The emergence of venture capital “mega funds,” fueling fast-growing but often unprofitable startups in the private market, has dramatically altered the entire venture capital ecosystem. This according to Elizabeth Traxler, Managing Director of investment manager Neuberger Berman’s private equity practice.
Speaking at a presentation in New York on the investment firm’s outlook for 2020, Traxler said the late-stage environment for venture capital has changed significantly in the past 10 years, primarily driven by “new, non-traditional entrants” into the asset class.
Traxler said the first newcomers to VC were mutual funds looking to secure allocations to companies prior to going public. These were later joined by hedge funds seeking similar exposure. But the most recent market entrants (such as SoftBank’s well known $100 billion Vision Fund) are those chiefly distinguished by their very large pools of capital.
Venture capital data for the third quarter of 2019 from Preqin found that nearly half of all VC funds closed this year to date were sized $100 million or more, up from around 30% in 2014, while 9.3% of all funds were sized $500 million or above, up from 5.2% in 2017).
These “mega-funds” have typically focused on funding innovative, often disruptive business models that are already on very aggressive growth trajectories, and where a large investment could propel even faster growth. Their super-sized, late-stage investments create what Traxler termed a “vicious cycle” in which the pursuit of growth generates a very high rate of cash burn on the part of the target company.
The impact hasn’t just been felt on companies, but on the entire venture capital landscape. Traxler said the new approach of the recent mega-funds stands in stark contrast to that of traditional venture capital funds, which have historically been comfortable investing in high-growth, unprofitable companies, but have tended to do so using smaller capital pools. In the past, she explained, this enabled VCs to invest at a more measured pace and to minimize the dilution of their investments in a single funding round.
A divergence between public and private market valuations has also emerged.
”Public shareholders value things differently—and often include the importance of an eventual path to profitability,” Traxler said.
Companies are also staying private longer. While in 1999 the median age of a VC company going public was four years, she noted that by 2018 the median age had tripled to 12.
In response, she said some traditional late-stage VC’s had opted to retrench by tilting to earlier stage investing, while others were simply raising larger funds.
Private equity outlook
On a more sanguine note, Traxler said traditional private equity may be an attractive allocation for investors seeing higher likelihood of a market correction in 2020. She said that the longer holding periods (often four to five years) for private equity investments helped diversify valuation risk away from more volatile, one- to two-year market periods.
She also cited private equity’s unique discretion in exit timing, which allows the PE group to sell a portfolio company at the time when the company is most ready and when the market is most receptive to a sale, enabling PE groups to maximize returns.