An Extension of “Comments on the State of the Venture Industry”, following “A New Game Plan: A Reset for Venture Capital, Innovation, and Entrepreneurship in 2023” a panel moderated by Jamie Montgomery and featuring panelists Ibrahim Ajami (Mubadala), Raj Ganguly (B Capital), Lo Toney (Plexo), Anu Duggal (Female Founders Fund), and Arif Janmohamed (Lightspeed Venture Partners) at the Milken Institute Global Conference 2023.
We are in the midst of a reset in Venture Capital. In 2022, US inflation reached a 40-year high, the Nasdaq posted its worst year of returns since 2008, global IT spend contracted, and US IPO volumes were the lowest since 1990. US economic factors always have a rippling effect in the financial sector, and the Venture Capital industry isn’t spared from that.
Venture Capital has and will continue to play a critical role in stimulating innovation in the US economy. Among public companies founded within the last fifty years, VC-backed companies account for half in number and three quarters by value. By the end of 2022, VC-backed companies accounted for seven of the ten largest publicly traded companies by market capitalization in the US: Apple, Microsoft, Alphabet, Amazon, Tesla, Meta, and NVIDIA. And all seven of these companies launched following an economic reset.
The venture industry will adjust to today’s economic environment. Total investment into new venture funds was down by over 80% in 2022 (see Fig. 1), following the same path as the 1987, 2001, and 2008 market corrections. The current annualized value of commitments has dropped an additional ~70%, bringing investment into new funds back to 2001 levels.
Venture investors and founders alike will feel increased pressure from this reset. In 2022, dollars deployed by venture investors declined to 2018 levels. The first quarter of 2023 saw only half as many Series C financings as Q1 2022 and only 28 Series C rounds occurred so far this quarter (see Fig. 2).
A major valuation reset appears to be well underway. The slowdown in growth rounds is stark and has coincided with an estimated 50% average price reduction to pre-money valuations (see Fig. 3). The “iron rule” in capital markets is that a 1% increase in interest rates equates to a 10% reduction in multiples. This can certainly be seen today with the increase in interest rates of approximately 5% corresponding to a ~50% multiple reduction. How much further valuations will correct and whether we’ve reached a steady state is yet to be seen, but the pace of this correction – 58% over three quarters – is unprecedented.
As we’ve seen, some of the best companies emerge from market corrections. The well capitalized funds – those that raised in 2022 – will have the opportunity to invest in these great companies. Unsurprisingly, these managers continue to allocate their fresh capital to follow-on investments (see Fig. 4).
Exit values in 2022 decreased precipitously, with a 91% drop in exit values from 2021 to 2022 (again, the lowest since 2011). Investors anticipate that the next wave of companies to IPO could be another 24 months away.
All this may sound worrisome and again, it may get worse, but this cycle happens every decade in the venture industry and venture outperforms the public market indices consistently following economic downturns (see Fig. 5).
The industry is evolving, and there’s a big question around how Venture Capital firms will adapt their strategy to take advantage of the current market.
Historically, there’s been a huge gap between the top performing managers and the rest. At the Milken Institute Global Conference earlier this month, I had the opportunity to dig into the basis for this dispersion with a group of leading investors. The dispersion of returns in venture follows the power law (also known as the 80/20 rule) where a small number of managers command the majority of the venture returns, and a small number of their investments command the majority of their portfolio’s returns.
Managers have different philosophies for how to achieve top-decile results and find the best companies. Some lean into the power law and manage the risk in their portfolios through diversification. Others opt to concentrate their portfolios from the beginning, which allows them to gain deeper expertise in a particular area, build thoughtful relationships with key stakeholders in that area, and make fewer but more informed investment decisions to concentrate on the best companies.
Where you stand on portfolio diversification is determined by where you sit, and track record speaks volumes to this. The perspective of Charlie Munger is that “The whole secret of investment is to find places where it’s safe and wise to non-diversify. It’s just that simple. Diversification is for the know-nothing investor; it’s not for the professional.”
If there is any doubt, we run a concentrated portfolio here at March Capital.
For founders, scarce resources and scarce capital means less competition. Less competition combined with the global availability of quality talent makes today an excellent time to build a company.
Great companies will emerge from this reset just as they have in past cycles, and more of the returns will be captured in the private markets. Our view is that the next wave of value creation will largely be driven by intelligent automation. The funds that will thrive will likely invest in this next wave of automation through long-horizon categories including AI, cloud & data infrastructure, cybersecurity, and software built for climate, genomics, and fintech.
For more on these themes and our perspective on the market, check out our panel, “A New Game Plan: A Reset for Venture Capital, Innovation, and Entrepreneurship in 2023”, at the Milken Institute Global Conference 2023 here.