Decline in Fund Formation

Fund formation has steadily declined since the peak in Q1’22, with Q3’24 recording the lowest new fund activity since Q3’17. This trend indicates a shift in the venture capital landscape, as investors focus on deploying existing capital rather than creating new funds.

What we are seeing especially in the CEE region and Europe generally, is that institutions such as the EIF have played an important role in fund formation. A lot of the funds that got money from public institutions would now have to raise their second one, but with more private capital, which they are finding rather difficult. According to PitchBook, 81% of all capital raised has flowed to established firms, typically for large funds exceeding $500 million. This level of concentration among well-established managers hasn’t been observed since 2008.

Here’s why:

• Private capital remains expensive due to relatively high interest rates and ongoing economic uncertainty.
• There is a lack of distributions, reflecting the current inability of VCs to generate actual payouts. This has led LPs to hesitate when considering (re)investment in new funds.
• A healthy VC ecosystem depends on IPOs and exits. While the IPO window is still closed, exits are becoming more frequent as an alternative.

VC Investor Focus on Existing Portfolios

In Q3, venture capital investors prioritized their existing portfolio companies over new investments. This shift demonstrates a more cautious approach, as investors dedicate time to engage with and support these companies in improving their operations and financial health. But there is also an issue arising with that development:

VCs are now advising their portfolio companies to reduce burn rates and achieve positive cash flow. They argue that if companies accomplish this, it is entirely up to them which direction to take next (follow-on financing, M&A, etc.). Yet, some investors may overlook the fact that achieving positive cash flow does not inherently justify previous, higher valuations. To command valuations in line with venture capital expectations, companies must still demonstrate the accelerated growth rates typical of VC-backed firms. After all: there is no VC-like valuation without VC-like growth.

Increase in Down Rounds (except for AI and ML)

Though AI and ML come as an expectation, the amount of down rounds in VC in Q3’24 has increased, as companies are struggling to maintain the high valuations they raised at in their previous round.

Even for companies that raise at a higher valuation, some of these valuations are “up” in name only. This is because new funding deals often come with difficult terms that ultimately reduce the company’s value in practical terms, such as liquidation preferences and anti-dilution clauses. With these kinds of stipulations, the company’s value in practical terms may be lower than it appears, especially if it fails to achieve a high exit price. In less-than-optimal exit scenarios, these conditions mean that most investors will receive less than they expect.

Buyouts as alternative Exit Strategies

Other exit strategies have involved buyout firms acquiring VC-backed startups, either as add-ons to existing investments or as entirely new platforms. Research suggests that this approach can bolster portfolio companies when the market cycle improves. However, corporate strategic acquisitions remain limited due to two main factors: potential regulatory scrutiny and the high valuations left over from the booming market of the early 2020s.

VC Deal Volumes Remain Elusive

Venture deal counts appear to have bottomed out, though a significant market rebound has yet to materialize.

The slow pace of VC recovery is largely due to ongoing challenges that continue to hinder exits, fundraising, and dealmaking. With liquidity still out of reach, venture investors have become more cautious, raising their standards and prioritizing quality over quantity. They are spending more time on due diligence and pushing for greater rigor in investments

Remaining VC Deal Volume Driven by AI

While global deal value has declined in Q3’24, much of the remaining activity is driven by large AI deals and by companies that last raised capital two to three years ago, when valuations were at historic highs.

These companies secured substantial valuations during the zero-interest-rate policy era, when capital was readily available. After implementing cost-cutting strategies to extend their cash runway, many of these startups are now returning to raise additional funding rounds.

Valuations climb driven by AI Deals and Legacy Peaks

At present, valuations are trending upward across most funding series.

While this appears positive, it is likely that these figures are largely influenced by exceptionally large AI deals and companies that last raised capital two to three years ago when valuations peaked. These companies secured high valuations during the zero-interest-rate period when capital was readily accessible. Now, after implementing cost-cutting strategies to extend their cash runway, these startups are beginning to raise new funding rounds.

Selected European Transaction Highlights