Powerful long-term trends boost venture capital outlook

October 2023  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

October 2023 Issue

If there is a single word to describe the first two decades of the millennium, it may well be innovation.

The pace of technological development is accelerating exponentially. The formation of Lyft, Snap, Spotify and countless other global mobile-first platforms would have been inconceivable prior to the era of fast, high-capacity wireless networks, the proliferation of powerful, pocket-sized connected devices and the emergence of cloud computing.

Each wave of innovation eclipses its predecessor in a virtuous cycle that encapsulates the compounding nature of technology. Chris Dixon, general partner at Andreessen Horowitz, summarises this by saying “the core growth process in the technology business is a mutually reinforcing, multistep, positive feedback loop between platforms and applications”. This dynamic has led to more significant value creation for technology focused companies and their investors, over subsequent decades.

Venture’s value creation

Venture capital (VC) firms have a multi-decade history of facilitating innovation. Four of the five largest public companies by market capitalisation at the end of 2022 trace their roots to VC funding. According to the National Venture Capital Association, half of all US public companies benefited from venture investment, while VC-backed businesses make up about 77 percent of US public market capitalisation, 81 percent of total patents granted by the US Patent and Trademark Office, and 92 percent of research and development spend. Since 2001, 53 percent of all initial public offerings (IPO) and 70 percent of technology companies going public had VC backing, according to Jay Ritter, a professor at the University of Florida. Still, venture accounts for less than 1 percent of total capital market assets.

Investing in innovation has generated strong returns for top-performing VC funds. The top quartile of global VC funds generated a 28.2 percent internal rate of return from 2001 to 2022. However, not all VC is created equal, as there is a wide dispersion in returns due to a relatively small number of investments driving most value creation in any given vintage year – the median performance of global VC funds is 13.2 percent over the same period. Analysis going back to the 1970s shows that 9 percent of VC-backed companies produced 100 percent of the investment gains. This is driven by top venture funds being able to generate a 100 times or even a 1000 times multiple on invested capital in a single company.

Having a stake in the companies within each fund cycle that have the capability to become next-generation category leaders means VC investors need consistent allocation across time. Being on the right end of such a wide range of return dispersion means selecting managers with sector expertise, trend awareness, venture and technology community relationships, access to deal flow, and the ability to negotiate terms and close deals that look attractive.

Adversity creates opportunities

Economic uncertainty, characterised by factors including rising interest rates to combat inflation, is putting pressure on margins and global growth. Organisations of all stripes are therefore seeking to boost productivity through cost-efficient technologies, especially enterprise software. As Satya Nadella, chief executive of Microsoft, told investors in an earnings call in April 2022: “In an inflationary environment, the only deflationary force is software.”

In our view, crises can promote robustness in the start-up ecosystem. Perhaps the clearest recent manifestation of this phenomenon was the coronavirus (COVID-19) pandemic, which drove increased use of solutions such as remote working and telemedicine.

“Innovation and disruption are constant and not subject to the whims of the overall economy,” wrote Bill Gurley, general partner at Benchmark, in December 2008 in the midst of the global financial crisis.

Benchmark was an early investor in Uber, Snap and Elasticsearch, which were founded during this time. All are now public companies with market values from $5bn to $60bn. This illustrates how some of the best VC outcomes can result from investments in companies that are created during suboptimal market conditions.

Market reset

While the cohort of traditional investors serving early and mid-stage companies has remained relatively stable, many non-traditional venture investors have withdrawn after deploying capital at historically high valuations in recent years. This has helped to reverse distortions and kickstart the normalisation of conditions.

As investment pacing, valuations and terms revert toward historical means, we believe the environment will be more compelling for traditional investors. Furthermore, we think competition will be reduced (both from fewer start-ups, but also lower R&D budgets at technology incumbents), talent availability will be more abundant and capital efficiency will be at the forefront of every company’s mind.

Rocketship for the mind

We see particular opportunities for disruptive and innovative technologies that stand to benefit from the digital transformation of the global economy, which is in its early stages and is likely a decades-long trend.

For example, an estimated $1 trillion of unproductive spending in the US healthcare system is being targeted by novel software applications. Telemedicine is expanding the reach and efficacy of care. Artificial intelligence (AI), advanced devices and robotics are improving diagnostics, surgery and the overall standard of care, while minimising or even eliminating redundant workflows.

Generative AI (GenAI) and machine learning (ML) offer many compelling potential use cases. GenAI allows machines to ‘create’ via writing, coding or drawing through human initiated prompts, and has the capability to significantly improve productivity in the knowledge-based economy, which currently employs about a billion people globally.

In addition, because AI is not a ‘one size fits all’ solution, we expect companies to emerge that focus on applications specific to certain use cases. If personal computers are “bicycles for the mind”, as Steve Jobs quipped, we expect the next generation of AI and ML to represent something akin to a rocketship for the mind.

Elements of success

Humankind faces countless predicaments in areas such as healthcare, education provision, workforce reimagination and financial services, to name a few. We believe our best chance to unravel these conundrums is by being investors in human ingenuity and perseverance.

Entrepreneurship has experienced strong tailwinds over the past decade from improved horizontal technology infrastructure. This has reduced start-up capital expenditures, allowing companies to operate with more flexible and dynamic cost structures as they scale their business, improve distribution through tech platforms and app stores, and seamlessly embed payment capabilities in applications.

Iconic companies are built in all market cycles, and we believe that VC is one of the primary avenues to invest in this innovation while generating attractive risk-adjusted returns. Companies are staying private longer and are achieving greater scale than in prior cycles, both of which improve the potential for value creation in private markets, all while market fundamentals and terms are improving.

Building a company from zero to one and scaling it to commercialisation continues to require significant work, skill and, of course, some luck. The core tools for value creation by venture capitalists that help improve the chance of success – domain expertise, networking, strategic guidance, governance – remain vitally important to start-ups, especially in today’s environment.

We think the need has never been greater, and the potential has seldom been so compelling. As Bill Gurley noted in September 2022: “If you’re going to build something from scratch, this might be as good a time as in a decade.”

 

Brijesh Jeevarathnam is partner and global head of fund investments at Adams Street.

© Financier Worldwide

BY

Brijesh Jeevarathnam

Adams Street

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