations have allowed German pension

funds to allocate capital to private equity and

the largest Japanese pension fund GPIF

invested in venture capital for the first time in

2014.

Despite these encouraging developments,

performance and profitability of Japanese and

German venture funds have historically been

far lower than that of the United States. With a

detailed understanding of the factors that

have influenced the venture capital industries

in the United States, Japan and Germany, this

comparative analysis took a closer look at the

internal rates of return of venture capital

40

investments but also the investment multiples

to provide an overview of the magnitude of

the observed differences. Despite the

difficulties that come with a comparative

analysis of venture capital exit activity

according to NVCA, EVCA and VEC data, the

emerging picture shows that the equity

market bubble had a dramatic impact on the

industry. The United States was able to

capture the technology boom and achieve

high valuations for investments in the vintage

years up to 1997 whereas returns in Germany

already peaked in the vintage year 1995

indicating that German venture capitalists

invested too late and fund profitability has not

recovered since. Japan’s fund returns showed

a brief peak for the vintage year 1998 and

have remained negative until now.

Remarkably, American venture funds have

displayed strong profitability across all

investment stages for long investment

horizons and have significantly outperformed

European venture capital investments. This is

particularly true for seed and early stage funds,

again reflecting the structural differences and

risk-aversion of European investors in

comparison to their counterparts in the United

States.

The striking magnitude of the observed

differences in the size and significance of the

venture capital industries in the three analyzed

countries may seem daunting and may even

appear discouraging. But it is frequently

overlooked that these dramatic disparities

represent potential complementarities. As

discussed above, the demand for seed and

early stage venture capital investments in

Europe and Asia is frequently met by

government agencies that are tasked with

addressing financing gaps and supplementing

the deficiencies of national venture capital

markets. As venture capital investments in

Europe and Asia have historically focused on

late-stage expansion financing and buyouts,

follow-on financing of entrepreneurs has been

neglected. This funding gap has created

global opportunities for cross-border

investments that have become a major driving

force for the convergence of capital markets.

As a result, in the first half of 2015, 83% of

investments up to series A financing in Europe

was provided by European investors whereas

in series B and later financing rounds 70% of

the capital came from investors outside of

Europe.

The year 2014 was a remarkable year for the

venture capital industries around the world

and 2015 holds promise to set new records in

venture capital fundraising and investments.

Global venture capital markets have finally

shaken off the ghosts of equity market bubble

and global financial crisis. The realization of

globally integrated venture capital markets is

now within reach as fund profitabilities

continue to improve and renewed investor

interest targets existing funding gaps and

emerging investment stage

complementarities.

41

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