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Venture Capital Trends

February 1, 2014

Back to basics, by Bryan Pearce and Dr. Martin Haemmig



Bryan Pearce
Americas Venture Capital 
Advisory Group Leader


Dr. Martin Haemmig
Senior Advisor on 
Venture Capital to 
Stanford University – SPRIE;
Adj. Professor at 
CeTIM, Munich

As the world begins to emerge from recession, the venture capital industry finds itself in a period of significant change.

Even as the basic metrics of deals and dollars invested improve and the exit environment brightens, the venture capital industry is consolidating, with the number of active investors declining annually and limited partners (LPs) taking a hard look at the track records and prospects of firms seeking to raise new funds.

Given the lengthy time and substantial amount of capital required to bring a company to exit since 2000, many VC firms are hard-pressed to show the level of returns that will inspire LPs to re-invest as these firms wind down funds raised between 1999 and 2001.

What do these trends mean for the global venture capital industry? Each of our chapters explores this question:

·        VC perspectives from the US

·        The future of venture capital

·        VC perspectives from Europe

·        What makes a country attractive to VC investors?

·        VC perspectives from China

·        Global corporate investor roundtable

·        Cleantech focus

Leading venture investors around the globe — some interviewed in this report — foresee an industry with fewer players investing smaller amounts in companies that will reach profitability faster.

Long­time industry players look to the industry of the early to mid-1990s — when company capital efficiency and fast revenue growth drove industry returns — as a model for the future.

Certain players in the venture industry will feel the pain of consolidation in this back­to-basics scenario, and it comes with some risk — several venture investors are expressing concern that the VC investor base, especially in Europe and Israel, could fall below critical mass. However, it appears that consolidation may be the best solution for putting the VC industry on stronger footing.

Recovering global VC investment

Global venture investment has recovered substantially since the first quarter of 2009, when venture-backed companies received only US$6.8 billion — one of the lowest levels in a decade — in the aftermath of the financial crisis. In contrast to those difficult times, global investment in 2Q 2010 reached US$10.6 billion, an improvement of nearly 56%.

As of 1H 2010, global investment was US$17.8 billion, ahead of the US$32.2 billion invested in 2009. Still, annual investment in 2010 is likely to be less than it was in 2006, reminding us that we are still in a period of recovery.

Recovery in venture investing has not been evenly distributed around the globe, however. Compared with 1H 2009, venture investment in the US in 1H 2010 grew 19% to US$12.4 billion. Due to its large venture market, the US was the primary engine of expansion, accounting for 56% of this growth.

Other geographies with smaller markets experienced faster recovery during 1H 2010 — notably, India, which saw VC investment grow 146%,Israel, whose investment grew 81% and China, where investment grew 51%.

In contrast, European investment in 1H 2010 grew more slowly than in the US, increasing just 17% to US$2.6 billion. Canada’s US$313.5 million investment in 1H 2010 represented the smallest rebound, an 11% gain.

Cleantech gains

Investment in cleantech has become one of the major drivers of overall venture investment. Cleantech’s share of global venture investment rose from 2% in 2003 to 15% in 2009. The US$3.0 billion invested in cleantech companies globally in 1H 2010 represents 17% of total VC investment in this period.

While capital-intensive cleantech verticals such as solar and biofuels continue to receive the bulk of investment dollars, there has been a clear shift toward energy-efficiency deals.

Energy efficiency, which encompasses technologies such as smart grid and energy management, is largely IT-enabled, allowing for VC firms to draw on their experience in software and communications.

Investments in this space also require less capital to bring to market and face fewer regulatory hurdles than renewable energy deals, while offering corporate customers more immediate return on investment.

Signs of life for venture-backed exits

As capital markets tightened in the wake of the financial crisis and venture-backed companies struggled to gain customer traction as a result of spending restrictions, the number of venture-backed IPOs dwindled in the mature venture markets.

Only eight venture-backed IPOs occurred in the US in 2009, raising US$903.6 million. Just three such transactions took place in Europe during this time, raising US$160.4 million.

There were no IPOs by VC-backed companies headquartered in Israel. In contrast, Chinese venture-backed companies completed 44 IPOs, raising US$4.5 billion — the result of continuing robust economic growth and a venture industry focused on investments in larger, later-stage companies.

Through 1H 2010, VC-backed IPO activity had already outpaced all of 2009, led by China, with 56 transactions, raising US$10.0 billion. In the US, US$1.6 billion was raised in 23 transactions, while in Europe, seven transactions raised US$90.6 million. Two Israel-headquartered companies raised US$42.4 million.

Although VC-backed activity increased, the median time from initial VC financing to an IPO exit remains long. In the US, the median time to IPO exit in 1H 2010 reached 9.4 years, the longest span on record. In Europe, the same process took 6years. However, the median time to IPO exit in China — just 2.6 years — stands in sharp contrast to the US and Europe as the later-stage investments in China took less time to reach an exit.

Shorter path to venture-backed M&A

The pace of venture-backed merger and acquisition activity through 1H 2010 was on track to meet or modestly exceed 2009 levels. With 182 M&A transactions through 1H 2010, the US is on a pace to surpass the 357 deals in 2009 by 2%.

Similarly, Europe’s 81 M&A transactions in 1H 2010 put it ahead of the 141 M&A transactions in 2009 by 15%. Israel, India and Canada all saw significant increases in M&A activity as well, albeit based on a small number of transactions. Only China, with just four venture-backed M&A transactions in 1H 2010 compared with 10 in 2009, is lagging last year’s pace.

In terms of valuations, US median M&A valuations went from US$27.5 million in 2009 to US$50 million in 1H 2010, with the median time from initial VC financing to exit holding at 5.3 years. In Europe, median M&A valuations declined slightly, from US$20.0 million in 2009 to US$19.0 million in 1H 2010.

The European median time to M&A exit also declined slightly in this period, going from 5.9 years to 5.3 years. These time-to-exit figures reinforce a positive trend of M&A transactions coming significantly faster than IPOs.

Global quarterly venture capital investment by geography
Total investment (US$b)


Source: Dow Jones VentureSource

Challenging fundraising environment

VC fundraising was challenging in 2009. In the US, only 134 funds were closed, raising US$13.5 billion — an average of US$101.0 million per fund. Contrast this with the 218 funds raising US$39.8 billion, an average of US$182.6 million, in 2007.

Through the first half of 2010, US fundraising showed improvement, with US investors closing on 76 funds totaling US$8.3 billion, on track to exceed 2009, yet only comparable to fundraising levels last seen in 2004.

The reasons for this decline include:

1.       Realized returns for the past few years have not lived up to the “glory days” of venture, when many LPs were initially attracted to invest in the venture capital asset class

2.       Many LPs still have an over-allocation to venture capital because of the decline in market value of their public and other alternative asset portfolios as a result of the financial crisis

3.       A concern over the number of VC firms relative to the perceived number of quality

Europe was similarly hard hit, going from a peak of 121 funds closed in 2007, raising US$9.6 billion at an average of US$79.3 million each, to 55 funds raising US$5.0 billion in 2009, an average of US$91.0 million.

In contrast to the US, European fundraising through 1H 2010 lags even the 2009 figures, with only 22 funds closed totaling US$1.7 billion.

http://www.ey.com/Media/vwLUExtFile/global_venture_capital_insights_and_trends_report/$FILE/icon-graphic-verti.jpg US and Europe VC fund-raising

http://www.ey.com/Media/vwLUExtFile/global_venture_capital_insights_and_trends_report/$FILE/icon-graphic-verti.jpg Number of active investors

http://www.ey.com/Media/vwLUExtFile/global_venture_capital_insights_and_trends_report/$FILE/icon-graphic-verti.jpg Number of active investors in Chinese and Indian companies

The number of firms investing in health care companies has not declined as sharply as overall, likely because the specialized knowledge required for investing in this industry creates a barrier to entry in the first place, limiting the surge in new entrants seen in other sectors. Also the number of firms making investments in cleantech companies has grown substantially since 2005.

Similarly, the number of firms investing in the consumer services sector — home to capital-efficient web-enabled companies — has grown in recent years. (See figure “Number of active investors in cleantech companies,” below.)

Survey: limited partners look for change

We recently completed a survey of 42 US-based LPs on investing in the VC asset class in the US. The majority of these LPs were endowments or pension funds that had been in operation for at least 30 years.

While they are focused on the US venture industry, their responses to key questions illustrate the challenges facing the global venture industry today, particularly in the mature markets.

Lack of satisfaction with venture returns

Queried on their satisfaction with VC fund investments, only 41% reported being somewhat satisfied or very satisfied. Nearly half of respondents (47%) are either “somewhat unsatisfied” or “not satisfied at all” with their VC firm investments. (See figure “Limited partner satisfaction with venture returns,” below.)

Focus on performance, carry and fee structure

In this context of dissatisfaction with overall venture returns, LPs are concerned about VC fund performance and fund manager compensation:

·        79% said that VC funds must yield 5% above comparable public benchmarks

·        90% said they would like changes to the industry carry structure

·        89% said they wanted changes to the management fee structures

LP outlook indicates need for change

A question on their outlook for venture capital yielded responses suggesting that LPs are looking for fundamental change in the venture industry:

·        89% said the venture industry returns will not improve until the size and/or number of VC funds is reduced

·        Respondents were evenly split on whether this period is merely a cyclical downturn for an otherwise robust asset class: 37% disagreed; 24% were unsure and 35% agreed. (See figure “LP outlook on venture industry,” below.)

Smaller is better

Quizzed on their views regarding the optimal size for a VC fund, the majority of respondents (54%) believed a VC fund should be less than US$300 million, with another 41% saying US$300 million to US$500 million was optimal.

Few respondents thought that funds greater than US$500 million were optimal, and no respondents felt that a VC fund larger than US$1 billion was appropriate.

Most will not “re-up” with their current portfolio

The real test of LP confidence is whether they will invest again, or “re-up,” with the VC firms currently in their portfolios. Many VC firms will face significant challenges in raising their next funds, as 60% of LPs indicated they were likely to re-up with fewer than half of the VC firms in their current portfolios.

http://www.ey.com/Media/vwLUExtFile/global_venture_capital_insights_and_trends_report/$FILE/icon-graphic-verti.jpg Number of active investors in cleantech companies

A new opportunity for corporate investors

The reduction in the number of traditional VC firms presents new opportunities for corporate venturing units.

Many large corporations are increasingly of the view that sourcing the best innovation from outside sources is the key to developing a competitive advantage. Procter & Gamble, for example, has a goal of obtaining 50% of its innovation from outside the company.

For both established and new corporate venturing units, a smaller venture capital universe means less competition from traditional VC firms for the best deals, more opportunities to join deal syndicates and greater ease of establishing relationships with VC firms.

In these challenging economic times, the strategic value brought by corporate venturing units — access to markets and distribution channels, reference customers and technical assistance — becomes even more attractive.

Limited partner (LP) satisfaction with venture returns


Numbers may not total 100% due to rounding
Source: EY 2010 LP Sentiment survey

http://www.ey.com/Media/vwLUExtFile/global_venture_capital_insights_and_trends_report/$FILE/icon-graphic-verti.jpg LP outlook on venture industry

LP expectations for reinvesting with current VC managers


Numbers may not total 100% due to rounding
Source: EY 2010 LP Sentiment survey

Conclusions and outlook

The global venture industry is undergoing a period of significant transition — call it “rightsizing” — in which the number of industry players is shrinking due to poor returns in the post-internet-bubble period and the resulting increased selectivity of LPs.

In reality, this transition has been underway in slow motion for a decade, but the arrival of the global downturn combined with the end of the 10-year term of VC funds raised in 2000 has accelerated the process.

For those VC firms that have placed good bets and earned respectable returns, LP funding will continue to be available. For entrepreneurs with new, promising ideas, VC funding will continue to be available. However, for more marginal funds, times will continue to be very challenging, and many may need to seek new opportunities outside the VC industry.

Overall, we believe that the venture capital model is not fundamentally broken — it continues to be an essential source of funding and a catalyst for the innovation, entrepreneurship, job creation and economic growth needed to lead the world economy into recovery.