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Judit Karsai: Deep crisis threatens venture capital market in Central and Eastern Europe

Judit Karsai[1]:Deep crisis threatens venture capital market
in Central and Eastern Europe

Although the crisis is not yet having any impact on the value of venture capital investments, and this year is expected to exceed last year’s record investment levels, the business climate in the CEE region’s venture capital and private equity markets has already changed radically.

Despite a brief stagnation due to the pandemic, the growth of the venture capital and private equity sector was fuelled until the first half of 2022 by the large amount of investable capital available through low interest rates, the very rapid expansion of digitalisation and the resulting high returns on exits. In 2021 and the first half of 2022, investments were still booming in both developed markets in Europe and in the CEE region. A number of large-scale investments were made in the region, which the regional funds could not have undertaken on their own, without the support of reputable foreign funds with extensive international experience.[2] This is the reason why the number of unicorn companies born in the region, i.e., companies valued at EUR1bn, has already reached 40. At the same time, funds worth EUR100m remain a rarity in the region, which could provide companies with sufficient investments at a later stage of their development. While an increasing number of lesser-known fund managers in the region are launching their second or third fund, and more and more entrepreneurs with a wealth of experience from successful companies are providing real support to new start-ups in the region as mentors, business angels or investors in equity funds.

The figures for venture capital and private equity investments in Central and Eastern Europe in 2021 show the highest investments since 2003, amounting to EUR4.15bn, covering 672 companies.[3] With this performance, the region represented 3% of the value of venture capital and private equity invested in all European companies, a very significant increase compared to 1% in the previous year. However, the region still lags far behind its share of around 10% of Europe’s GDP and 27% of its population. This development gap is illustrated by the fact that the region’s share of 0.228% of GDP invested in the region is only a third of the 0.749% for Europe as a whole. However, there are large differences between countries in the region. With its 1.574% indicator, Estonia, which achieved a far outstanding performance based on the volume expressed as a proportion of GDP, achieved the highest ratio not only in the region, but in the whole of Europe. The Polish market, the largest in the region, has the highest investment value, while the Hungarian market has been leading the way for years in terms of value and number of early stage investments.  The very high number of Hungarian companies receiving funding in the region was reflected in the fact that 40% (241) of the 607 companies receiving capital in the region in 2021 was located in Hungary. This particular record is mainly due to the activities of Hiventures, a state-owned management company that manages a range of exclusive government funds, whose investment portfolio includes both incubator investments and investments to rescue mature businesses. (Hiventures’ investments between 2018 and the first half of 2022 ranked ninth in Europe.[4]) Nearly 60% of the record amount of capital invested in the region in 2021 came from venture capital investments, while the remaining 40% came from private equity fund buy-outs. Looking at Europe as a whole, the ratio is the reverse, suggesting that venture capital, which provides smaller amounts of capital to younger firms than private equity funds, is still much more important in the region than private equity, which finances acquisitions.

Despite the outbreak of the Russian-Ukrainian war in February and the escalation of the war, the rapid growth of investments in the region continued in the first half of 2022. The value of investments already reached USD3.2bn in the first half of the year, compared to USD1.4bn in the first half of 2021. The large increase was mainly due to investments from outside the region. During the half-year, USD1.1bn was received from US venture capitalists and USD1.1bn from European investors outside the region. Among the biggest deals of the first half of the year was a USD94m round B investment received by Hungarian cybersecurity firm SEON, which came from Silicon Valley investor IVP. The other significant investment this year was a USD220m round D capital raise by Czech online home delivery company Rohlik, which was led by Sofinova. The third deal of note was the investment received by the Lithuanian cybersecurity company Nord Security, which was provided jointly by Novator Ventures, General Catalyst and Burda Principal Investment.[5]

In 2021, the amount of capital raised, i.e., the amount of capital committed to new funds, was also higher than in the previous two years, amounting to nearly EUR1.78bn. (True, this record is only two-thirds of the EUR2.6bn collected in 2018, the highest amount since 2007.) In 2021, following a temporary decline due to the pandemic, the region’s weight in Europe remained broadly unchanged at 1.4%. In terms of fund investor composition, the largest proportion of funds in the region continues to be public. In 2021, a quarter of the funds came from here, while only 8% of all European funds came from public sources. However, pension funds with significant volumes of investable capital, and thus the ability to invest in mature companies and finance larger equity funds, accounted for a fifth of the total capital raised in Europe in 2021, compared to 8% in the region. In 2021, the Hungarian market led the fundraising in the region with EUR466m, representing 28% of the total fresh capital raised in the region. Unusually for the region, half of the funding was provided by a foundation previously set up from the budget. In 2021, most of the 35 new funds in the region was also established by fund managers on the Hungarian market (13).[6]

While investments continued to reach record amounts in Europe, the year 2022 was already characterized by skyrocketing inflation and interest rates, exploding energy prices, severely deteriorating growth forecasts and the threat of a recession. The golden age of venture capital in Europe over the last ten years is now over, including in the CEE region. International trends also prevail in the CEE venture and private capital markets, but everything is happening here on a slightly smaller scale and with some delay than in the more developed markets of Europe. Volatility in the energy, equity and debt markets, as well as inflation caused by supply chain disruptions, also pose serious challenges for transaction-oriented investors in the region. The significant change in business sentiment is already evidenced by recent data from the CEE Confidence Survey, which is regularly carried out by the consultancy company Deloitte. From 149 in summer 2021, the confidence index fell to 58 in summer 2022.[7] However, this level is only slightly above the lowest level of 48 measured so far, one year after the outbreak of the global economic crisis, in the autumn of 2008. Investor concerns indicate that investors are expecting a reduction in the funding available for transactions, are less willing to take the time to do new deals in the future and are reducing their market activity. In addition, the proximity and escalation of the Russian war against Ukraine is having a particularly strong impact on the investment decisions of investors in the region, which means that they should not only be prepared for higher investment costs and lower return multipliers.

The discrepancy between the market’s soaring performance and the deterioration in business sentiment can be explained by the special, somewhat sluggish way of adapting to the crisis of the venture capital and private equity industries. When international capital flows stall at the beginning of a crisis, venture capital and private equity funds continue to have the capital they have been committed previously by their investors. While the choice of investment targets is made more difficult due to the uncertainty of company valuations, even if investors’ bargaining power vis-à-vis founders is increased. There was an increase in the share of assets held in venture capital funds in funded companies at the expense of free capital that can be mobilized for new investments. However, in the changed market situation, it is difficult for the funds to withdraw their capital from the financed companies as planned, because the company valuations imagined at the time of entry are no longer valid in the new situation, so they have to wait with the sales. However, financing companies that are kept longer than planned is not only a problem because it commits funds intended to other purposes, but also makes it more difficult to raise new funds. This is because potential investors in new funds usually use assets recovered from previous funds to finance new commitments. In times of crisis, the resources of future investors will dwindle anyway, as the value of assets in public markets will also depreciate. Investors are reluctant to undertake relatively riskier investments at the expense of their impaired assets in an uncertain market situation, and are thus shifting their wealth into safer assets. This means that new fund raising will slow down, the size of the new funds will be smaller and the number of fund managers will also fall. When the crisis ends, exits are the first to pick up, freeing up fund resources and returning capital to fund investors, who are now more willing to take on riskier investments as confidence grows. The boom in fundraising and the opening up of the credit market will open the door to new capital investments, thus kicking off the boom in investments.

The countries in the region are facing extremely high inflation, many of them are highly dependent on Russian gas supplies, energy prices in the region have also skyrocketed, and the escalation of the war in Ukraine makes the economic development of the region particularly uncertain. The changing geopolitical importance of the region, the reorganization of supply chains are all factors that will reshape business processes in the region. This is also likely to lead to a decline in investments in the region and a slowdown in the creation of new funds. However, this will only happen with some delay and more slowly than in more developed parts of Europe. The slower impact of the crisis in the CEE region is probably explained by the relatively smaller markets and lower transaction values compared to the West. In addition, as the region has a particularly high share of B2B transactions, i.e., many companies that can generate revenue from the market relatively early on are invested in, it does not rely exclusively on venture capital. In any case, companies here have not previously been subject to the kind of aggressive valuation that has already led to a rapid correction in the West. The decline in valuations tends to be limited to investments in round B and beyond, of which there are still relatively few in the region. Of the nearly 400 deals in the region in the first half of 2022, only one was worth more than USD250m—an USD628m investment in the ‘F’ round of Estonian unicorn company Bolt—while eight deals were in the USD100m to USD250m size range. Such transactions included investments in Rohlik, Ataccama and Productboard.[8] (During 2021, eight and eleven such transactions took place in the region in the above two size ranges.) The vast majority of investment in the region is in pre-seed and seed stage companies.  The shrinking volume of venture capital will not be a completely unknown situation for young companies in the region, as they have already had to rely exclusively on their own resources to a much greater extent than their European counterparts.

As was the case during the coronavirus pandemic, governments across Europe are expected to allocate public resources to mitigate the impact of the crisis, as the funding gap widens due to dwindling private resources. They will seek to minimise the disruption to the funding of their start-ups, which have a very promising fast-growth potential, and to rescue their struggling companies that are important to the state. As public intervention is expected to be market-driven, public authorities will require a certain proportion of private capital to be involved by investors in order to receive government funds. They are also likely to seek to increase the existing benefits for venture capital and private equity fund investors in order to encourage investments.[9] In the CEE region, however, the involvement of public/community resources in fund raising is already so significant that a strong increase in this could hinder market considerations and risk crowding out private investors. At the same time, among the government actions to promote innovation through the venture capital sector, governments in the region can use many other means, in addition to increasing and reallocating resources, to create better conditions for their competitive young firms to operate in the post-crisis period. This could include creating seamless start-up opportunities, developing visa rules to retain and attract talented founders and industry leaders, favourable regulation of employee share option schemes, developing legislation to enable digital experimentation, facilitating the participation of innovative start-ups in public procurement, and the widespread digitisation of government services.

 

A cikk eredetileg a G7 portál EKONOMI rovatában jelent meg, 2022. szeptember 28-án.

 

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[1] Judit Karsai works as a scientific advisor at the Institute of Economics, Centre for Economic and Regional Studies, Hungary (karsai.judit@krtk.hu)

[2] Konrad Koncerewicz: Top 100 CEE Startups That Closed Funding Rounds In 2021. March 8, 2022. https://www.vestbee.com/blog/articles/top-100-cee-startups-that-closed-funding-rounds-in-2021

[3] Invest Europe: 2021 Central & Eastern Europe Private Equity Statistics, June 2022. https://www.investeurope.eu/media/5283/cee-2021-activity-statistics-report.pdf

[4] Leah Hodgson: Europe’s most active domestic venture investors. August 15, 2022. https://pitchbook.com/news/articles/top-europes-domestic-venture-capital-investor

[5] Zosia Wanat: Undeterred by war in Ukraine, VCs keep investing in central and eastern Europe. August 22, 2022. https://sifted.eu/articles/war-ukraine-vc-central-eastern-europe/

[6] Invest Europe: 2021 Central & Eastern Europe Private Equity Statistics. June 2022. https://www.investeurope.eu/media/5283/cee-2021-activity-statistics-report.pdf

[7] Deloitte: Experienced and well capitalized. Private Equity Confidence Survey Central Europe. https://www2.deloitte.com/content/dam/Deloitte/ce/Documents/about-deloitte/Private-Equity-Confidence-Survey-July-2022.pdf

[8] Zosia Wanat: How CEE is escaping the tech downturn – for now. September 22, 2022. https://sifted.eu/articles/how-cee-is-escaping-the-tech-downturn-for-now/

[9] Judit Karsai: Startups in the shadow of the coronavirus. April 17, 2020.
https://old.kti.krtk.hu/blog/judit-karsai-startups-in-the-shadow-of-the-coronavirus/12875/

 

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