Accelerating out of 2Q19, both the S&P 500 and Nasdaq indices hit all-time highs, trading at close to 19.8x trailing earnings. Last week the U.S. Bureau of Economic Analysis announced that GDP increased 2.1% for the quarter, and while a marked decline from the prior quarter, it was still a reasonably compelling figure. Interestingly, consumer spending which accounts for approximately 70% of the activity, increased 2.9% in the quarter (although credit card delinquencies are up 22% since 2015). Macroeconomic Advisors estimated that revenues for the S&P 500 companies grew 2.6% in 2Q19, while FactSet estimated that earnings declined 1.9% year-over-year (first time in recent memory), perhaps suggesting that operating costs have increased markedly over the past few months.
Against this narrative, the National Venture Capital Association and Pitchbook released their 2Q19 report with screaming headlines about investor liquidity. Quite simply, it was a tremendous quarter with $138.3 billion of exit value created (via either IPOs or M&A transactions), nearly half of which was due to the Uber IPO alone. Year-to-date exit value totaled $188.5 billion, more than any prior year, suggesting broad-based activity and a robust environment. And there will be even more to come: CB Insights is tracking 362 “unicorns” globally, 18 of which are valued in excess of $10 billion each. These mature private companies will seek investor liquidity at some point in the near future.
For the entire quarter, there were 2,338 financings which raised $31.5 billion, keeping the venture capital industry on pace to once again exceed $100 billion in annual investment activity. While the number of investments has been relatively constant since late 2012, the advent of “mega deals” (in excess of $100 million round sizes) has dramatically increased the amount of capital invested. Year-to-date there have been 123 “mega deals” which, while only 2.5% of all financings, accounted for nearly 45% of the capital invested.
The amount of seed and angel activity continued to meaningfully decline in the quarter, registering $1.7 billion across 1,001 deals. The median age of those companies at the time of these financings was slightly over three years old, suggesting that the amount of “pre-seed” activity is high and now an important part of how many entrepreneurs are funding their businesses. In part due to the proliferation of accelerators and incubators, entrepreneurs are able raise very modest amounts of capital to accomplish a handful of initial milestones. The average size of these financings was $1.7 million at a median pre-money valuation of $7.6 million.
Early stage activity (Series A and B rounds) remained relatively constant with $8.9 billion invested in 754 deals (average size of $11.8 million). The median valuation was $30.0 million. Late stage financings (Series C and D rounds) continued to account for much of the activity with $20.9 billion invested in 583 deals (average size of $35.8 million). It is these rounds when there starts to be significant separation in terms of amount of capital invested and valuations, particularly for those companies that are scaling quickly. Series C median valuation in 2Q19 was $115 million, while Series D companies commanded a median valuation of $418 million. Over 70% of the capital of the Late stage financings was invested in “mega deals” yet were only 17% of the companies. To underscore the separation at these Late stage rounds, the 25th percentile companies were valued at $140 million on average, while 75th percentile companies were valued at $1.08 billion (as compared to $702 million in all of 2018).
Notably, corporate VCs are hanging in there. In 2Q19, 311 companies raised $13.0 billion in financings which a corporate investor was a member of the syndicate; that is,13% of the financings included a corporate investor yet those rounds accounted for over 41% of the investment activity, indicating that corporate investors tend to participate in later rounds.
Back to where the attention was focused this past quarter – exit activity. In addition to the more notable IPOs of Uber, Lyft, Pinterest and Zoom was the Slack IPO, which was a “direct listing” like the Spotify IPO in April 2018. Many recent enterprise technology IPOs have been priced at 25 – 30x revenues (not earnings). Notwithstanding the extraordinary IPO activity in 2Q19 ($130.8 billion), the M&A exit activity was relatively underwhelming with only $7.3 billion versus $22.6 billion in 1Q19 and $10.7 billion in the year ago quarter. In fact, year-to-date the ratio of number of new investments to exits is 12.7x. Historically, this ratio has hovered between 10.0x – 10.5x so the growing backlog of private companies is notable, especially with the number of large rounds with somewhat impatient later stage investors. Bookmark that.
As this liquidity windfall is distributed back to investors, grateful limited partners are expected to recycle much of it back to venture firms in the form of new commitments, suggesting good times ahead for fundraising. Through the first half 2019, 103 funds were raised totaling $20.6 billion. In 2Q19 alone, 66 funds raised $11.0 billion but only two funds were larger than $1.0 billion. Interestingly, in 1Q19 the average and median fund size were $259 million and $103 million, respectively. At the end of 2Q19 those amounts had declined meaningfully to $202 million and $81 million, indicating a trend of much smaller fund sizes. There was an even more dramatic decline in the number of “first time” venture funds with only 10 raised through 2Q19, and they were only 2.9% of all capital raised. Yet against this backdrop, SoftBank just announced its second Vision Fund totaling $108 billion of commitments.
According to Cambridge Associates, venture returns through 1Q19 have been consistently compelling when compared to public stock indices, certainly over longer time horizons. The lack of liquidity is often pointed to as the principle reason as to why limited partners are not more aggressive venture capital investors. The narrative over the last decade has been one centered around “unrealized gains” which have been dramatic but unfortunately unrealized. In a recent Fenwick & West survey of venture terms for 215 financings in 2Q19 over 86% were “up-rounds” (the average price per share increase was 58%). It will be fascinating to see if limited partner sentiment recalibrates over the next 6 -12 months as the 2Q19 IPO liquidity is distributed.
As an interesting point of comparison, the venture market in China has struggled mightily in 2Q19. Notwithstanding that the Fortune Global 500, which was released this past week, included 129 Chinese companies (first time ever that the U.S. did not lead in the medal count), the overall investment activity declined a dramatic 77% decline from 1Q19. The $9.4 billion invested across 692 companies compares unfavorably to the 2Q18 level of $41.3 billion. Quite clearly there is anxiety about trade tensions as well as relatively lofty private company valuations. Interestingly, though, China last week launched the Science and Technology Innovation Board (“STAR Market”), which is part of the Shanghai stock exchange but only for local investors. On the opening day, 25 technology companies raised $5.4 billion, with the index closing ahead 140%. Go figure.
Somewhat insulated from this is the Israeli venture capital industry which saw $3.9 billion invested in 254 companies year-to-date. In 2Q19 alone, 125 companies raised $2.3 billion, but $1.2 billion of those financings were for only 10 “mega deals” (considered greater than $50 million round size).
The Institute of International Finance recently released its quarterly survey of global debt levels that showed it to be $246.5 trillion at the end of 1Q19, which had increased by $3.0 trillion over the quarter. This unprecedented debt level is now 320% of global GDP. The situation in the U.S., while relatively in better shape, is still worrisome with $69 trillion of debt at 101% of GDP. The role this plays on the venture capital industry and fund flows is certainly worth monitoring. Quite clearly, the current environment has investors desperately looking for returns with high growth companies such as those in venture capital portfolios. As a point of comparison, Facebook, Amazon and Google grew revenues 28%, 19% and 19%, respectively, this past quarter. But are we living on borrowed time with the historic economic expansion in the U.S.?