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2021: Looking back at the venture capital industry
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. 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.
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.
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, 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. 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.
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, 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. 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.
Read More at https://blog.iimb.ac.in/2021-looking-back-venture-capital-industry/