Saying the Quiet Part Out Loud…

Are we staring at a correction?

According to U.S. Census Bureau data, over 5.4 million Americans filed applications to start companies in 2021, which was 53% greater than the pre-pandemic level of 2019. While Covid has been devastating for so many, arguably it was dramatic accelerant for innovation and entrepreneurship – either out of necessity or opportunity. Last year also witnessed the greatest level of venture capital investment in recorded history with nearly $330 billion invested in approximately 15,500 companies according to Pitchbook and National Venture Capital Association data, which once again underscored that only a small percent of all companies actually raise venture capital. Much of the anxious chatter now centers around whether we have just seen another bubble.

The economic signals are confounding, and it is near-impossible to descry a bright and obvious path forward. Gross domestic product grew 6.9% quarter-over-quarter which was up from the 2.3% in 3Q21. For the year, GDP increased 5.7% in 2021. Weekly jobless claims are trending downward and unemployment currently stands at 4.0%. Industrial output grew in 2021 at 5.5%, the highest rate since 1984. While analyst consensus expects a slight reduction in 4Q21 EPS for the S&P 500, U.S. corporates should report very strong earnings to end the year.

U.S. household net worth stood at $144.7 trillion at the end of 3Q21, according to Federal Reserve data, while total household debt was only $15.6 trillion. Coupled with a nearly 20% increase in home prices in 2021, the U.S. consumer should feel rather content notwithstanding that pesky inflation and pending interest rate increases.

Certainly, VCs do. The animal spirits ran wild in 4Q21, particularly with early-stage investors (below). Of the $88.2 billion invested in 3,356 companies in 4Q21, nearly one-third of that amount was invested in early-stage companies with an average round size of $23.9 million, which is dramatically larger than any prior quarter. Entrepreneurs may be signaling the need for longer cash runways heading into a more difficult financing environment or large capital raises are a point of differentiation in the market. Or there may simply be too much early-stage capital available.  Early-stage median and average pre-money valuations in 2021 were $46.2 million and $119.2 million, respectively. Late-stage median and average pre-money 2021 valuations saw eye-popping increases to $114.5 million and $775.4 million, respectively. The 6.5x step-up in average valuations from early to late stage falls in the “unrealized” bucket, which has reinforced those animal spirits.

The pattern repeated itself in the 4Q21 angel and seed stages as well. The dramatic spike in amount of venture capital invested was just as notable as the fairly significant step-down in the number of deals which started in 1Q21. This may reflect a heightened sensitivity to risk for seed investors or that valuations for seeds have simply been priced too high. The average size of seed rounds in 4Q21 was $4.6 million; the median and average pre-money valuations for seed stage companies in 2021 were $9.5 million and $18.5 million, respectively, also significantly greater than any prior year. Five years ago, those valuations were $5.0 million and $6.9 million.

Undeniably, much of this enthusiasm is driven by extraordinary, head-spinning exit activity. In 2021, there were over 1,600 exit transactions valued at $774.1 billion – levels never before achieved – and nearly 3x the record-setting level of activity in 2020. The entire decade prior to the pandemic saw a total exit value of $1.07 trillion. Global M&A activity in 2021 was $4.9 trillion, according to Pitchbook, with $2.8 trillion of that activity in the U.S. Notably, technology M&A transactions increased more than 50% in 2021. Of the total exit values in 2021, $681.5 billion was due to public offerings across 296 offerings.

The robust public equity markets have clearly supported, even encouraged, an historic IPO market. Over the last six quarters, there has been $866.1 billion in IPO value generated, as compared to $126.4 billion in acquisitions and a mere $21.9 billion via buyouts. The extraordinary special purpose acquisition company (SPAC) activity, which has since summarily ceased, somewhat obfuscates the trend as many of those SPACs have yet to “de-SPAC” and still sit as public shell companies. In 2021, 556 SPACs raised nearly $135 billion and now have a two-year fuse to acquire an asset.

In order to achieve ataraxia, here’s the rub – most public listings involve significant investor lock-ups, so remains “unrealized” for extended periods of time. According to a Cambridge Associates (CA) analysis, over 90% of the gains in 2020 were unrealized. In fact, nearly one-quarter of CA’s U.S. Venture Capital index is comprised of public stocks, and therefore, generated significant mark-ups in 2021. Problems set in when high-flying public stocks experience significant volatility. The Nasdaq composite is down nearly 16% just in the past eight weeks – 60+ Nasdaq stocks are down more than 50%.

Notwithstanding the recent disturbing trading of the Renaissance IPO index, venture capital has been the best performing private capital asset class for the past three years (although the data are lagging). According to Cambridge Associates, the horizon pooled return U.S. Venture Capital Index as of 3Q21 generated 9.6%, 44.1%, 83.7%, and 27.6% IRRs for the prior quarter, year-to-date, trailing 12 months, and last five years, respectively. This performance compares very favorably to all common public equity indices. A Pitchbook 2020 analysis concludes that U.S. venture capital generated 71.7% horizon pooled IRRs versus 30.8% for S&P 500 and 40.4% for the Russell 2000 indices. Notably, venture capital returns were consistent across varying fund sizes.

Not unexpectedly this performance drove dramatic fundraising activity by venture firms. In 2021, 730 funds raised $128.3 billion, another highwater mark (in 2020, the prior record-setting year, 733 funds raised $86.9 billion). The riches were not shared equally, though. First-time fund managers only accounted for $9.1 billion (10.5% of total) raised across 172 funds (23.4% of total). The median fund size raised in 2021 was $50.0 million, which was an increase from the $42.1 million in 2020, while the average fund sizes were $188.1 million and $156.9 million, respectively. Clearly the more established fund managers are raising ever larger funds.

All this fundraising is conducted against a broader liquidity context. According to an analysis by the Financial Times, over $12.1 trillion of equity and debt was raised in 2021 globally, of which $5.0 trillion was raised in the U.S. Refinitiv data shows that $1.44 trillion of equity was raised globally in 2021, suggesting relatively high systemic debt levels. A Pitchbook analysis of the “dry powder” overhang in venture capital estimates that $222.7 billion has been raised but not yet invested by venture capital firms in the U.S., which may be important should VCs need to weather a prolonged recession. Coincidentally, the overhang is virtually the same amount of capital as was invested in late-stage deals in 2021 ($228.5 billion).

Not to be lost in all this activity, a recently released analysis from the Massachusetts Institute of Technology (MIT) of the Paycheck Payroll Protection (PPP) Program, which was launched with great fanfare at the outset of the pandemic, concluded that only ~25% of the $800 billion program actually went to pay wages for jobs that otherwise would have been lost due to the pandemic. While a relatively modest amount was directed to venture-backed companies, the National Bureau of Economic Research estimated that the PPP program spent $169k to “protect” jobs with an average salary of $58k. MIT concluded that 72% of the funds went to households in the top 20% income bracket.

With an increasingly speculative market many analysts are cautioning investors from being overly exposed to public equities. While it is likely too early to declare a “bubble,” it is informative to review the cycle of past bubbles (below). Arguably, there have been several boomlets in a handful of sectors over the recent past due to accommodative monetary policies, unprecedented stimulus spending, and investors searching for returns. While corrections of these boomlets may be uncorrelated, they point to systemic issues of ”too much capital chasing too few quality opportunities.” The Financial Crisis Observatory at the Swiss Federal Institute of Technology, which is tasked with tracking bubbles, recently flagged that a “green-energy” bubble burst in early 2021 as those stocks have plunged 45% from their peak.

A commonality to many of the recent sector corrections is the unmasking of “technology posers;” that is, companies dressed up as high margin “SaaS-like” business models. WeWork and Compass are not really technology companies, but rather slickly packaged real estate companies. Rent the Runway and Casper are retailers, not the “closet in the cloud” or a leading “sleep economy” company as both have described themselves. Nearly 98% of Oscar’s revenues are from insurance premiums. The U.S. affiliate of FTX, FTX Gaming, is poised to release a “crypto-as-a-service” platform. As broader public equity investors come to understand the fundamental economics of these businesses, a reset in valuations is likely not far behind.

Today’s shiny penny is non-fungible tokens (NFTs). According to Chainalysis, almost $41 billion was spent on NFTs in 2021; UBS and Art Basel estimated that there was approximately $50 billion spent in the global art market. Fortune estimates that the combined value of NFTs today is $16 billion, suggesting a high level of NFT trading. It is estimated that 360k owners hold 2.7 million NFTs, although only 9% of those people account for 80% of all NFTs purchased. Adjacent to this sector, venture capitalists have invested more than $30 billion just in 2021 in crypto companies according to Pitchbook – nearly 10% of all venture activity last year.

Breaking news this week was a massive leak of Credit Suisse private bank data of 18k secretive accounts that total over $100 billion of assets, $8 billion of which was deemed “problematic.” Setting aside that many of these accounts are held by despots, fugitives, and other international criminals, it would be fascinating to see where those “investors” placed their bets.

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