The private equity and venture capital industry in the US
continues to expand its important role as a major driver of
technology commercialization, job creation, and productivity
enhancement. Private equity, defined as the combination of
venture capital and buyout/ mezzanine activity, remains a very
attractive asset class for institutional investment.
Despite public market turbulence beginning in late-March
2000, venture capital activity is producing several noteworthy
trends:
- Total venture capital investment in 2000 is projected to
reach $100 billion for the first time. This is nearly 18
times the total investment in 1995.
- Venture capital funds raised a record amount of capital
through the third quarter of 2000 – over $70 billion
compared with $9 billion in the whole of 1995.
- Although the number of $1 billion and larger venture
funds being raised continues to grow, key venture firms have
said that they plan to invest these funds at a slower pace
than in recent quarters, and that a portion of these large
funds will be kept available to provide additional rounds of
funding to existing portfolio companies.
- A record number of companies have been funded by the
venture capital industry in 2000.
- Despite very uncertain public markets, with conditions
changing almost daily, venture-backed companies raised a
record level of capital through initial public offering
(IPO). Interestingly, in 1999 and the first three quarters of
2000, about half of all IPOs were venture-backed companies.
This is more than double historical levels.
- More impressive is the acquisition market (M&A) for
venture-backed companies. When comparing the dollars raised
through IPOs with the dollars realized through M&A, the
M&A totals are now much higher, have sustained rapid
growth since the mid-1990s, and are extremely important to
the industry. This is why proposed regulatory action in the
US, which threatens the continued health of M&A exits,
continues to command much attention from the US National
Venture Capital Association (NVCA).
- Corporate venture groups continue to be significant
players in the venture capital world. Rare, in their current
form, just five years ago, corporate venture groups now
provide about one-sixth of the capital deployed in companies,
and invest in one-third of all companies funded. Many of the
new groups on the scene co-invest with established venture
firms. This creates an interesting dynamic, not only during
the due diligence phase when the investors are considering
funding a start-up, but also later on when exit options are
being considered.
- The internal rate of return paid to venture investors has
come down from its sky-high peak, but continues to be far
above historical levels. For the year ended on March 31,
2000, early-stage venture funds paid an average initial rate
of return (IRR) to investors of 270%. Few in the industry
view those rates as sustainable in the long term.
Historically, the industry has paid its investors between a
20% and 25% rate of return. This is considerably higher than
most other institutional investment vehicles, but again, far
below recent levels.
More than 75% of venture investment continues to be in
technology companies with internet, communications, and
information technology sectors dominating the landscape.
While this article was being written, there was much media
attention given to the dotcom fallout in the US. With the rapid
decline in valuations placed on technology-based publicly
traded companies by the investing public, the valuations on
pre-public companies also fell. Many business models that may
have been realistic and sustainable in a high-valuation
environment proved unsustainable as valuations fell. This
valuation decline needs to be separated from the underlying
increasing quality of deal flow that venture capital firms see.
Reports from the field are that many of today's entrepreneurs
coming forward with business plans are experienced operating
managers in technology-based companies. Many of those companies
spawning entrepreneurial alumni were themselves
venture-backed.
The following chart lists the average valuation for initial
venture (Series A) financing rounds for internet-related
companies:
Quarter |
Average
post-money valuation ($ million) |
1Q 1999 |
23.18 |
2Q 1999 |
23.77 |
3Q 1999 |
28.34 |
4Q 1999 |
30.83 |
1Q 2000 |
59.48 |
2Q 2000 |
29.51 |
3Q 2000 |
28.73 |
Source: Venture Economics & National Venture Capital
Association
In fact, the challenges facing the industry largely centre
on the availability of human capital, both in the portfolio
companies and within the venture capital firms themselves. As
the amount of money managed continues to increase, a venture
firm must carefully balance the number of companies funded
(affecting the number of board seats a venture firm partner
commits to) and the average deal size (which affects that
fund's strategy on portfolio company stage and valuation). In
1999, the number of professionals (those at the venture partner
level and above) increased by 22%, compared with the historic
4% - 5% growth. This has enabled venture funds to invest
effectively and prudently in more companies. Still, the ratio
of professionals to number of deals funded continues to be
lower than a few years ago.
The search for talent for portfolio companies is even more
daunting. Many one-person/ one-idea start-ups are funded each
week. No one-person venture-backed company has ever gone
public. As a company grows beyond one person with a great idea,
to become a self-sufficient, successful going concern, the
organization needs to scale up its leadership, technical
talent, and employee base. The venture capital industry
recognizes both the short-term and long-term need for talent.
The NVCA, in coalition with other groups, has been actively
encouraging the increase in the number of H-1B visas available
to talent not otherwise eligible to work in the US. The
longer-term solution involves programmes for both adult
training and enhanced public school systems at all age
levels.
Venture capital firms in the US
The dominant basic structure for venture capital activity
continues be a private, limited partnership (or equivalent)
which is generally unregulated and government-independent. The
role of the venture capital firm is to bring together a network
of investors (limited partners) and entrepreneurs (portfolio
companies). The venture firm's investment in the portfolio
company is equity, long-term, very hands-on (often the venture
capital firm partner will become a board member of the
portfolio company), patient, and supportive. The venture
capital firm, and subsequently the investors, realize a return
on investment when the portfolio company's stock increases in
value allowing the venture capital fund to exit through an IPO
(flotation) or acquisition (M&A).
Table: Amount of money raised by US venture capital funds
by year
Year |
# Funds being
raisied |
Money raisied
by VC funds ($ billions) |
1994 |
131 |
8 |
1995 |
154 |
9 |
1996 |
158 |
11 |
1997 |
220 |
17 |
1998 |
252 |
29 |
1999 |
391 |
59 |
9mos2000 |
366 |
70 |
Source: Venture Economics & National Venture Capital
Association
Often misunderstood by those not familiar with venture
capital in the US is the fact that venture firms are private,
and generally independent of governmental involvement. The two
major areas of federal government support are in the Small
Business Investment Company (SBIC) programme and in basic
research. A small number of venture capital firms configure
their funds as a designated SBIC. This programme, organized and
managed by the US Small Business Administration, an agency of
the federal government, provides certain guarantees and
matching funds for small business investment. The venture
industry recognizes the importance of several basic research
programmes, sponsored by several arms of the federal government
including the Advanced Technology Program (ATP) of the National
Institute of Standards and Technology (NIST), the Small
Business Investment Research (SBIR) programme, and the National
Institutes of Health (NIH). In fact, many seed and early-stage
investors have relationships with these programmes as well as
research programmes of leading universities.
Private equity funds are raised specifically as venture
capital funds or buyout/ mezzanine funds. Venture capital funds
provide growth capital for companies from the seed stage
through an acquisition or IPO. Buyout funds work primarily with
established companies, both private and public, to create value
through reengineering and reconfiguration. Historically, buyout
funds have raised about four-fifths of the money going to
private equity, leaving around one-fifth for venture capital.
Starting in 1999, venture capital funds have actually raised
more money than buyout funds. This may have been fuelled both
by the much higher returns paid by venture funds in recent
quarters, and the recognized number of attractive investment
opportunities for growth capital.
Wealthy individuals investing their own money are called
angel investors. Often these angel investors will join together
to form a group. Whether individually or together, these angels
invest in start-ups. In some cases, angels and angel groups
compete with early and seed-stage focused venture capital funds
for deals. Other venture capital firms consider the angels as a
kind of farm system for creating companies for their future
investment. No one has accurately measured the total investment
activity of the angel community, but some estimates put the
angels, taken together, at roughly the size of the organized
venture capital community.
Investment patterns
Historically, between 70% and 80% of venture capital is
invested in high-technology companies. In recent years, much of
that has gone to internet-related companies:
Year |
Percent of
venture capital investment going to internet-related
companies |
1998 |
36% |
1999 |
66% |
9 months 2000 |
77% |
Source: Venture Economics & National Venture Capital
Association
Because of the increasing importance of the internet in both
consumer and business-to-business sectors, we expect this
percentage to continue increasing. What has shifted in recent
quarters is the type of internet-related company receiving
money, and the underlying business model. The crop of
internet-related companies receiving funding are those related
to enabling internet software, expanding bandwidth,
infrastructure, and/ or a transaction fee-driven revenue
model.
Year |
Number of
companies financed |
Total venture
capital invested ($ billion) |
1995 |
1,321 |
5.5 |
1996 |
1,997 |
11.2 |
1997 |
2,699 |
17.1 |
1998 |
3,161 |
21.8 |
1999 |
3,959 |
59.5 |
9 months 2000 |
4,554 |
80.7 |
Source: Venture Economics & National Venture Capital
Association
There has been much discussion about the effect of recent
genomics breakthroughs on the resurgence of biotechnology
investment by venture capital funds. For several years, venture
capital investment in biotechnology has been in the range of $1
billion to $2 billion. During this time, the total US venture
capital investment grew from $5 billion to almost $100 billion.
Biotechnology companies were considered a difficult investing
space for venture funds because of a very long maturity period
(often 10 years or longer) and the huge uncertainty of the
results. Recent genomics and other enabling technologies have
resulted in biotechnology investment opportunities which more
closely resemble traditional venture deals. Biotechnology
investment could reach record levels of $3 billion or higher
for 2000. However, that remains a very small piece of the whole
pie.
Industry performance
Spectacular returns over the past several quarters have
clouded the fact that the venture capital industry historically
has returned around 20% to its investors. As investor returns
appear headed back toward historical levels, venture capital
continues to attract record amounts of institutional and
individual capital.
Table: Peformance of private equity funds
Timeframe
ending 6/30/2000 |
IRR for
venture capital funds |
IRR for
buyout funds |
1 year |
143.3% |
23.6% |
5 years |
51.2% |
18.5% |
10 years |
27.4% |
17.2% |
20 years |
19.9% |
20.1% |
Source: Venture Economics' Private Equity Performance
Index (PEPI)
What's ahead
Over the near term, the continued softening in valuations
will inevitably affect investment choices, exits, and fund
performance. The venture capital industry has seen seven years
of strong growth. The past several quarters have seen a
frenzied pace, which is not typical and probably not
sustainable. After all, no one has repealed the business
cycle.
That said, institutional money and individual money is being
made available to the industry at record levels. There is no
reason to believe that high-quality business plans and
management teams will have trouble getting funding over the
next few years. The deal flow pipeline remains very strong.
National Venture Capital Association
1655 North Fort Myer Drive
Suite 850
Arlington, Virginia 22209
USA
Tel: 1 703 524 2549
Fax: 1 703 524 3940
www.nvca.org