Well, that sucks.
In the face of unprecedented economic devastation, investors were expecting a very challenging 2Q20. Au contraire. Domestic equities crushed it: the Russell 3000 Growth and Russell 3000 Value were up 28% and 15%, respectively – admittedly on the heels of a dramatic 1Q20 downdraft. The broad U.S. bond market unexpectedly increased 2.9%. Price of gold increased 12.5%. According to Refinitiv, through 1H20, venture capital performance was up 26%. Does this mask deeper concerns?
Venture investors for the first time this past quarter invested more in Later Stage than Early Stage deals, highlighting the desire to invest in what is familiar and arguably more “de-risked.” Similarly, VCs invested in more follow-on opportunities than first time financings. Notably, 37.5% of Early Stage investments in 1H20 were greater than $10.0 million, which was also a highwater mark. In fact, 15.0% of Early Stage investments were greater than $25.0 million which is somewhat oxymoronic.
Given that the first part of 2Q20 was spent triaging existing portfolios, not unexpectedly the level of venture capital activity was down across all stages. According to Pitchbook and the National Venture Capital Association, the number of deals declined by 23.2% to 2,197 with $34.3 billion invested, which is still a robust pace, in large measure due to the prevalence of “mega” financings. In 2Q20, there were 57 venture rounds greater than $100.0 million.
Round size is closely watched by industry analysts. When economic times are good and capital is plentiful, round sizes tend to drift upwards as investors are flush and entrepreneurs are eager to exploit new market opportunities. Year-to-date median round sizes have stayed consistent with 2019 levels – Early Stage at $6.0 million and $8.8 million for Later Stage in 2020.
A potential warning sign involves the level of venture-backed exit activity which was at a decade quarterly low of $21.2 billion across 147 transactions. At $45.3 billion year-to-date, the venture industry is on pace to have the lowest level of exit activity in the past five years. Of greater importance are the valuations realized upon exit which remained reasonably strong: the median acquisition, buyout and IPO valuations were $82.5 million, $120.0 million, and $636.0 million, respectively. According to Pitchbook, the number of U.S. M&A transactions in 2Q20 declined 24% while the overall transaction values dropped 41% when compared to 1Q20. Capital efficiency becomes even more critical to generating compelling returns when M&A outcomes are below $100 million.
Significantly, 2019 was the first year in the last decade when limited partner contributions to the venture capital was greater than distributions made by venture capital funds. The robust exit environment and strong returns over the last handful of years facilitated the raising of larger and larger venture funds. In 2Q20, there were 148 funds which raised $42.7 billion. Year-to-date there were 24 funds raised by established firms that were greater than $500 million causing the average fund size in 2020 to be slightly larger than $300 million (median fund size is $101 million year-to-date).
The theme of concentration, be it around fewer established venture firms or fewer Later Stage companies, is echoed in the global data as well. Preqin tabulates that $61.3 billion was raised by 292 firms in 1H20 which is 35% fewer firms than in 1H19. Globally, $112 billion was invested in 6,379 deals, which while a modest 2% decline in invested capital, it is a 20% reduction in the number of companies. In 1H20, 31% fewer private equity firms (552 firms) raised $259 billion, which was only 4% less than was raised in 1H19.
Analysts estimate that there is approximately $120 billion of “dry powder” managed by U.S. venture capital firms. Much of this capacity is a function of recent venture capital performance, particularly when compared with private equity which was quite exposed to the early 2020 downdraft. According to Refinitiv, through 1H20 venture capital performance was up 26% while private equity was down 11%. Venture capital benefited from the strong performance from the healthcare and technology sectors during the early days of the pandemic. Interestingly, Preqin estimates that there is $1.45 trillion of private equity “dry powder” globally but that approximately 85% of it is held by funds raised between 2017 – 2019, which would not be able to bail out older struggling leveraged portfolio companies – expect the number of busted LBOs to spike.
The economic uncertainties in 2Q20 caused more than 40% of the companies in the S&P 500 Index to withdraw full-year earnings guidance. Corporate earnings in 2Q20 are estimated to have decreased 44% which would be the largest quarterly decline since 4Q08 (69% decrease) which was the depths of the Great Recession. In 1Q20 net profit margin for the S&P 500 Index was 7.1% which is meaningfully below the five-year average of 10.6% and the lowest since 4Q09 according to FactSet. Paradoxically, in the face of falling (collapsing?) earnings the public equity markets keep surging.
While the merits of causing such deliberate economic devastation at the pandemic outset might be debated, it is instructive to look at other parts of the world, specifically China, to see how the approach to dramatically locking down the “hot zone” around greater Wuhan to arrest the spread of COVID-19 allowed the economy to recover more swiftly. In 2Q20, China’s GDP rose 3.2% year-over-year, after “only” decreasing by 6.8% in 1Q20. SMH…shaking my head.
All things considered, U.S. IPO activity in 2Q20 was reasonably strong with 62 offerings that raised $18.5 billion, which was an increase of $8.7 billion from 1Q20 but $14.2 billion lower than the 2Q19 level. In June 2020 alone, there were 28 IPOs that raised $13.5 billion, pointing to a strengthening market heading into the summer. Much of this activity was driven by the explosion in SPACs (Special Purpose Acquisition Company) or “blank check” companies.
According to SPACInsider, there were 48 SPACs which raised $18.6 billion in 2020, which easily beats the $13.6 billion raised in all of 2019. In 2Q20, there were 24 SPAC IPOs which raised $7.2 billion or nearly 40% of all IPO proceeds. Of the 318 SPACs ever created, there are now at least 108 with $40 billion per Barron’s trolling around for something to acquire (recall that SPACs have a pre-determined amount of time to close an acquisition or they are liquidated). In 2020, the average SPAC IPO was $400 million in size.
Of course, financial alchemy in the pursuit of investment returns often turns out poorly, and now it is further complicated by a pandemic, recession, and disruptive national election cycle. Through 2Q20, the number of corporate defaults globally equated to the entirety of 2019. So, while investors seem cautiously enthusiastic about the “recovery” since 1Q20, there are a number of flashing warning lights, not least of which how quickly it all can be reversed as witnessed in March 2020.
Source: S&P Global.