In recent years, a number of institutional investors have withdrawn from venture capital, after losing confidence in it; some have even declared that the model is ‘broken’. The latest evidence suggests, however, that this view is outdated – that the venture capital market is not broken, but more alive than ever.
Some will probably find this surprising. But current market dynamics suggest that US venture capital – across both current and coming fund vintages – has the potential to perform strongly. This is leading some investors to review past assumptions and redefine their approach to investing in venture capital.
The collapse of the dotcom bubble in 2000 hurt many institutional investors and led to a mass desertion from venture capital. Having had their fingers burned, until recently many have been unwilling to make new commitments to the asset class. But as the memory of the dotcom bubble era fades, LPs are increasingly recognising that the 1999/2000 period was an exception to the norm; instead they’re focusing on the long-term trends that drive US venture performance.
For instance, one indicator of the current strength of the market is the pace of new company creation. Over a 25-year period, this has grown at a sustainable rate of about 4-6 percent annually, but the current pace – about 800 new companies created per year – is below the long-term trend of about 1,000. A look at data tracking VC-backed exits suggests that of these 800 companies, around 15-20 are likely to have a very large exit at some point in the future. Another 20% will be write-offs, and the rest will generate average returns. This performance has enabled the venture industry to generate impressive net IRRs of 15-30% for many vintage years.
This model is the blueprint for a successful strategy, but it didn’t work during the dotcom era. Venture capital wasn’t “broken”, as some claimed – there was simply too much capital chasing too many deals. In 2000 alone, an astonishing $109 billion (in today’s currency) was raised by venture capital firms. That was nearly 10 times more than just five years earlier, and 9 times more than the equivalent figure today. Evidence suggests that the cyclicality in venture capital performance is actually caused predominantly by the cyclicality in investor behaviour – whereas the rate at which successful venture-backed companies are created is comparatively stable over time.
Some of the 800 venture-backed companies created every year will revolutionise specific industries. Some may even revolutionise the way we live and work, as a quick glance at some of the biggest companies in the world demonstrates.
Over a time span of 35 years, and with the initial aid of venture capital funding, Apple has grown to become the second largest company by market cap globally, currently competing head-on-head with Exxon for the number one position. Google now has a market cap of around $170 billion, with venture capital funding central to its success. And Facebook is re-defining the social networking space, with a valuation higher than any other privately held private equity or venture capital-backed company ever.
In addition to these world leaders, the US venture industry has created a stockpile of privately held companies likely to have successful, high-profile exits in the near future, such as Facebook, Groupon, Zynga, Twitter, LinkedIn and Bloom Energy – all of which are attracting high valuations on private trading platforms.
Today’s valuations are primarily driven by the nature of the underlying business models – not by an oversupply of capital, as some market participants and commentators have suggested. The characteristics of successful venture capital investing have typically been fast scalability, capital efficiency, crowd sourcing, network effects and viral, self-reinforcing growth. Today, successful business models increasingly combine many of these at the same time. Some of today’s most successful business models thus create ‘winner-take-all’ markets. For internet-related investments, a key enabling factor behind this new type of business model is the high penetration rate of web-access through fixed and mobile devices, and the resulting changes of customer behavior. When venture funds exit some of these next generation companies, it will create headlines that may lead some institutional investors to rethink their allocation strategies.
Institutional investors understand that a constant investment pace is crucial to investing successfully in private equity and venture capital. However, some find that in practice, this is not always a simple task. This seems to be particularly true for venture capital.
But with company creation growing steadily at 4-6% annually, and investment levels still highly cyclical, opportunities abound for LPs prepared to make sometimes contrarian decisions. Although estimating future performance is always a difficult task, returns from US venture capital in the coming years are likely to surprise many.
While strong returns are likely to tempt investors back, the risk of venture capital overheating again is limited, for a number of reasons. First, current fundraising at $13 billion is so low that the industry can not only absorb some additional capital easily – it is in need of more. Second, based on their experience during the dotcom era, leading venture capital fund managers act in a disciplined manner when raising funds, even in the face of strong investor demand. Third, institutional investors are more aware than ever that they need to be highly selective when making commitments to venture capital funds.
The US venture capital industry is currently at an interesting – and potentially very exciting – moment in its evolution. Money inflows to US venture capital are at a multi-year low, which helps to limit competition for new deals. Equally, a strong pipeline of high-profile venture-backed companies should generate a string of successful realisations over the coming years, increasing the exit momentum for the entire industry.
All of which means that current and future venture funds, especially those managed by the leading fund managers, have the potential to perform as stronglythan investments in any other alternative asset class – if not more so.
Nils Rode is the co-head of investment management at Adveq, an independent global private equity investment management firm.