What did we see in 2016? What do we forecast for the coming year in VC, PE and M&A?
Our editorial staff weighs in below:
Adley Bowden, Vice President, Market Development & Analysis
What stood out in 2016 to me, across both private equity (PE) and venture capital (VC), was the sheer volume of capital that was raised on top of the already massive stores of dry powder. This came even as deal volume and investment amounts held at relatively modest levels, due largely to historically high valuations. In the venture world the other standout was, as we predicted earlier this year, that the high-flying unicorns were largely able to still raise money or move their business models toward profitability and extend their runways.
These two standout trends play into what I see as the biggest questions marks for 2017:
1) Can investment managers maintain the discipline they have so far exhibited (assuming there’s not a change in the business cycle) or will all that capital burn a hole in their pockets? With all the pressure on fees, it’s awfully difficult to justify doing nothing… Ultimately, I expect to see a weakening of discipline as firms find new strategies and routes to put the capital to work. I don’t think we will see a total lack of discipline by any means, but I do imagine some interesting structures and head-scratching deals will happen.
2) Will the late-stage, private, high-growth-company asset class prove it’s here to stay or will it blow up in the face of VCs, hedge funds and mutual funds in spectacular fashion? Yes, these unicorns really do represent a new asset class. And if we don’t see a significant amount of liquidity generated through IPOs or large M&A deals in 2017, it’s going to create a lot of indigestion for investors that are running out of what is an already long investment time horizon. My take, the cream will rise to the top and prove that these companies are for real and capable of generating vast investment returns for the bold. But we will also see more than a few go the other way, leading the investment community to rethink and better target in the future the right companies take into “Unicorn Land.”
Andy White, Analysis Manager
Venture fund returns will fall.
VC investment activity in the US has soared since the depths of the financial crisis. Simultaneously, valuations increased dramatically, forcing VCs to pay more for each investment, regardless of whether the valuations were warranted. As a result, the value of a fund’s portfolio is predicated on valuations obtained during a hot investment environment, which may end up proving to be “irrationally exuberant,” to borrow a phrase.
We can see from the chart below that more recent fund vintages are showing very solid returns through the middle of 2016, with the median IRR at 15.3% for 2009-2013 vintages. More mature funds, pre-2009 vintages, have a median IRR of 5.2%.
On paper, the new era of venture investment is far outpacing historical returns. But at this point, those returns are just that—on paper. We can see from the chart below that the very vintages which show strong IRR figures are still holding a massive proportion of the fund’s value in active portfolio companies. For reporting purposes, this value is factored into the fund IRR calculations, propping up returns. We know that it’s unlikely for all the investments still held to reach an exit, and it’s also unlikely that many of those still held will reach an exit at the value which they received at their last funding round. So unless the winners far outshine the losers, we will see IRRs drop.
Nizar Tarhuni, Senior Analyst
With so much capital already raised in a more challenging deal environment, the intuitive notion would be that 2017 fundraising figures will subside. I agree, however, I think we’ll be surprised and the decline will be softer than expected.
Sovereign wealth funds negatively impacted by volatile commodity prices will need to find higher-earning assets to help replenish some the capital they’ve spent to fund social programs—and PE might well be a place they look to do that. Further, larger LPs will continue to support larger vehicles in an effort to secure advantageous fund terms. This trend along, with managers marketing more funds with longer lifecycles, could help drive larger commitment checks flowing to PE.
Garrett James Black, Senior Analyst
PE: With elevated levels of dry powder exerting upward pressure on valuations, private equity firms will still have their work cut out for them when it comes to finding targets that are not only worth top dollar but also can potentially service debt through the three planned interest-rate increases in 2017 (although it’s worth noting given inflation and political volatility that monetary policy is still quite loose and those increases may well not happen). Accordingly, even given continuing sell-off by aging baby boomers, along with continued corporate divestitures and consolidation in key sectors such as healthcare, overall PE activity is set to, at best, stay flat with the levels observed in 2016. It’s not a matter of demand, it’s a matter of supply of worthwhile targets.
VC: Venture investors have already appeared to ride the hype cycle from bubble to halfway back, hoping that outliers—such as Snap’s IPO—actually occur and signal all the more brightly, injecting a sense of optimism into the industry as a whole. I am quite dubious of such a prospect, however. The investing side of venture is somewhat rosier because not only do they have plenty of cash on hand, they merely have to continue grappling with the slow reset in founder expectations around financing sizes and valuations that continued throughout 2016. Moreover, they shall continue their increasingly rigorous risk assessments around each financing stage’s benchmarks. When it comes to liquidity, however, many unicorns will have a hard enough time getting ready to go public throughout the course of the year—some consequently shall delay, others became unicorns recently enough they have no reason to go public unless a broad window opens in the IPO market, and last but not least, said broad window is subject to the raft of political concerns that spiked volatility in 2016 and look set to continue doing so in the coming year. That’s not even taking into account any economic shocks. So VCs will likely have to continue looking to M&A for liquidity, which should ameliorate matters somewhat.
Elizabeth Armon, Analyst
2016 saw the highest concentration of $500 million+ VC-backed exits in over a decade, led by large M&A transactions in the healthcare sector, as industry giants doubled down on R&D efforts and purchased innovative startups—e.g. AbbVie-Stemcentrx ($10B), AstraZeneca-Acerta Pharma ($4B).
In recent years, public companies have sat back and watched the drama of the Valley play out. Now, as frothy valuations, business models and market compatibility with unicorn valuations come under increased scrutiny, public companies and private equity firms are likely to fill the gaps in their portfolio with aging VC-backed companies. In 2017, a larger M&A deal pipeline will continue as Fortune 500 companies look to buy innovation, which will both augment and/or grow