Twilight Zone…

What a remarkable week, and not just because of the political “twilight zone” we are now dialed into, but the current S&P 500 bull run officially became the longest one over the past 70 years. Since this run started in March 2009, the index has increased 323% over the past 3,452 days. Unfortunately, over the past 20 years, U.S. public equity markets have returned only 6.5% per annum, which is well below longer term equity returns of 10%, per DataTrek Research. Inevitably this has caused many institutional investors to seek greater returns elsewhere. Against this backdrop, seemingly unrelated occurrences such as the crash of cryptocurrencies, performance of emerging market equities, repatriation of overseas cash, and the level of household debt start to make more sense. Mostly due to levels of unprecedented innovation, these fund flows have also contributed to what has been yet again another very strong quarter in the venture capital industry.

Bull Run

Quite clearly, 2018 is on pace to exceed 2017 in overall venture capital activity, which would make it the most active year in nearly two decades. Per the National Venture Capital Association and Pitchbook, this past quarter $27.3 billion was invested in 1,859 deals, for an average of $14.7 million, which given the diversity of activity is a relatively meaningless number. For instance, more than 60% of all deals included non-traditional venture investors and 20% of all capital was invested in “unicorns” which suggest very large round sizes. As a point of comparison, Chinese venture capital firms have invested $2.4 billion in U.S. companies through May 2018 per the Rhodium Group. In 2Q18, $11.5 billion was invested in 592 early stage deals but this includes 24 financings that were larger than $100 million (recall these are “early stage” companies); more than half of these 592 financings were larger than $25 million. The median Series A and Series B round sizes were $11.3 million and $29.3 million, respectively. Keep those numbers in mind when we look at the exit environment.

Additional color is provided when looking at either end of the investment spectrum. There were 792 angel and seed stage deals which accounted for $1.8 billion (average of $2.3 million per deal). It is quite clear that there is now a relatively large amount of “pre-seed” investment activity given the significant inflation in the size of seed rounds. Furthermore, this is the fewest number of seed investments since 4Q13, quite notably given quarterly seed activity has been consistently greater than 1,000 deals per quarter. Conversely, the late stage activity has remained quite strong with $14.9 billion invested in 475 deals. This is the third greatest quarterly investment pace in a dozen years. Investors seem to be eagerly looking for “de-risked” venture investment opportunities, possibly at the expense of the most nascent emerging ideas.

2Q18

Exit activity has improved, without debate. Year-to-date there have been 419 venture-backed exits for $28.7 billion in (disclosed) value. This year has seen a marked step-up in exit valuations. The median acquisition exit was $95 million (see below) while the average was $225 million, suggesting that there were some very significant liquidity events this year. Year-to-date there were 43 venture-backed IPOs for $6.3 billion of exit values with 29 of them in 2Q18 alone. Interestingly, there are only 3,671 public companies in the U.S. today as compared to over 7,300 in 1996, to underscore that going public is hard and quite a rare feat.

What is less obvious is how much capital was required to achieve these outcomes. Recall above that the median Series A and B rounds raised $40 million of capital in aggregate, which is tricky when exits are only $100 million. This dynamic really underscores the requirement to be capital efficient and for investors to own a lot of each company. Appreciate how over-used this phrase is but the math starts to breakdown much above these investment levels.

Exit no data

The most recent venture performance data reported by Cambridge Associates (1Q18) for one-year net returns was 15.0%, which should only improve with greater liquidity in subsequent quarters. The three, five and ten-year marks are 9.4%, 16.8% and 10.1%, respectively; the longer durations consistently outperform comparable public benchmarks, underscoring why venture funds are ten-year commitments. And these are NET return data after fees and expenses, which makes comparisons even more favorable.

Venture Capital - Fund Index Summary - Horizon Pooled Return

Interestingly, a survey conducted by Wilshire Trust of over 1,300 pension plans highlights this chase for returns. Over 59% of all pension assets are in stocks, an increase from 57% in 2Q17. More specifically, pension funds greater than $5 billion in assets allocated 20% to alternatives (including venture capital) which is significantly above the 17% in 2Q17.

This improved exit environment supports a robust fundraising environment for venture firms. In 2Q18 72 funds raised $10.8 billion, slightly exceeding 1Q18’s strong pace. While the median fund was $65 million, notably firms raising successor funds do so at 1.4x increase in fund size. Interestingly, 26 first-time funds raised $1.9 billion through the first six months of 2018 which, notwithstanding the continued concentration of capital around a few dozen firms, the venture industry does accommodate new venture managers with novel investment strategies. In fact, there have been 15 “micro-venture” firms created which have raised in total $308 million year-to-date.

This gap between invested and raised persists and is getting more accentuated. Venture-backed companies have become quite reliant on non-venture sources of capital such as sovereign wealth funds, private equity funds, corporates and family offices. Preqin tallies that there is $1.1 trillion of “dry powder” just with private equity funds. And then there is SoftBank’s Vision Fund which has created somewhat of an arm’s race amongst the larger venture franchises to raise ever larger funds.

Raised vs invested

Arguably the collapse of cryptocurrencies captured the greatest number of financial headlines this quarter. From the January 2018 highs, the total market capitalization of all cryptocurrencies plummeted from $800 billion to below $200 billion now. Bitcoin is trading around $6,000 per token, which seems inconceivable given it was at $19,000 in December 2017. Perhaps this is all due to the lack of regulatory clarity or maybe it actually was a speculative bubble after all, one that took six months to deflate, littered with numerous fraudulent ICOs. And recall that the total crypto market capitalization was a mere $18 billion at the end of 2016 – so perhaps we have not yet touched bottom. Those seeking greater returns need to step carefully through the token minefield.

The collapse of many foreign currencies also may reflect some of the desire to find greater returns in other seemingly attractive asset classes. Putting aside the self-inflicted wounds in Turkey, Venezuela, Argentina, etc, these issues have the risk of being more systemic than the bursting of the cryptocurrency bubble. These difficulties overseas will have investors seeking safety and returns in U.S. alternatives, suggesting supportive fund flows for venture managers, at least in the short to medium term.

GDP growth in 2Q18 was a robust 4.1% and with 91% of all the S&P 500 companies now having reported second quarter results, it is not surprising that 79% of them have exceeded analyst forecasts. It is somewhat surprising though, that of the $2 trillion of cash held overseas by U.S. companies, only $218 billion (through 1Q18) has been repatriated. Perhaps executives are struggling to find productive uses for all that cash. Coincidentally, there were $189 billion of stock buy-backs in 1Q18, which was a dramatic increase from the $50 billion in 4Q17. And was done with public equity markets flirting with near-record highs.

The Federal Reserve Bank of New York recently announced that at the end of 2Q18 U.S. household debt had reached a record level of $13.293 trillion, which was an increase of $82 billion from 1Q18. This level is now 65% of aggregate GDP, which is somewhat confounding given the rising interest rate environment, yet likely reflects consumer confidence given the robust public equity markets and low unemployment levels. Living in the shadow of the longest bull market can induce anxiety in some. In the midst of the Great Recession of 2009, debt was 87% of GDP, which was not that long ago.

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