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The pre-IPO market is under pressure; demand for initial public offerings appears to have hit its peak; and the mergers & acquisitions boom is looking tired, to say the least. Under the circumstances, few would be surprised to hear that the venture capital industry’s best days may be behind it. In fact, an analyst at research firm Pitchbook Data recently told the Los Angeles Times that “‘there are a lot of indicators that we’ve reached the peak of the VC investment cycle.'”
According to the newspaper, initial-stage investments, or “first financings,” have declined by more than 40% from 2014 totals (as of December 1), while the associated dollar value is off roughly 8% to $6.9 billion. Meanwhile, the funds raised from “exits”– selling or bringing to market portfolio companies–have fallen to $93.8 billion, nearly a third lower than in the prior period. That said, the sector has continued to see an influx of capital: $37 billion has been invested so far, a nearly 9% increase from last year’s tally.
A harsher monetary policy regime
To be sure, the divergence between the tepid operating environment and a still-warm investment climate may eventually resolve itself in favor of further good times ahead. However, it is likely that developments that have helped to cool activity elsewhere will eventually impact the venture capital space. Among the most important, perhaps, is a Federal Reserve tightening cycle, which will likely lead to a more hard-nosed assessment of risk and valuations across markets and sectors.
One result of the Fed’s ultra-easy policies during the past seven years has been a relentless reach for yield and returns. That has helped boost valuations across the board; among the biggest beneficiaries has been publicly-traded equities and privately-held companies, including the $1 billion-plus technology unicorns. However, in recent months, investors have gotten cold feet. They have become more cautious and, in some cases, have been reconsidering the values of illiquid and other hard hard-to-value holdings.
For the venture capital industry, the shift likely won’t prove helpful. For one thing, it makes it harder for firms to cash out, or to generate the kinds of returns that were more commonplace during headier times. Moreover, the fact that the growth-stage private market has become such a big factor in technology investing has naturally drawn some VCs into the fold: many are holding on to investments–some of which are larger than in the past–for longer than they used to, heightening the risk that they could, so to speak, be left holding the baby.
Other clouds on the horizon
Not helping matters is the fact that the private equity industry, which represents another pool of prospective buyers for venture capital investments, is facing challenges of its own. As noted in “Dark Clouds Looming for Private Equity,” the outlook for this asset class, which has been among the best long-term performers, seems somewhat cloudy. It has recently come under the regulatory scrutiny amid complaints about transparency and excessive fees, and it’s traditional reliance on heavy dollops of leverage means it could be especially vulnerable in a tightening monetary policy environment.
In fairness, some developments suggest the VC industry may less exposed than it seems, in part because a sizable share of returns have been coming from a broader array of investments. Citing data from consultant Cambridge Associates, Business Insider reported that “since 2000, over 60% of…industry returns on average came from investments that were outside of the 10 largest outcomes.” BI added that this was “a significant departure from the pre-1999 era when the top 10 investments were a much larger percentage of the total pie.” In other words, success no longer comes down to having a few home runs.
One thing that many venture capital firms remain dependent on, however, is attracting and retaining talent. In many cases, that has meant tapping into traditional technology strongholds such as Silicon Valley and New York, where the costs of living and operating a business are fairly expensive. At the recent Post Seed event at Ruby Skye in San Francisco, for instance, one panelist asked fellow VC investors whether startups were “burning capital twice as fast just by paying San Francisco rent.”
High proportion of high tech
As it happens, that question also served to highlight another long-standing feature of the space: it has been dominated by high-tech start-ups. According to the National Venture Capital Association, the software industry, for example, has been the largest investment sector for 21 straight years. Should equity market conditions deteriorate, either because of a Fed-inspired de-risking that puts extra pressure on formerly high-flying sectors, or because a market bellwether such as Apple suggestw that conditions are changing for the worse, sentiment in the VC industry will likely also be affected.
In the end, it is probably too soon to say for sure whether this part of the investment universe will be spared from the cooling trends that have affected others. But if history is any guide, that seems unlikely.
Michael J. Panzner is a 30-year Wall Street veteran and the author of three books, including Financial Armageddon, which predicted the 2008 global financial crisis.
