Prof. G.Sabarinathan1 examines the swelling tide of capital, the growing allocation to alternative investments, institutional evolution and demand-supply dynamics that have impacted the role of the VC industry in the governance of investee firms
It has been an eventful week for venture capital (VC). In USA, which I will focus on for now, Elizabeth Holmes, founder of Theranos was convicted.2 Interestingly, Holmes’ conviction coincided with the end of a year when the US VC industry hit a funding record of $ 330 billion in 2021!
Coincidentally, perhaps, the Indian VC industry also invested a record $ 77 billion in 2021, even if most of the money was from outside. If you are numerically challenged, like me, to give you a point of comparison, that is almost five times the Rs 1.2 lakh crores mobilized from the public markets in the form of Initial Public Offerings (IPOs) in 2021.
Underlying these huge increases in volume are fundamental developments that have changed the industry from its origins in the fifties and sixties in the USA and the late eighties in India. I will focus on the US industry, mainly because the rest of the world follows what the US VC industry does, in spite of the fact that institutional conditions and the industry contexts in which they invest vary considerably across the world.3
I focus on the factors relating to the supply of capital here. For a well rounded analysis, though, one has to consider factors that relate to the demand for capital in the world of entrepreneurship as well.4
The swelling tide of capital
At the core of it all is the fact that the VC industry has been attracting several times more money than it was designed to manage. According to a widely cited paper written by Professor James Poterba,5 the industry raised $ 3.5 billion of capital between 1970 and 1980 which works out to an annual average of around $ 319 million, but varying across years, with the capital raised in one year
in 1975 being as low as $ 20 million. In the decade that followed, starting 1981, the number increased to $ 26.5 billion over a seven year period, leading to an annual average of $ 3.78 billion. This increase is attributed to a change in the rate of taxation of capital gain, which is the burden of Professor Poterba’s thesis.
Once the world of investment realised the potential for extra ordinary returns, VC seemed to have caught the imagination of fund managers. The volume of capital committed grew until it reached seriously large proportions from the mid-nineties, leading to the “tech boom” and beyond. Data from the Money Tree Survey published by PWC annually, shows that funds invested in start-ups from 1995 to 2000 was US $ 235 billion.6 It remained more or less constant during the whole of the following decade, possibly due to the crisis that emerged during the period. From 2000 to 2010 the volume of funds invested was US $ 263 billion. In the decade that followed from 2011-2020 the funds invested increased dramatically to US $ 753 billion. That was not all. The average size of the transactions also increased substantially during the decade from 2010 to 2020.
Growing allocation to alternative investments
In the vocabulary of portfolio management, investments in venture capital funds are considered to be part of a broader set of investment opportunities known as alternative investments. They acquire the label alternative because they complement investments in more traditional opportunities like stocks and bonds. While there seems to be no precise definition of this class of investment opportunities it is generally understood to include real estate, commodities, hedge funds and private equity, including venture capital. Apart from the high returns private equity and venture capital are expected to deliver they are also supposed to have a low correlation with returns from mainstream investments, making them even more attractive to a diversified portfolio.7
From a supply perspective, therefore the increase in VC activity can be traced to the increase in the allocation of capital to VC as an asset class. According to Preqin, an important source of data for the alternative asset industry,8 assets under management of the alternative assets industry increased from $ 4 trillion in 2010 to $ 10.8 trillion in 2019. Within alternatives, the allocation to the VC industry increased from around 4% to 6%, during the same period.9 Yet, many institutional investors like pension funds seemed to have underachieved the allocation they had planned for alternatives in their portfolio, suggesting more capital is likely to wash ashore on to the world of alternatives.
This is a far cry from the early days when David Swensen10 institutionalized allocations by pension funds and endowments to alternatives realise the benefit of diversification of institutional investment portfolios and the rates of returns they produced when those investments succeeded.11
The big get even bigger in VC
Within the world of VC, success in investment performance seemed to beget success in raising larger funds as institutions wished to seek safer havens in funds with attractive track records. According to
a quarterly update from Pitchbook in November 2021, VC funds raised by funds with a size of $ 1 billion or more increased from 15% in 2006 to more than 35% in 2020.
On the one hand larger funds suited fund managers, given their compensation structure of a fixed fee of around 2% per annum, linked to the size of the capital mobilized and 20% by way of incentive compensation linked to fund performance. At the same time, growing fund sizes increased the pressure on fund managers to put money to work. That could well be one of the factors supporting the ever growing deal size noted earlier. The amount of funding accounted for by funding rounds of $ 100 mn or more increased from $ 4.5 billion on 2012 to $ 136.5 billion in 2021 according to another survey, again by Pitchbook, in October 2021. The number of global mega VC funds increased from 28 in 2015 in 91 in 2021.12
It also led to other interesting phenomena. Investors seemed to be ploughing more and more capital into later stage investments. This development was not lost on industry observers.13 The phenomenon of increasing deal sizes was however accompanied by a delay in exits.14 According to one estimate the median age of VC funded companies in 2019 was 8.2 years.15 This has to be viewed in light of the fact that most venture funds had a ten-year life with two single year extensions at the most. An eight-year median holding period would imply that half of the investments or more would be a source of anxiety for VC fund managers in terms of achieving an exit. At the same time investment in the seed and Series A stages where businesses get started and were declining.
Terms of supply
Observers have pointed out to changes in the terms of supply of capital too. VC funds are now considered to be a lot more founder friendly. Gone are the days when by the time a startup went out to raise its Series A, the probability of the VC fund manager replacing the management team with professionals of his choice was more than 50% and it would be a rare founder who would raise several rounds of VC funding and still ring the opening bell at it IPO. Instead, the personality of the successful contemporary entrepreneur is more likely to resemble the all-powerful Zuckerberg, Chesky, Neumann, Musk or Kalanick.16
This change is far more profound than the cyclical ups and downs in valuation and the time to exit that observers like to write about. It has far-reaching implications for the industry. For, at the core, as important as anything else about it, has been the role of the VC organization as a model of governance.17
Those canons of governance have been enabled by the extensive contracts that VC investors are known to write. As they learned more and more about the art of early stage investing these contracts grew in complexity to empower the investor to exercise control over the enterprise. Given that the VC investor had a fiduciary role with regard to the investor who had entrusted him with the capital in the VC fund, these covenants were essentially intended to protect the interests of the capital provider. To that extent these covenants may be purported to have enhanced the efficiency of the capital allocation process.
The dilution of the role of these covenants is an important shift. The question though is how permanent this shift is. The waxing and waning of investor control is not unheard of in the world of investment. In the frenzy of deal doing during the tech boom investors ended up writing agreements that were relatively soft. In another context, lenders to private equity transactions lightened up on their prudential covenants leading to what came to be known as “covenant-lite” loans. When the loans went bad the market went back to more onerous conditions, even if briefly. The current shift in power in favour of the entrepreneur appears to resemble the trend in the end of nineties. It would be interesting to see if there will be a similar switch back if the market for early-stage investment were to turn, yet again.
Institutional Evolution
Even as these changes swept across the VC industry, a number of other institutional developments emerged, as though to suggest that vibrant markets abhor vacuums. At the earliest end of the origin and evolution of enterprises, the incubator which was an institutional artifact developed by the technology transfer offices of universities has been adapted and repurposed into a market driven institution known as the accelerator.18 Encouraged by their early success, some of these accelerators have moved downstream into providing early-stage funding.
The angel industry, which was considered to be the original source of early-stage equity capital after an enterprise had exhausted the 3Fs, namely founder, family and friends, came up with the nearly ubiquitous angel networks to address many of the economic challenges that individual angels faced. More recently angel networks have been mobilizing early-stage VC funds, also referred to often as micro-VC funds.19 Together, these institutional arrangements seem to be filling the gap left behind by the ever growing size of the Series A, the term used by the VC industry for the first round of funding provided by institutional VC investors.
At the other end of the deal size, large deals have been possible because of the entry of many new categories of investors who have been attracted by the rates of return that the industry seems to promise. Prominent them are corporate venture capital arms. For a long time, corporate investors were not taken seriously in the VC industry, given their tendency to be sporadic in their investment interests. Entrepreneurs also often saw conflicts of interest between their enterprise and the corporate investor. A host of other investors also entered the scene. Their longevity and sustained interest in VC investing has surprised observers. So much so, one author refers to them as “tourist investors.”20 In 2018, they funded 1443 deals, 16% of total deals funded worth $ 67 billion or 51% of capital provided, making them significant as a source of funding. That fraction increased to 77% in 2021.21
Allowing companies to remain private for long enough without affecting the liquidity for early-stage VC investors has been the emergence of secondaries. I had noted earlier the significant increase in the periods for which VC funded companies remained private. Secondaries buy out VC stakes from VC fund managers instead of making direct investments in companies, which they do less often. In the past twenty years secondaries have become an important part of the early-stage investment industry, going from being completely unknown with less a billion dollars of investments to a $ 33 billion22 in 2018 and $ 55 billion in the first half of 2021 alone.23 The growing volume aside, the industry has developed a set of specialized managers of capital, focusing on specific opportunities in the secondaries space.
At the end of the venture life cycle, the emergence of the Special Purpose Acquisition Vehicle (SPAC) cannot be ignored, even though its limited history raises an occasional question about its sustainability and whether it will remain an enduring phenomenon that is here to stay. From eleven SPAC based exits in 2000, IPOs around SPACs increased to 329 in 2021, representing almost 15% to 20% of the exit proceeds during the year. SPACs seem to have come to the rescue of early-stage investors thirsting for liquidity as they stared helpless at the nearly decade long drought in IPOs from 2010 to 2019 before the current flood of IPOs that started in 2020 and 2021.
The demand side of the story
While all these observations describe the evolution in investor preferences, there have been shifts on the demand side as well. VC started as a source of really early-stage funding in the 50s and 60s. Its early origins were in what Vannevar Bush envisaged as “profitable investment opportunities in small technology-based firms”, which evolved into “Sputnik driven funding” comprising “extremely high value-added, cutting edge electronics and other components”. The challenge that the VC fund has been facing from that time is what Kenney describes as “an organization aiming to formalize a previously informal investment function, particularly one that had always had affective and charitable dimensions and high loss rates.”24
As the potential for high returns became apparent the VC industry started attracting more and more commercially driven capital. The Small Business Investment Companies demonstrated the profit potential in this sector. Legislative changes such as the clarification to the Prudent Man Rule in the Employee Retirement Investment Security Act of the USA, opened the spigot of institutional capital even more.25
Till the advent of the technology boom investments were modest in size. They were staged. They were governed by tight covenants that allowed the investor a great deal of control over the enterprise. While early customer acquisition costs were borne by the capital provider, the subsequent costs of customer acquisition had to be paid from the revenues of the enterprise. Cash flow neutrality was a key virtue that was eagerly awaited by the enterprise as well as the investor. As a result, frugality was a virtue, epitomized by the idea of the start-up as a resident of some garage or the other for much of its early growth period. Compensation for key employees was largely non-cash in the form of stock options.
Much of this appears to have changed. The prospect of grabbing market territory rapidly by leveraging network effects and paying high customer acquisition costs from investment funds, setting up fancy offices and paying top dollars for employees appear to be some of the key differences in contemporary start ups. Parsimony is probably not a virtue any longer. Fail fast and fail cheap probably is a dictum only for books like Eric Ries’ Lean Startup. On the contrary, the dominant scaling paradigm seems to be the idea in the metaphor that is being bandied around the Theranos story: Fake it till you make it. That faking is costly as investors in Theranos realized at the end of a princely $ 660 million that went up in red smoke. The list of such costly failures is long. Crunchbase publishes from time to time a list of startups that burnt investor capital before they shut shop.
So, what is the use of all this walk down memory lane? Is it an idle exercise in business history? No. On the contrary it is to remind ourselves that the VC industry that we see today, that has evolved during the past decade, is different from the one that came into existence. More importantly, as one sits back and reflects on these developments, one is tempted to ask this basic question: Does it make sense to expect that the VC industry will play continue to play its part as a gatekeeper or guardian of risk capital who will ensure that its investee companies will turn out to be paragons of virtuous governance as they were supposed to in the early days of the industry? Does the investment activity of VC funds in the past five to ten years warrant that belief? Surely a lot of research is required to answer that question. It does appear safe to suggest though that it is time to ask that question.
1Professor G. Sabarinathan teaches Finance at IIMB. He used to offer an elective course on early stage investing. Views in this piece are personal.
[2] Just in case you are curious to know about the enterprise or the entrepreneur, you may like to read this https://www.newyorker.com/news/q-and-a/what-john-carreyrou-expects-at-the-trial-of-elizabeth-holmes. The Wall Street Journal is said to have broken the news. But their stuff sits mostly behind a paywall. If you are a subscriber here is the link to Carreyrou’s exposes. https://www.wsj.com/articles/theranos-has-struggled-with-blood-tests-1444881901
[3] A number of academic studies look at this issue. See for example, Formal institutions, culture, and venture capital activity: A cross-country analysis by Yong Li and Shaker A. Zahra in Journal of Business Venturing, 2012, Vol 27, pp 95-111 for a study that compares the context across 68 countries.
[4] A host of factors drive the volume of capital committed to VC funds. Tax rates, availability of high quality investment opportunities, prospects for returns in competing alternatives are some of the factors identified by Paul Gompers and Joshua Lerner. See “What Drives Working Capital Fund Raising, NBER Working Paper No 6906, January 1999 by Paul A Gompers and Josh Lerner.
[5] Venture Capital and Capital Gains Taxation by James Poterba, NBER Working Paper No 2832, published January 1989
[6] https://www.statista.com/statistics/277501/venture-capital-amount-invested-in-the-united-states-since-1995/
[7] The belief about low correlation is not accepted universally. For an alternate view on this please see https://blogs.cfainstitute.org/investor/2020/12/16/myths-of-private-equity-performance-part-iii/
[8] https://www.preqin.com/academy/lesson-1-alternative-assets/past-present-future-of-the-alternative-assets-industry
[9] https://www.preqin.com/insights/research/blogs/future-of-alternatives-2025-investors-inexorable-push-to-alternatives
[10] Swensen’s investment approach has been documented by him in his book Pioneering Portfolio Management. A student of James Tobin, Swensen laid down the foundations of a path breaking approach to investing in alternative assets as also for growing endowment funds. He is considered to be the architect of the enviable endowment pool that Yale University has.
[11] The rate of return produced by venture capital and private equity funds, after adjusting for the relatively high riskiness of those investments and the high fees and costs that fund managers charge in comparison to mutual funds that invest in listed securities is still a matter of much disagreement between practitioners and academics, notwithstanding the gargantuan multiples some of the “home run” investments produce.
[12] https://pitchbook.com/news/articles/norwest-raises-biggest-fund-yet-as-industry-mega-fund-pool-nears-100b
[13] https://techcrunch.com/2020/11/13/fintech-vc-keeps-getting-later-larger-and-more-expensive/
[14] https://venturebeat.com/2017/07/17/vcs-double-down-on-mega-financings-adapt-to-delayed-exits/
[15] https://files.pitchbook.com/website/files/pdf/PitchBook_2019_Venture_Capital_Outlook.pdf
[16] Travis Kalanick, founder of Uber, is not associated with the enterprise any longer. But he well could have been at the helm if he had shown a little more tact. In any event Kalanick led the company till 2017, just two years short of the IPO.
[17] See for example The structure and governance of venture-capital organizations by William A Sahlman, in Journal of Financial Economics, Volume 27, Issue 2, October 1990, Pages 473-521
[18] You can know more about accelerators from Accelerating Entrepreneurs and Ecosystems: The Seed Accelerator Model* by Yael V. Hochberg, available at http://yael-hochberg.com/assets/portfolio/IPEHochberg.pdf . Also see for an interesting account of Y Combinator, considered to be not just the pioneer in the field but also one of the most successful among accelerators, see https://www.wired.com/story/how-y-combinator-changed-the-world/. The story talks about the transformative role that Y Combinator has played on the demand side.
[19] One report in Crunchbase estimates that in 2015 there were 236 micro vc funds in the USA. For an industry overview of micro VC funds please see https://www.cbinsights.com/research/past-present-future-micro-vc/. Micro VC has caught on rapidly in India as well.
[20] See for example https://files.pitchbook.com/website/files/pdf/PitchBook_2019_Venture_Capital_Outlook.pdf [21] Q4_2021_PitchBook_NVCA_Venture_Monitor.pdf
[22] https://pitchbook.com/news/articles/secondaries-growth-shows-no-signs-of-slowing-down
[23] https://www.settercapital.com/media/reports/Setter_Capital_Volume_Report_H1_2021.pdf
[24] How venture capital became a component of the US National System of Innovation by Martin Kenney in Industrial and Corporate Change, Volume 20, Number 6, pp 1677-1723
[25] The prudent man rule required pension funds to invest the capital from the pension funds like a “prudent man”. The fiduciary responsibility that this rule cast on pension fund managers deterred them from investing in venture funds. The clarification allowed them to invest in pension funds on the grounds of the diversification benefit they provided to pension fund managers. See the working paper by Paul A Gompers and Josh Lerner cited above. For practitioners this legislative development alone may have led to a change that led us to the VC industry as we know it today.
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