Oops!… I Did It Again…

As the immortal singer, Britney Spears, shared with us over 15 years ago, the venture capital industry “did it again;” that is, in 2Q16 it has invested more capital than it raised. While the amounts raised and invested in the 1Q16 were effectively the same (initially estimated to be $12 billion), during this past quarter VC’s invested at a pace nearly twice the amount that was raised, $15.3 billion versus $8.8 billion, respectively (per NVCA data). Yet again, the financing gap has re-emerged.

The last 90 days were tricky. Notwithstanding current estimates for 2Q16 GDP growth of 2.4%, and a June employment report which was startlingly robust with nonfarm payroll jobs increasing by 287k, heading into this past quarter 1Q16 GDP growth was a disappointing 1.1%. June unemployment came in at 4.9% and notably wages grew a reasonable 2.6% year-over-year. More importantly, some level of “clarity” was brought to the national election stage but alongside a steady drumbeat of horrific terrorist events around the world. Over the course of 2Q16, analysts’ expectations for S&P 500 earnings estimates declined 2.7%, with the tech sector forecast being lowered by 7.2% according to FactSet. Perhaps it is not surprising that the amount raised declined nearly 27% quarter-over-quarter given some of this turbulence and uncertainty, but it is curious that the amount invested spiked up over the same period.

U.S. venture firms raised $8.8 billion across 67 funds which compares to $11.1 billion and 82 funds in 2Q15 and $14 billion (final tally, up from $12 billion preliminary estimates of a few months ago) and 67 funds in the prior quarter; in fact, 1Q16 was the strongest fundraising quarter in the last decade. Of the 67 funds raised, 48 were follow-on funds which means just under 30% of funds raised were from first-time managers. As is consistent with the capital concentration theme that emerged over the past few years, the venture industry continues to consolidate around a handful of global brands leaving numerous smaller focused funds to fill in the gaps.

  • The Top Ten funds raised $5.5 billion or 62% of all dollars yet were only 15% of the number of funds, while the Top Five funds raised $4.0 billion or 45% of the total. In shorthand, less than 10% of the funds raised just about half the capital
  • There were two funds of over $1.0 billion in size
  • Median fund size was $37 million while the average was $131 million, which is quite misleading given the handful of mega-funds
  • Funds were raised in 15 states although 50 of the 67 funds reside in California, New York or Massachusetts
  • The remaining states accounted for only $1.1 billion or 12% of the capital (and one of those funds captured $525 million or nearly half that amount)
  • Nearly 7% of the capital was raised by first-time managers with an average fund size of $34 million, and the largest of these was Liberty Mutual Strategic Ventures which is corporate-sponsored
  • 43 of the 67 funds were $100 million or smaller in size, while 16 were smaller than $10 million

Liquidity tends to be the most reliable predictor of limited partner interest in venture capital. Woeful IPO activity has been widely reported, even though public equity markets were hitting all-time highs. There were only a dozen IPO’s in 2Q16, nine of which were biotech companies, and only $893 million was raised. To put that in some context, 961 companies raised venture capital in that same quarter – quite a narrow funnel to get to IPO. According to NVCA, there were 64 M&A transactions involving venture-backed companies, which was meaningfully down from the 91 in 1Q16. Another source, Pitchbook, tallied 153 M&A transactions valued at $15.2 billion which calculates to less than $100 million on average, which likely indicates that there were a lot of distressed sellers last quarter when taking into account some of the few exceptional outcomes which would have captured much of that value. This current year is trending to be the weakest M&A year since 2010, which is striking given the low-growth environment and nominal cost of capital.

In an effort to improve prospects for liquidity, the Jumpstart Our Business (JOBS) Act was passed in 2012 which instituted new rules as of June 2015 called Reg A+, which promised to reduce reporting and legal requirements to assist smaller companies going public. According to the Securities and Exchange Commission, while 94 companies had filed to raise $1.7 billion pursuant to these new Reg A+ rules in the past year, only a few have managed to get public. Issues have involved challenges to raise investor awareness given how small some of these offerings are to conflicting state regulations (fascinatingly, Reg A+ allows companies to publicly raise up to $20 million without an audit, which is illegal in many states). As a point of comparison, at the end of 2Q16 the China Securities Regulatory Commission reported that there were 894 companies waiting to go public on Chinese exchanges.

Interestingly, Cambridge Associates recently released 1Q16 venture capital performance data (there is a one quarter lag given reporting delays) that show 1-, 3-, 5- and 10-year returns of 6.6%, 20.6%, 15.0% and 10.4%, respectively. Across the board this performance was 300 – 500 basis points better than the associated Dow Jones Industrial Average and S&P 500 indices (in fact, it was more than 1,000 basis points better for the 3-year benchmark). And in an environment when interest rates are basically zero, risk assets like venture capital continue to be able to raise funds, even with modest and inconsistent liquidity.

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So given all of this VC enthusiasm, at least relative to 1Q16, where did the invested capital go? Consistent with the concentration theme witnessed for fundraising, the top ten companies (0.5% of the total companies) captured over $6.0 billion of the $15.3 billion invested (40% of the total dollars). This was the tenth consecutive quarter with investment activity in excess of $10 billion. Across all 961 companies in 2Q16, the average size financing was $15.9 million (which was larger than 20 of the funds raised in that period!).

While there is some movement quarter-over-quarter as to which stage and sector are hottest, Software continues to dominate with over $8.7 billion (57% of the total) in 379 companies (39% of the total), which runs somewhat counter to the notion of capital efficient business models and is likely due to the “Uber” effect where software unicorns suck up most of the later stage capital in order to scale as private companies.

  • 2Q16 was the fifth straight quarter of declining deal volume which has not been below 1,000 companies since 1Q13
  • Biotechnology was the second largest category with $1.7 billion invested in 100 companies which is off somewhat from the $2.0 billion in 1Q16. This level of activity has been reasonably consistent over time, even in light of the tremendous IPO activity, although recent declines in public biotech stocks likely account for this quarter’s softness
  • There was evidence of a pullback in the Financial Services category which raised $0.6 billion across 25 companies and is down from the $0.8 to $1.3 billion per quarter pace over the last year. The consumer online finance sector has been hit hard recently with questionable activities at some of the more notable names. According to Venture Scanner, there are now 1,379 fintech companies which have raised a total of $33 billion, causing some concerns about the ability to generate compelling returns across that entire group.
  • Silicon Valley companies raised $8.2 billion (53% of the total) across 311 companies (32% of the total), suggesting perhaps that Valley-based companies are raising larger rounds in general.
  • Interestingly, LA/Orange County clocked in as the second most active region with $2.1 billion and 70 companies, pushing NY Metro ($1.4 billion and 124 companies) and New England ($1.0 billion and 97 companies) back to third and fourth places.
  • All of California had 404 companies raise $10.7 billion
  • Twenty states had less than 3 companies raise venture capital; 8 had no companies

The stage of investment often reflects risk tolerance for venture investors. Seed and Early stage investment activity were both down in 2Q16 (5% and 12%, respectively), while Expansion increased 112% with an average size financing being $29 million. Quite clearly investors are doubling down on their perceived winners and are less likely to take on new perhaps riskier ventures. Consistent with that, First-time Financings (companies raising their first round) declined 8% to $1.7 billion. Later stage activity declined 35% reflecting investor fatigue with inflated valuations for many of these companies. Much of the dialogue in the market now is focused on getting to break-even as opposed to growth simply for growth’s sake.

1 Comment

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One response to “Oops!… I Did It Again…

  1. Great analysis, Mike. Very helpful. Angels and certain strategics should note the early stage funding gap, which they might be able to fill. And early stage companies should note the implications for their valuations: beggars can’t be choosers.

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