United States: Market introduction

Author: | Published: 4 Jan 2001
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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

Tel: 1 703 524 2549
Fax: 1 703 524 3940