Venture capital: What’s the big deal?
Please note: This article is intended for readers with a solid understanding of investments. Investing in venture capital, like private markets more broadly, is often complex, illiquid and brings higher idiosyncratic risks than public markets, and so is only suitable for experienced investors. This communication is also general in nature and provided for information/educational purposes only. It does not take into account any specific investment objectives, the financial situation or particular needs of any particular person.
Venture capitalists aim to back the unicorns of tomorrow, providing funding to companies which they believe have the ideas, people and potential to deliver high long-term growth. With the higher risk of early business failure, it’s a complex segment to navigate, but the rewards can be substantial. Here we give an overview of the venture capital market, and the opportunities and risks for investors.
What is venture capital?
Venture capital (VC) is a form of private equity investing, which provides funding to emerging businesses in the very early stages of their development. It aims to capitalise on new technologies, innovations and emerging entrepreneurs that could disrupt and shape the future.
These start-ups may be little more than a small team with a business plan or concept that they are looking to execute and scale rapidly – and often have no assets or cashflow. VC funding gives them access to vital capital to realise their idea – and in exchange, backers secure an ownership stake in potential future stars. VC funders may also share their expertise, experience and network, informally or via a Board seat, to improve the chances of success.
Ultimately, these nascent companies are usually looking to become large-scale businesses that are listed publicly via an IPO or snapped up as an acquisition target. If (and of course it’s a big if) their dream is realised, it can be a win for their early investors too.
The evolution of the VC market
The first VC firms emerged after World War II, with the industry taking off during the 1970s in California’s Silicon Valley, now a globally renowned hub for tech innovation. Some of the best-known companies today – including Apple, Amazon, Facebook (now Meta) and Google (now Alphabet) – were VC-backed in their early days1. The industry’s development has not been without setbacks, however, having experienced several boom-and-bust cycles, not least the notorious dot-com era at the turn of the millennium.
The VC market has evolved substantially over the past decade, as investors are increasingly turning to private markets for both returns and portfolio diversification. Assets under management in VC funds have grown rapidly (see chart), with dry power exceeding $530bn in September 2022, according to Preqin2. As more investor capital has flowed into the market, so too have the size and number of deals made. There are currently more than 5000 venture capital funds in the market globally, targeting $400bn in capital, giving investors more choice than ever3.
Venture capital assets under management, 2001 – Q3 2022
According to Matt Spence, a managing director at Barclays Investment Bank, two key things have changed compared to 10 years ago: “First, the amount of capital going into companies at seed round (ie very early stage) has increased dramatically – now, a seed cheque can start at around $2 million. VC fund sizes have grown as a result, in some cases into the billions, so have more capital to invest larger amounts into a greater number of companies. Second, VC firms are investing beyond traditional tech companies into new innovation trends around sustainability and artificial intelligence, as well as technology in areas such as automobiles and mobility, aerospace and defence, transportation and industrials.”
There has also been a shift in the geographical spread of VC opportunities, allowing investors to diversify further. While Silicon Valley remains a core hub, new centres have emerged elsewhere in the US and globally. Asia (notably China) is the most developed market outside the US, accounting for around 25% of funding and 33% of deal share in Q4 2022 (vs 48% and 35%, respectively for the US)4. Europe is also gaining ground, having seen significant growth in recent years.
VC in the current environment
Current market conditions are undeniably more challenging than in recent years, as rising interest rates, untamed inflation and a weaker macroeconomic outlook take their toll on risk appetite. As elsewhere in private and public markets, investors are reassessing valuations and the price they’re willing to pay for riskier companies, and have started to hold off capital deployment as they do so.
Valuations have begun to come down from previous highs – aggregate deal value reached $346.3bn for the first three quarters of 2022, down from $685.1bn in 2021, as fewer deals took place at lower price multiples5. The number of IPOs has also dropped substantially, falling 32% globally in 20226, as investors hold out for better conditions.
For investors, entry levels are lower and there is less competition for deals. And while the longer investment holding period for VC carries more duration risk, it allows more time for the exit environment to potentially recover. However, due diligence will be more critical than ever, given the risk of further readjustment in the market.
Ways to access the VC market
Investors can access the VC market in a number of ways, including:
Direct: Investing directly in a company within the venture capital ecosystem is one option. This is a higher-risk strategy given the concentrated company risk and skill needed to assess the opportunity.
Funds: Investing in a fund of venture capital companies managed by a General Partner. These provide more diversified exposure and investment selection is outsourced to a professional team. However, top-tier funds can be difficult to access and capacity-constrained, with new funding requirements often met by existing investors. Choosing a manager with the required skills and experience is also key.
Fund of funds: Investing in a portfolio of venture capital funds. This can provide even greater diversification and may also offer exposure to top-tier funds that are otherwise difficult to access. The trade-off here tends to be higher costs due to the double layer of management fees.
Secondaries: Secondary funds buy existing interests or assets from primary fund investors, often at a discount. Investors in secondaries come in at a later stage in a company’s lifecycle, which offers more visibility and a shorter holding period. However, secondary market transactions can be complex, and discount negotiations take time and skill, so again finding an experienced manager is important.
Risks and things to consider
Early-stage companies, by nature, have little available data or track record on which to base investment decisions. Extended due diligence and understanding of the market dynamics are key to uncovering viable opportunities.
One trend that has accelerated in the past 3-5 years is the use of data science as an integral part of deal selection. In traditional private equity, managers’ networks and contacts are a crucial part of sourcing investment opportunities. With the sheer number of VC opportunities, it is extremely difficult to manually filter them effectively.
Some managers are turning to data science to give them an edge in the initial stages of their search to identify and prioritise opportunities for further analysis. This new technology can help highlight momentum, develop and track financial performance metrics, and reveal potential weaknesses or areas for improvement7.
Risk of failure
Start-ups have an inherently high risk of failure – to meet targets, and for the business as a whole – and VC managers accept that statistically, a number of their portfolio investments will likely fail. For that reason, they tend to invest in much more diversified portfolio (around 30-40 companies) compared to a buyout private equity fund of a similar size, which would typically have around 8-10 holdings. Often only one or two successes are needed to deliver positive overall returns.
Lack of liquidity
Private market investments, including VC, are by nature less liquid than public markets and there is no guarantee of returns.
Looking to the future
In a world where the pace of change is accelerating, the household names of the future may look very different to today. The VC market offers access to new innovations and ideas, technologies and trends, that are emerging across the globe.
Please note: Past performance is not a reliable indicator of future results The value of investments can fall as well as rise and you may get back less than you invested.
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