The future is arriving earlier than expected — and venture capital is on a tear

September 2021 | SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

September 2021 Issue

While the coronavirus (COVID-19) pandemic has caused an unprecedented level of disruption in the global economy, it has also forced consumers and businesses to adapt quickly to remote working conditions and social distancing.

Technologies such as digital payments, cloud computing and e-commerce have been relied on more heavily, enforcing an expedited change in consumer behaviour which is unlikely to fully reverse once restrictions are lifted.

The effect has been particularly felt in the venture capital (VC) space where a higher portion of portfolio holdings are on the right side of these changes. However, while VC valuations have indeed responded, there is a risk that parts of the market are becoming overheated.

Venture capital going from strength to strength, driven by improved prospects for tech

Given these developments, it comes as no surprise that VC-backed deal flow has been very strong in recent quarters. That said, the number of venture-backed deals completed globally increased only modestly in the first half of 2021: a total of 8989 venture-backed deals were completed in the first half of 2021, compared to 8890 during the same period last year.

However, average deal sizes have increased significantly on the back of higher valuations. Average venture-backed deal sizes we track were $71.5m in Q2 2021, over three times the $21.3m figure during the same period in 2019, prior to the outbreak of the pandemic. This also partially reflects a higher portion of later-stage deals being completed compared to recent years. Aggregate venture capital deal value in the first half of 2021 reached $375.3bn, up from $146.5bn for the same period in 2020, at the height of the financial market turmoil.

Software deals have been a key component of this trend and have made up some of the largest deals so far in 2021. With the risk of infection in the workplace, businesses have reconfigured their IT infrastructure to allow employees to work remotely. This move to working from home has drastically increased the dependence on cloud-based software as a service (SaaS) in particular, with deals in this space heating up. Examples include a $12.3bn deal by Thoma Bravo, a private equity (PE) firm focused on the software and tech space, to take Proofpoint Inc private; and a $5.3bn deal backed by PE firms Clayton Dubilier and KKR to take Cloudera Inc private.

The brighter prospects for VC have also led to heightened interest from investors. A total of $142.4bn was raised by VC funds in 2020, 21.3 percent of the total amount of capital raised by PE and VC (PEVC) overall – up from 15.5 percent in 2019.

In addition, the average size of funds closed also climbed to $155m in 2020 from $107m in 2019. These inflows along with the performance of the asset class has allowed VC’s share of total PEVC assets under management (AUM) to continue to climb. While VC represented 17 percent of total PEVC AUM in 2010, it has been climbing steadily since, reaching 27.2 percent by the end of 2020.

Favourable market environment further boosting PE and VC valuations

Accelerated technological adoption is not the only trend driving the growth of the PEVC industry. For now, at least, the backdrop remains conducive to further growth. On one hand, institutional investors continue to rotate out of actively managed public equity vehicles and into a combination of passive exchange-traded fund (ETF) exposure and PEVC.

At the same time, rock bottom government bond yields are forcing allocators to move up the risk spectrum, making more room for riskier PE allocations. We expect these factors to help drive global PEVC AUM to increase from $5.3 trillion at the end of 2020 to $13.2 trillion in 2025, a growth rate of 19.7 percent per year.

The wave of fiscal and monetary stimulus unleashed by the authorities has helped drive asset prices to new highs and the impact has been more prominent in PEVC given the higher risk and higher return profile. According to our data, global PE returned 23 percent in 2020 compared to 16.3 percent for public equities.

That said, there are potential risks on the horizon. With economies reopening, supply chain and labour market disruptions have led to a spike in inflation, with US consumer prices increasing 5 percent year-on-year in May. While a debate rages as to whether this increase will be temporary or more of a permanent shift, longer-term inflationary expectations remain at reasonable levels. The 10-year break-even inflation rate in the US currently stands at 2.2 percent, which is down from a recent peak of over 2.5 percent in May. This is one of the key reasons why long-term treasury yields have been able to remain rooted to comparatively low levels, with the 10-year yield currently at a mere 1.36 percent.

Low treasury yields have been instrumental in incentivising asset allocators to divert more to PE as they seek higher expected returns. In addition, low financing costs have also helped improve the economics of leveraged buyout funds, which has further bolstered returns. Perhaps most critically, low rates have made equities – both public and private – more attractive in relation to fixed income and allowed asset valuations to climb higher without impeding their attractiveness to investors. Global public equities currently trade at a forward PE ratio equating to an effective earnings yield of 5.3 percent – still comparatively attractive compared to treasuries.

Against the improving economic backdrop there may be limited room for concern over valuations overall, in public and private markets alike. For now, at least, the virtuous cycle that is driving the PEVC market to fresh highs is showing no signs of abating.

Cameron Joyce is vice president of research insights at Preqin. He can be contacted by email: cameron.joyce@preqin.com.

Cameron Joyce

Preqin