With their pockets full, investors are looking to bet on a new generation of firms. Global venture investment—which ranges from early “seed” funding for firms that are only just getting going to funding for more mature startups—is on track to hit an all-time high of $580bn this year, according to PitchBook, a data provider. That is nearly 50% more than was invested in 2020, and about 20 times that in 2002.

The type of investor piling into venture activity has changed just as dramatically. It was once the preserve of niche venture-capital firms run in Silicon Valley. These raised funds from and invested on behalf of pension funds and other end-investors, often relying on their vast networks of connections with company founders. Now, however, only three of the ten biggest venture investors by assets under management are traditional VC firms.

Instead, deals led or solely struck by private-equity shops, hedge funds and others that used to conduct little venture activity are on track to nearly double from $144bn in 2020 to $260bn this year (see chart 1). That accounts for a staggering 44% of global VC activity, up from 20% in 2002. “Crossover” funds like Tiger Global Management, which straddle public and private markets, are deploying capital at a breakneck pace. Behemoth pension funds are increasingly directly investing in startups.

The flood of money from deep-pocketed investors has helped swell valuations. But it is also flowing to once-neglected corners and new opportunities. Venture activity now extends well beyond Silicon Valley and America more broadly, and is financing enterprises working on everything from blockchains to biotech.

The wave of capital is also transforming how VC works. VC firms are adopting new strategies as they seek to differentiate themselves in some respects, and to mimic their Wall Street competitors in others. That comes with both benefits and drawbacks for the business of innovation.

The modern venture-capital industry sprouted from a laboratory at Fairchild Semiconductor, a Silicon Valley chipmaker, in the 1960s. Arthur Rock, a banker for Fairchild who became a vc, raised $5m in his first fund and returned $100m over seven years. Two of Fairchild's founders, Eugene Kleiner and Don Valentine, soon followed, setting up Kleiner Perkins and Sequoia respectively. Both are still large vc firms today.

The approach was to back risky startups in the hope that the big successes, like Google, would carry an entire portfolio. Seed investments were often made before a startup earned any revenue. Then came an alphabet soup of successive funding rounds, typically ranging from series a to c, as a company matured. The vcs’ funds were closed-ended, meaning they distributed returns to investors, usually pension funds, endowments and other long-term-oriented investors, within seven to ten years, after taking a cut of their own.

Veni, vidi, vc

The venture capitalists did not just provide finance. They also played consiglieri, often taking a seat on a company’s board. They offered a wealth of experience and access to a network of contacts, introducing startups to professional chief executives, for instance. Entrepreneurs flocked to Sand Hill Road, the home of many Silicon Valley vc firms, in the hope of being funded. The industry’s reliance on personal connections made it rather like an old boys’ club.

The model proved astoundingly successful. Although vc-backed companies represent less than 0.5% of American companies created every year, they make up nearly 76% of the total public-market capitalisation of companies started since 1995. Over time vcs increasingly bet on slightly older “late-stage” startups (which, for their part, delayed going public). Some vc firms opened offices abroad. Andreessen Horowitz, also based on Sand Hill Road, was founded in 2009 and rose towards the top.

Why, then, is the model being disrupted? The frenzy is a result of both the entrance of new competitors and greater interest from end-investors. That in turn reflects the fall in interest rates across the rich world, which has pushed investors into riskier but higher-return markets. It has no doubt helped that vc was the highest-performing asset class globally over the past three years, and has performed on a par with bull runs in private equity and public stocks over the past decade.

End-investors who previously avoided vc are now getting involved. In addition to alluring returns, picking out the star funds may be easier for vc than for other types of investment: good performance tends to be more persistent, according to research in the Journal of Financial Economics published last year. The success of big tech, much of which was backed by vc dollars, may have been another attraction. Investors may have previously underestimated the earning potential of the tech industry, says Fred Giuffrida of Horsley Bridge, a fund that invests in vc funds. They may now be correcting for this.

The rush of capital has pushed up prices. Venture activity for seed-stage startups today are close to those of series A deal sizes (for older companies that may already be generating revenue) a decade ago. The average amount of funding raised in a seed round for an American startup in 2021 is $3.3m, more than five times what it was in 2010 (see chart 2).

But funding is also reaching new terrain. In 2002 84% of venture activity, in terms of value, took place in America. That share is now about 49%. China’s share grew from below 5% in the 2000s to 37% in 2018, before its tech crackdown brought it down to nearer 20%. Capital has instead sought greener pastures in Europe (see Business section). Keith Rabois of Founders Fund, a vc firm, argues that, if done right, investing in less heated sectors can help produce attractive venture returns.

Software startups continue to be popular with venture capitalists. But “you’re seeing a broadening of who gets funded,” says Josh Lerner of Harvard Business School. Riskier biotechnology, crypto and space ideas are being backed. Moderna, a pharmaceutical company that produces covid-19 vaccines, was spun out of Flagship Pioneering, a vc firm. Green tech, which saw a boom and bust in the 2000s, is resurgent. pwc, a consultancy, estimates that between 2013 and 2019 climate-tech venture deals grew at five times the rate of overall startup funding.

For many old-school venture capitalists, this new competitive world is unsettling. “We need to react,” acknowledges Roelof Botha of Sequoia. Though rising valuations bolster returns on current portfolios, they dry up future returns. Crossover funds are less price-sensitive than traditional vcs. And for later-stage startups, investors’ money is more fungible, says Mr Giuffrida. It matters less who is investing than how much they are willing to pay. Furthermore, the market for orthodox vc firms is becoming tougher. Despite the venture boom, fundraising by new niche vcs in America has fallen from a peak of $14bn in 2018 to an expected $5.5bn in 2021.

One part of the traditional firms’ response is differentiation. Many crossover investors tend to take a data-driven approach, building portfolios of startups that resemble an index of top performers in each sector. They eschew playing large roles in their portfolio companies. To contrast with this, some vcs are emphasising their personal touch. Crossover funds “are transactional capital. We are relationship capital,” says one early-stage investor.

One fund in Austin, Texas, 8vc, is expanding its startup “incubator”, which currently nurtures and spins out five or so companies a year. Slow Ventures, another vc firm, is even investing directly in the career paths of individuals, such as online-content creators, who may not yet run a proper business. Without a compelling offering, says Ben Horowitz, co-founder of Andreessen, vcs either need to be willing to overpay or close up shop altogether.

Another response is to scale up. Some angel investors, who invest their own money without a team or firm, are spreading their wings and evolving into solo venture capitalists, who invest external funds. They can move fast—there are no other partners to convince before doing a deal. Elad Gil, a prominent solo vc, made around 20 investments in the first half of 2021 and is raising a $620m fund, an astonishing sum for an individual investor.

The biggest and best-known vc firms are also expanding. Andreessen has grown its investment team from about 25 to 70 in the past four years. It offers companies support on everything from diversity and inclusion policy to a vast network of potential hires and customers.

The line between vc and other investors is also blurring further, and not just because Wall Street is encroaching onto Sand Hill Road. Big vc firms are becoming more like other asset managers, too. Sequoia is expanding its presence in public markets. In October it said that its American and European venture funds will sit within a larger, timeless fund. When portfolio firms go public, their shares will flow to the superfund instead of to end-investors. This allows Sequoia to capture returns even after an ipo. Crossover funds like Tiger already seamlessly transfer holdings from their private to public funds. Other large vc firms may follow suit.

Sequoia’s superfund mirrors Wall Street’s fascination with permanent capital. “Many of the dynamics in private-equity markets are now spilling over into venture markets,” says Mr Lerner. vcs and private-equity funds used to raise money from investors every few years, which can be costly and prevent them holding on to investments. Leading buy-out firms like Blackstone and kkr found ways around this. Nearly a third of kkr’s assets under management are now permanent.

Sequoia is also becoming a registered investment adviser, joining Andreessen and other large funds, like SoftBank. That allows it to hold more “secondary” shares—stakes that are not bought directly from the issuing company. (vcs’ secondary holdings are usually capped at 20% of their portfolios.) Andreessen’s status as an adviser allowed it to launch a $2.2bn crypto fund in June that mainly invests in digital tokens, rather than startups.

The biggest funds are best placed to benefit from the new world. Funding from a top vc firm sends a signal of a startup’s quality, argues Mike Volpi of Index Ventures. And because non-traditional investors often rely on such signals to guide their dollars, their value has only risen. The result is that the industry has become more unequal: although the average American vc’s assets under management rose from $220m in 2007 to $280m in 2020, that is skewed by a few big hitters. The median, which is less influenced by such outliers, fell from $70m to $48m. But this is not to say that the industry has become dominated by a few star funds. Market shares are still small. Tiger Global, for instance, led or co-led investments worldwide worth $5bn in 2020, just 1.3% of total venture funding. Startups have diverse enough needs so there is plenty of scope for a variety of vc firms to exist, reckons Mr Volpi.

Company founders, for their part, have gained bargaining power as investors compete. “There’s never been a better time to be an entrepreneur,” says Ali Partovi of Neo, a vc firm based in San Francisco. Ten years ago, most new founders had not heard of a term-sheet, a document describing the terms and conditions of an investment, says one venture capitalist. Now, many startups work with “accelerators” like y Combinator to learn the basics. Cloud computing and other software-as-a-service (SaaS) tools allow some firms to expand without much capital investment.

The time taken to strike a deal has shrunk from several weeks to days, if not hours. Zoom has changed the nature of fundraising. Biodock, a microscopy startup, had ten calls with vcs scheduled in a day, which gave it more power in negotiations, reckons Michael Lee, its founder. Founders receive “refreshes”, top-ups of equity during fundraising rounds. To get ahead of the rush, some investors are offering companies cash even before they start looking for more funding.

The shift in power away from investors is welcome in some respects. The outsized returns of vc firms will be competed down. Moreover, tech is no longer terrain that only well-connected venture capitalists in Silicon Valley can make sense of. The performance of SaaS firms, for instance, can be assessed using data on users’ behaviour. The relationship between founder and venture capitalist might matter less than it used to, particularly as the startup grows.

But there are costs, too. Shortened deals can lead to fomo (fear of missing out) for investors and, sometimes, worse investment decisions, says Mr Partovi. The shift has also weakened governance. As the balance of power tilts away from them, vcs get fewer board seats and shares are structured so that founders retain voting power. Founders who make poor chief executives—such as Travis Kalanick, the former boss of Uber, a ride-hailing firm—can hang on for longer than they should. The relationship between vc firms and a founder lasts about ten years, longer than many marriages, notes Mr Partovi. You wouldn’t choose your spouse in a hurry.

Another risk is that the market is too frothy. Some investors point to bumper profits for tech companies and the financial health of even the youngest startups as reasons for being optimistic about valuations. But “companies are being priced on the assumption that everyone will win. Statistically that won’t happen,” says Mr Giuffrida of Horsley Bridge.

Stellar returns for investors, then, are not assured. But the broader question is whether the innovation that is taking place is worth the risk. “If too much stuff gets funded, that’s generally good. It’s much better than nobody funding Moderna,” says Mr Horowitz. And capital can drive new ideas, not just the other way around. Investors have typically been willing to bet on riskier but more innovative startups during past venture booms, finds a study by Ramana Nanda of Imperial College London and Matthew Rhodes-Kropf of mit Sloan School of Management. Resilience, a capital-intensive drugmaker founded last year, has raised $800m and already bought several factories. This would not have been possible even two years ago, says Drew Oetting of 8vc. Venture activity in the space sector grew by 70% globally to $7.7bn in 2020. “There are more moonshots,” reckons Mr Lerner of Harvard.

In tech the result could be more vibrant competition. The big-tech firms used to gobble up challengers: acquisitions by Amazon, Apple, Facebook, Google and Microsoft rose after 2000 and hit a peak of 74 in 2014. But they have fallen since, to around 60 a year in 2019 and 2020, perhaps owing to a fear of antitrust enforcement (see United States section). More startups are making it to public markets. Listings, rather than acquisitions or sales, now account for about 20% of “exits” by a startup, compared with about 5% five years ago.

Wherever valuations go, it looks like the changes to the structure of vc will last. Outsized returns in early-stage investing were bound to be bid down eventually. As vc firms themselves are forced to innovate, a broader range of ideas is being backed in a wider variety of places. The pandemic was not the disaster that venture capitalists had first expected. It has nevertheless transformed what they do. ■

(Nov 25th 2021)

The masking of intent may also be true of visitors to the temple of private equity. On the surface, investors in such funds might hope to harvest a reward—an “illiquidity premium”—for locking up their money for five to ten years. That allows private-equity funds time to turn sluggish businesses into world-beaters. The pitch is seductive. Capital has flooded in as readily as pilgrims flock to the shrine at Knock.

Perhaps, though, private equity’s pilgrims are really after something else. These institutional investors may face limitations on how much they can borrow. Private equity offers a way round such constraints: it is liberal in its use of debt to juice up returns. And that is not all. The value of privately held assets are not assessed all that often. That is a plus for those who, for ignoble reasons, would like not to be told how volatile their investments are.

This is a conclusion of a new paper from aqr Capital Management. Its authors look at the returns on private-equity purchases (“buy-outs”) of American businesses. They find that, after fees, private equity outperformed the s&p 500 index of large companies by an average of 2.3% a year between 1986 and 2017. That is quite the winning margin. But on closer examination, it looks less impressive. Buy-out targets tend to be small firms that are going cheap—that is, they have a low purchase price relative to their underlying earnings. An investor would have achieved higher returns from a basket of small-capitalisation “value” stocks than by putting his money in private equity.

The edge that private equity had over large listed stocks seems also to have dulled. In the past decade returns have been no better than the s&p 500. This may be because more capital is chasing buy-out targets. Private-equity funds once purchased businesses that were much cheaper than s&p 500 firms, says aqr. But the gap in valuations has closed.

Why are pension funds still so keen to push money into private equity? A tenet of textbook finance is that investors can build a portfolio that fits their preferences by choosing the right mix of equities, the risky asset, and cash, the risk-free asset. Nervous types might keep most of their assets in cash. At the other extreme, a risk-loving investor may wish to borrow (ie, have a negative cash holding) so that stockholdings exceed 100% of his capital. An investor with a limited ability to borrow can instead turn to private equity. Its funds take on $1-2 of debt for every $1 of equity.

The aqr authors point to another appeal. Illiquid assets, such as private-equity holdings, are not revalued in line with the price of publicly traded companies—“marked to market”—all that often. A common practice is to rely on self-appraisals. These tend not to reflect the day-to-day fluctuations in the price of listed firms. All this makes for artificially smooth returns.

Such smoothing has several advantages. When stock prices fall, the value of private-equity funds appears to fall less sharply. A mixed portfolio of public and private equity will look less volatile than a pure portfolio of listed stocks. The true riskiness of private equity would only become apparent in a prolonged bear market. Otherwise, it appears to offer diversification, albeit of a specious kind.

Some investors are forced to sell stocks (to “de-risk”) when prices fall, to comply with solvency rules. In such cases a bit of returns-smoothing is helpful, as a rigid marking to market would oblige investors to sell stocks at rock-bottom prices. That said, capital tends to flood into private equity when markets are booming. A lot of buy-outs will then be at peak prices.

The best private-equity funds are skilful investors. But the discretion they all have over how they report returns makes it hard for investors to judge who the best are. One study finds that half of funds claimed to be in the top quartile. Still, smoothed returns and leverage may be what investors are really after. Like lovelorn pilgrims to Knock, they will treat any other reward as a bonus. ■

Feb 21st 2019