The Venture Capital industry in the US: is reality contradicting the expectations?

What happened in 2015?

The Venture Capital (VC) industry in 2015 has deployed a total of USD 78 billion in the US (according to PitchBook), marking the second highest full year total amount invested in the last 20 years.

A primary explanation for the growth in VC is the arrival of exponential organizations, which have, owing to new technologies, disrupted traditional sectors of the economy (for example Uber in the transportation service). “The convergence of technology across sectors is becoming increasingly important and has emerged as a common thread as companies with innovative, disruptive technologies and business models continue to catch the eyes of investors,” said Tom Ciccolella, US Venture Capital Market Leader at PwC.

Another important factor that has induced growth in the VC industry is the environment of low interest rates, which have made investments more profitable than usual due to the lower risk premium on investments required to satisfy investors’ appetite. Furthermore, the sector has been host to a wave of nontraditional venture investors.

A new player in town

Venture capital invested in the US experienced a slight growth between 2006 and 2013 from around USD 28b to USD 44b, respectively. This effect depends on the increasing number of seed stage investments and the steady rise of both early and late stage investments. A major upturn in the US venture capital occurred in 2014 where the capital invested rose by 52%, from USD 44b to USD 67b. This occurred amidst a period where nontraditional venture investors such as hedge funds, mutual funds and corporate funds become more active. In 2014, the overall value of their contribution to VC increased by USD 14.1b, accounting for approximately 62% of the overall increase in VC activity. Their share in the venture capital industry increased from 4.8% to 13.8% for hedge funds and from 4.8% to 17.7% for mutual funds from 2013 to 2015. Their contribution can thus not be disregarded.

Demand for alternative investment products has been on the rise, partly due to the seeking of growth opportunities. With low interest rates prevalent among economies, funds have been seeking out different ways to achieve positive returns on their investments. The low costs of capital associated with low interest rates throughout the past few years has freed up more capital and given way to a significant increase in venture capital funding from various types of investors seeking to benefit from these conditions.

A prominent example has been Tiger Capital Management, a hedge fund that has significantly increased its presence in the venture capital industry. Its backing of international startups has grown as has its focus in America with investments in Postmates, a delivery on-demand service and Avant Credit Inc. Other funds have jumped on the bandwagon and are paying particular attention to high growth private companies in particular at late stages. Investors have a desire to thwart the greater risk correlated with young companies and feed companies with capital as to attain market shares.

Expectations for 2016 were dismal

During the fourth quarter (Q4) of 2015, the VC investments and number of deals declined after a period of consecutive growth. This decrease in VC activity lies on multiple contingent situations.

Decreasing mega-rounds

The term “mega-round” is usually used to indicate rounds of investments with a size higher than USD 100 million. Overall, the number of mega rounds decreased from 39 in Q3 to just 18 in Q4, by far the lowest total over the past year (according to PitchBook).

IPOs falling short of private valuations

Probably the biggest concern in the last quarter of 2015 was the fact that IPOs prices were falling short of recent private valuations. Indeed, the discrepancies, mentioned above, have spooked many investors to re-evaluate their VC portfolio or even to write down as a loss a discrete number of VC investments in order to reflect the fair market value. Those miscalculations were mainly due to too optimistic valuations, concentrating too much on growth opportunity instead of actual profitability. As a result, investors are now being more cautious on their VC deals.  Another reason of low IPOs prices can be found in more and more startups, especially in the tech industry, which are increasing the competition in the market.

Potential increase of interest rates

According to experts, speculation over additional interest rate increases appears to be influencing the investment decisions of some investors. Indeed, they are looking for more appealing expected returns for a given level of risk.

Uncertainty of markets

The instability of the markets worldwide, driven by the slow growth of China, the Oil’s volatility, the US elections and the fear of Brexit, is shaping the investors as more risk averse, negatively affecting  the VC activity.

Decrease in non-traditional venture investor activity

Given the tumultuous start of 2016, hedge and mutual funds may be inclined to withdraw from VC activity. Indeed, VC investments do not constitute their core business and they may be pressured to obtain more stable returns and reduce risks. Venture capital has experienced  growth in the past two years owing to capital invested by hedge and mutual funds. The role played by ‘nontraditional venture investors’ in VC may be coming to an end.

2016 so far: A triumph over expectations

Given the aforementioned considerations regarding the VC industry in 2016, numbers appear to contradict these expectations. Although the number of deals, at 1,810, was low in Q1’2016 as opposed to a total of 2’417 deals achieved in Q1’2015, the amount invested does has remained relatively unchanged (USD 18b, Q1’2016 / USD 19 b, Q1’2015).

Although these numbers contradict expectations, experts believe that the drop in VC activity is due to the fact that large VC firms are still investing the funds raised during 2015, in an attempt to minimize the risk of their investments. This theory is supported by the different trends currently taking place at the different stages of investment.

Seed stage

The role played by investors in the seed stage has been of great impact in recent years as investments have become increasingly popular at this stage. Increased investments, lead to an increase in private valuations: more money on the table gave start-ups the ability to push up valuations and raise more capital. As mentioned before, these valuations are not paying out in the public market as expected. The seed stage is the one that had the biggest impact on total volumes, this stage being the riskiest one due to the longer time horizon.  As we can see from the graph, the Q1’2016 numbers are close to the pre-2013 levels, due to an increase in risk aversion toward the market.

Early stage

Even as the number of rounds also fell at the early stage in the U.S., marking one of the lowest levels in the last 5 years, the resilience of abundant capital investments remained strong. With USD 6.6b of investments, the Q1’2016 was the third-highest quarter per total deal value since 2013.the amount of capital invested remained more than robust. In fact, the $6.6 billion invested during Q1’2016 was the third-highest quarterly total since 2013 began.

This may lead to suggest that VC firms are still deploying the capital accumulated over the past few years, but taking more precautions in terms or valuation as well as enhancing their ability to create value from their investments.

Late stage

At the late stage, total value remained healthy, with activity increasing relative to the previous quarter. These numbers may be misleading given the overall decrease of the VC industry. Nevertheless, these numbers reflect nothing more than an increase in the risk aversion of investors who are placing added focus on the quality of investments. These later stage investments will more likely be less risky, due to a smaller time horizon. This, combined with an abundance of capital, explains the numbers shown in the graph above.

The graph below shows a comprehensive picture of the trends occurring at each of the stage combined with an overview of the VC industry.

Valuations and exit value

 

The first quarter of 2016 was host to a total of 155 completed exits with the lowest total exit value per quarter since 2010, marking a serious threat for VC industry.

Despite the IPOs having fallen short on the previous private valuation and this led to a mistrust of the market, this is not the main reason why we are experiencing this low VC exit activity. In fact, as shown in the graph below, most of the VC exits are via M&A. Low interest rates increased the M&A appetite of corporate buyers for startups. However, higher risk aversion is forcing corporate buyers to close deals at more assured values.

 

Fundraising

The fundraising activity in the US was extremely solid during the Q1 of the year, collecting capital for USD 10.6b (third-highest value since Q1’2010); thus, the sentiment of LPs and GPs seems positive for the long term. The amount of capital raised was mainly boosted by large funds, as USD 650mln Battery Ventures XI and USD 1,300mln Founders Fund VI. Institutional Investors tend to prefer larger funds because, historically, they have shown a lower volatility in the long run. It is clear that LPs are still willing to commit to the upper tiers of venture firms, whether they target the early or late stages.

Given the success of fundraising, fund managers have more than enough capital to invest for the rest of 2016, which should help to further soften any continuation of a decrease of the VC activity.

A major furtherance in VC fundraising relates to more focus being placed on the quality of investments. Investors are paying more attention the cost of investments and enhancing their ability to achieve value added. « A flight to quality combined with still-abundant amounts of capital could result in sustained strong totals invested across fewer nancings of proven companies » (Pitchbook report)

New trends, new expectations?

Expectations regarding the activity of ‘nontraditional venture investors’ remain uncertain for the coming year. Opportunities capable of providing a robust growth potential that will be able to withstand a conceivable fall in valuations and increased market volatility are disappearing. The total amount of VC investment in 2014-15 was inflated by the increase in their activity. Furthermore, the year of 2016 began on unstable ground and investors seem to be searching for quality investments, providing guaranteed returns and liquidity, rather than quantity. A fall in valuations and in the number of mega-rounds makes the future of VC ambiguous. Confident returns from 2015 are gone and while participation has begun to fade, it has not disappeared. Opportunities still exist but uncertainty constrains more risk averse investors to invest.  Two trends seem to be prevailing in the US VC industry in 2016: Investors have become more risk averse and the quality of investments is improving. These steps have been taken to impede on any negative shocks that may originate from changes in exogenous variables of the economy.

Sources: Pitchbook Data Inc. reports and public information