Venture capital is having its day in the sun. Cast your minds back to March 2020: investors were rightly concerned that fund managers would call capital en masse to support portfolio companies and exit markets would be closed for business. That never came to pass. Instead, surplus flows back to LPs across the private capital spectrum totaled $38.6bn over the first nine months of last year. And the stars of the show were VCs.
The quarterly performance of venture capital reached a decade high of 12.4% in Q3 2020, Pitchbook data show. PE had a similarly purple patch, returning a record 13.3% in the same quarter.
But VC is now comfortably lord of the private manor. Preliminary figures for Q4 last year show venture fund IRRs close to doubling those of buyout funds (11.5% vs. 6.4%). Across one and three-year time horizons VC, again, comfortably comes out on top (see chart below).
This renaissance was only made possible by the sudden reversal in risk appetites that came after last year’s brief stock market collapse. In the end, 2020 turned out to be one for the record books, with 20 billion-dollar IPOs in the US, more than ever before. The two dominant themes of both the pandemic and recent IPO activity, technology and health, have played to venture’s strengths.
Last year saw the float of Snowflake at a valuation of $33.2bn, the largest software IPO of all time, as well as other notable names like Palantir and Airbnb. LPs in the VC funds behind the roster of names that have been riding exuberant stock markets have been handsomely rewarded.
Maintaining momentumWhat does this mean for investors going forward? Can venture maintain its recent momentum? The first thing to consider is that, with VC funds distributing heavily back to investors, LPs will be taking a close look at their private capital allocations. It should be expected that investors are underweight on venture strategies if they have not already been committing new capital. But the decision to channel more money into venture will depend on whether it is expected to deliver.
There is some evidence to suggest that it may struggle in the short term. Sentiment has flipped in recent weeks, with a rotation out of bubbly growth stocks into unloved value picks. The thinking is that with vaccine rollouts progressing and economies gearing back up, these undervalued assets will see big earnings gains. And because they have been out of vogue, investors have picked these up at discounts.
The potential for central bank stimulus and the recovery to deliver higher inflation and interest rates has also been motivating this behavior. Growth stocks are valued on tomorrow’s expected profits and so are especially sensitive to higher rates, which reduce the value of future cash flows.
Tech IPOs in 2021 may therefore lose some steam. This could mean that VC returns cool off for a period, potentially giving way to private equity, which is less sensitive to the vagaries of the IPO window.
However, even if distributions pull back, that really shouldn’t matter to LPs committing capital today. As you’re reading this, VC managers are finding the bold ideas, software platforms and drugs that will be in demand in years to come—whatever the weather in IPO markets.