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By Lily Wang, Partner at Expon Capital. as published in Insight Out #29.
Over the years, more and more funds and family offices have not only set up their operations in Luxembourg, but also expanded their presence with the hiring of front-office professionals. Today, there are about 40 front-office investment professionals in Luxembourg in VC alone, without even considering the EIF and EIB. This number is much higher in PE. This large talent pool creates opportunities for more Luxembourg-born managers in the future.
There is also an increasing collaboration and collective effort among all professionals across service providers, investment funds and law firms to attract more investments and funds to Luxembourg and, hence, more talent, creating a virtuous circle in the ecosystem. LPEA plays a critical role in facilitating this collaboration.
VC could be a good diversification.
Venture Capital (VC) is a strategic diversification tool because it invests in emerging trends and technologies before they reach mainstream adoption. This approach allows investors to tap into the potential for high returns by identifying and supporting innovative startups poised to disrupt established industries. For instance, Tesla’s focus on electric vehicles (EVs) and sustainable energy has fundamentally disrupted the traditional automotive industry, which once dominated transportation. Tesla’s success highlights how VC-backed companies can challenge and transform long-standing market norms, rendering previous industry standards obsolete. By investing in such forward-looking ventures, VC provides a unique opportunity to benefit from the shifts in consumer preferences, technological advancements, and market dynamics, underscoring its value in diversifying investment portfolios.
Within the VC asset class, there are many different strategies offering various levels of risk, return and diversification. The strategies vary by
i) stage (seed, scale-up, growth equity/late-stage),
ii) software vs hardware,
iii) geography (country, region, global),
iv) business model (B2B vs B2C),
v) sector (generalist, healthcare, climate, spacetech, fintech, cybersecurity, deeptech).
Different VC strategies vary significantly in their risk-return profiles. For example, seed stage investment is obviously riskier than the scale-up stage. So a seed-stage VC fund often has a larger number of portfolio companies and a greater portion of capital reserved for follow-on investments to bet on one winner, i.e., fund returner. As software companies reach a scale-up phase of 2-5m EUR in annual recurring revenues, the risk is much lower, since the product market fit is proven, and the scaling potential can be quantified with measurable sales efficiency based on the existing sales team. With reduced risk on each investment, the fund strategy is not betting on a single fund return, but good performance across most of its portfolio. As those companies reach late-stage, the risk of the company is much lower, but the return potential is more limited, particularly during a tough IPO market period.
One firm, two strategies
In the case of Expon Capital, we manage two strategies. First, for the seed-stage strategy, the Digital Tech Fund (DTF) focuses on investing in software companies located in or setting up operations in Luxembourg. The DTF has public and private investors, including SNCI, the State of the Grand Duchy of Luxembourg, the Luxembourg Chamber of Commerce, SES, Cargolux, Proximus, Post, BIL, Arendt, as well as family offices. It was created to support Luxembourg’s startup ecosystem, which is wholly overlooked. Fund returners have already been identified out of just 13 portfolio companies in Fund 1.
Second, the scale-up strategy focuses on investing in European software companies in climate tech, health tech and digitalisation. The main investors in the fund are family offices. While climate tech and digital health are pretty popular now, we have been early movers since 2017, have tested what works and what doesn’t, and built a strong network. There are, of course, real business opportunities in these markets, like our Refurbed, Sympower and Hellobetter portfolios. But we remain more diligent than ever, given the availability of capital in those two markets.
How are VC investors paid?
While the business model is typically similar to PE, a VC fund is usually much smaller in size than a PE fund. The economics of Venture Capital is primarily driven by carried interest, not management fees. Success in VC hinges on the long-term performance of investments, as carried interest represents a share of the profits generated. This aligns incentives, prioritising substantial returns from successful ventures over the steady, but lesser income from management fees.
People always assume that VC investors are chasing the next big thing, whether AI, blockchain, or the internet of things. But ‘hot deals’ don’t often equate to good investments. The hype surrounding these deals can inflate valuations, leading to unrealistic expectations and potential overinvestment. Savvy investors recognise that real value lies in identifying under-the-radar opportunities with solid fundamentals, rather than chasing popular, overvalued ventures. VC investors are paid to access high-quality deals and generate returns, rather than investing in the most popular and expensive company.
After identifying the right investment, it is about creating value throughout the portfolio management lifecycle.
The three key value creation drivers of an investment are operational improvement, multiple expansion, and leverage. Operational improvement is the combination of growing revenues and expanding margins, driving returns more consistently over time compared to multiple expansion and leverage. This is particularly true in the current market with the high cost of debt.
Value creation is a long-term process requiring a time commitment and experience managing companies and relationships with founders. VCs typically have c.6-12 meetings annually for each active investment, including both board and strategy meetings. The number of meetings could significantly increase during the period of a new financing round. VCs invest the time to share the learnings and knowledge they have accumulated over the years, having been exposed to so many – both successful and unsuccessful – startups.
In addition, VCs share their network with their portfolio companies. There is also peer knowledge sharing among portfolio companies. Furthermore, VCs provide the playbooks to founders on what to do and how, based on learnings from decades of startup experience from the best entrepreneurs and VCs.
In this market, profitability is everything. Some companies have fundamentally unprofitable business models. Others have business models that are already profitable, but not yet EBITDA positive and would be, if they chose to reduce the annual revenue growth rate from 80% to 20%, by lowering sales & marketing costs. How do VCs help portfolio companies measure profitability? Numerous metrics are used, such as CLTV/CAC, payback period, NRR, ARR/FTE, etc. On top of analysing the numbers, it is essential to understand the changing market dynamics and competitive landscape, and attract the right talent to convert strategy into reality.
Finally, it is about exits – both good and bad ones. Typically the best performing companies are usually the last to be sold, as they continue to grow quickly and offer attractive value over time.
Summary
VC could offer good diversification for investors. There are various strategies within the VC classes with very different levels of risk, return and diversification. GPs’ interests are well-aligned with LPs by focusing on return generation and value creation.
