PitchBook December 29, 2016
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:
What stood out in 2016 to me, across both private equity and venture capital, 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 to take into "Unicorn Land."
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.
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.
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.
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 their current strategies
Driven by competition from strategic acquirers and a lack of buyout-ready targets coming to market, private market valuations reached new highs in 2016. In addition, PE firms have been on a fundraising tear during the last few years and are now looking to deploy that dry powder.
Eventually, these pricing pressures will unwind, but it likely won’t happen next year. Cash-rich corporate acquirers will continue their growth-by-acquisition focus, and financial buyers will continue deploying capital at a similar pace. Due to the higher purchase-price multiples, expected future PE returns will decrease and fundraising will dampen accordingly.
In 2017, banks and other financial institutions will respond to the existential crisis of being disintermediated from customers by more aggressively investing in initiatives to further implement technology into their core businesses. This will come in the form of both formal partnerships and strategic M&A in the fintech sector.
Furthermore, digital currencies will become more widespread as legal tender initially in the third world. Cryptocurrency markets will remain robust given demand for capital outflows and demonetization in some of the largest emerging economies.
Exits aside—they will need to come back eventually, but to some degree that is irrelevant for this point—maybe the venture industry has seen a bit more transformation than many realize. Since 2013, deal sizes have seen a ton of growth, and until this year, the actual number of yearly financings had also seen much of that same growth. The low deal count of 2016 may not be a part of a doom-and-gloom prophecy; VCs are simply being smarter about the investments they're making.
Fundraising hit a record amount in 2016 (and has been strong for several years), so there's plenty of capital ready for investment. But rather than spray-and-pray or copycat methods of dealmaking—how many ways can you offer to deliver me a burger before I realize that I don’t need a burger?—VCs are honing on strong metrics and KPIs before a deal, a technique that may lower the number of investments and require more capital per deal. In the long run, it could help assemble portfolios built for multiple strong exits, rather than relying on a couple massive ones.
Throughout 2016, we felt venture investor sentiment dampen from what was a raging party the year prior—capital invested and deal count took a dip, as did the number of VC-backed exits. This year’s funding squeeze led to startups, thankfully, putting more focus on their sustainability and quest for profitability. Amid the chill, however, fundraising hit unexpected levels, with the number of new vehicles staying level with the prior year, and total capital raised hitting an all-time high.
Looking ahead to 2017, I expect a continuation of some of the trends seen through 2016, namely the focus on operating sustainably and pushing toward profitability. Sadly, this will probably mean more layoffs as startups work to decrease burn and, in the process, elongate their runway. We may also see an increase in the number of flat or down rounds—as well as exits via M&A—as companies that secured lofty valuations in 2015 find that their metrics aren’t able to support an attractive valuation in the current market.
As for venture investment, all that money VCs raised in 2016 has to go somewhere, so expect capital invested to hit healthy levels. Whether that means many startups will be funded, or perhaps consolidating investment into certain bell cows, remains to be seen.
Three of the four biggest buyouts completed during 2016 were deals agreed to during 2015. That doesn’t seem like a coincidence, and it’s not solely a factor of timing. There’s not a pipeline of other mega-deals still in play. Private equity firms seem to have rolled back their ambitions in recent months, forgoing massive acquisitions and instead focusing on deals of a more modest scale.
There are surely several causes at play, ranging from an absence of attractive and available assets to the ease (or lack thereof) of acquiring debt. There’s probably some correlation between smaller deal sizes and the overall depression in private equity activity compared to the booming levels of 2015. Whether more deals exceeding $5 billion start to pop up in 2017 could well serve as a bellwether for the industry’s health as a whole.
Check out more of our 2016 Year in Review coverage by clicking here!