Given the obvious anxiety and frustration that surrounds us all, the US venture industry is also exhibiting some fatigue as we finish the 88th month since the last recession. This is the fourth-longest period of economic growth in US history (admittedly, at 2.1%, the growth over this period of time is the slowest since World War II). According to the National Venture Capital Association, this past quarter $15 billion was invested in 1,810 deals which compares unfavorably to both the prior quarter ($22.1 billion, 2,034) and 3Q15 ($21.1 billion, 2,559), signaling perhaps a period of digestion given how much had been invested during 2014 – 2015 window. Notably, this was the lowest quarterly deal volume since 4Q11, a period spanning 19 quarters.
What is most interesting is the activity beneath the headline data. Year-to-date annualized investment activity suggests that 2016 will see approximately $74 billion invested in just under 8,000 companies, which would still make it the second most active year in the past decade, although with a marked deceleration. The amount invested is consistent with what was deployed in each of the last few years, but the median round size across each stage of financing has increased significantly as the level of deal activity has declined. For instance, early stage round sizes are tracking to be nearly $5.5 million this year versus $3.0 million in 2013. Just in the past six quarters, seed stage investing activity has declined dramatically: in 2Q15, there were 1,547 seed deals as compared to 898 this past quarter. As a percent of overall activity, seed investing dropped from 55% in 3Q15 to 50% in 3Q16.
The direct implication of larger round sizes is to provide companies with greater runway but this flies in the face of the capital efficiency mantra, something venture capitalists shouted from mountain tops when we were in a more challenging fundraising environment. In the early stage category, nearly 54% of deals in 2016 were greater than $5 million in size, which compares to 32% of investments right on the heels of the Great Recession in 2010. Have investors drifted, becoming less dogmatic about hitting interim milestones with as little capital as possible?
One of the emerging story lines in the back half of 2016 is the pullback of late stage “unicorn” financings – only eight new “unicorns” were created this past quarter. In 3Q16 the top ten largest venture financings in aggregate raised $2.1 billion which represented 14% of overall activity. In the prior quarter that number was 40%. The largest round in 3Q16 was $474 million, raised by a Boston-based biotech company called Moderna. Notably only three of the top ten companies were software companies, which over the past few years has been the category that represented so many of the “unicorns.”
The data also risk masking a number of other important emerging themes when considered in the aggregate, so here are a couple of other nuggets to consider:
- The broader software category captured $27 billion to date in 2016 or nearly 50% of all dollars invested; biotech was second with $6.3 billion invested or 11% of capital
- Through 3Q16 the 357 healthcare technology sector deals raised $2.6 billion which was 6% of the overall activity
- Average round size for healthcare technology is $7.4 million which is meaningfully below the $9.3 million for all categories
- The number of late stage deals (355) in 3Q16 has dropped materially from 3Q15 (429) and is down 36% from the high water mark set in 2Q14 (555), reflecting a steady decline in large mezzanine rounds
- Just over 13% of all financings to date in 2016 included a corporate venture investor; the corporates greatest impact in 3Q16 was felt in the late stage rounds where those investors participated in 23% of those financings versus only 5% of all seed rounds
- A dozen states had less than 3 companies venture-financed in 3Q16, underscoring the continued concentration of capital in a handful of markets
In general, investment activity is bolstered by investor confidence that a predictable exit environment will continue. In 3Q16 there were 162 venture-backed exits which generated $14.6 billion of value, coincidentally an amount just below how much was invested that quarter. The top five M&A transactions accounted for just about 50% of that value. Notwithstanding the underwhelming IPO market – year-to-date there have only been 32 IPOs with average proceeds of $67 million – the annualized exit activity suggests that there will be in excess of $50 billion of exit value created. The greatest level of exit activity over the past decade was in 2014 with nearly $82 billion of activity; the annual average for the last ten years is $39 billion.
Liquidity feeds right into the fundraising conditions for venture fund managers. This past quarter there were 56 new funds which raised $9.0 billion for an average fund size of $161 million. This is significantly greater than the $77 million average fund size in 3Q15. This fundraising pace is somewhat less than the prior three quarters but meaningfully ahead of 3Q15 which saw only $4.1 billion raised by venture capitalists. Interestingly, the top ten funds closed on $6.1 billion or 68% of all capital raised, indicating a further concentration of investment managers; in the prior quarter 62% was raised by the top ten funds. Just over 40% of funds raised this past quarter were less than $50 million in size.
The projected $43.2 billion raised in 2016 is on pace to be the strongest year since the early 2000’s. Notwithstanding this robust pace, the “funding gap” persists, strongly suggesting that non-VC’s are continuing to invest aggressively in start-ups. According to the recent Preqin Quarterly Update (3Q16), in a survey of active institutional investors in private equity, 71% expressed a “positive” perception of the asset class while 56% expected to increase their allocations to private equity (and of those, 59% planned to do so before year-end).
The other closely watched quarterly report is produced by Cambridge Associates, which recently released its Venture Capital Index and Benchmark Statistics with data as of June 30, 2016. While year-to-date 2016 performance has trailed other public indices, the Venture Capital Index consistently and meaningfully outperforms over longer periods of time. The 3-Year, 5-Year and 10-Year venture returns were 19.2%, 13.6% and 10.4%, accordingly, while the S&P 500 Index was 11.7%, 12.1% and 7.4%, respectively.
So where does that leave us as we enter the final quarter of 2016? The elephant (and donkey) in the room is the US elections, clearly. Interestingly, this past quarter the European venture capital investment pace fell by 32% in the wake of Brexit and was 39% lower than the same period in 2015, according to Dow Jones VentureSource. Isolating just the United Kingdom, the news is even more disturbing: U.K. venture firms invested only $58 million in 3Q16 versus $282 million in 2Q16 and $656 million in 3Q15 – that is what running into a wall looks like, a huuuge wall.
Here are a couple of other noteworthy developments that add to the economic commentary for 3Q16:
- There is another group of “unicorns” out there – the human ones – the billionaires. Total wealth held globally by all 1,397 billionaires fell by $300 billion to $5.1 trillion since 2014, mostly as a result of commodity price deflation and drop in the value of technology and finance holdings, according to a report jointly published by UBS and PricewaterhouseCoopers. Family Offices are an important class of Limited Partners.
- In the midst of unprecedented global turmoil, Saudi Arabia just raised $17.5 billion in the largest sovereign bond issuance ever; there was $67 billion of demand, making it nearly 4x over-subscribed. Why is this important? Let me count the ways: institutional investors seeking greater returns, the transition of an oil economy to a more diversified one (recall Saudi Arabia also announced the goal to create a $100 billion (with a “b”) tech fund with Softbank), strength of global capital flows, investor rotation to emerging markets.
- Slowing growth in China compounded by extraordinary levels of debt and inflated real estate values have set off flashing yellow lights in many corners of the global capital markets. It is quite clear that credit growth is still faster than nominal GDP growth in China, and that often does not end well. Analysts estimate that the local housing sector is singularly responsible for nearly half of all investment in China today.
As complicated as the world now appears, the financing of innovation remains attractive and compelling, drawing in both investors and great entrepreneurs, hopefully making many of these issues background noise.