Given the obvious anxiety and frustration that surrounds us all, the U.S. venture industry is also exhibiting some fatigue as we finish the 88th month since the last recession.
This is the fourth-longest period of economic growth in U.S. history (admittedly, at 2.1 percent, the growth over this period of time is the slowest since World War II). According to the National Venture Capital Association and PitchBook, this past quarter $15 billion was invested in 1,810 deals, which compares unfavorably to both the prior quarter ($22.1 billion, 2,034 deals) and the third quarter of 2015 ($21.1 billion, 2,559 deals), signaling perhaps a period of digestion given how much had been invested during the 2014-2015 window. Notably, this was the lowest quarterly deal volume since the fourth quarter of 2011, a period spanning 19 quarters.
What is most interesting is the activity beneath the headline data. Year-to-date annualized investment activity suggests that 2016 will see approximately $74 billion invested in just under 8,000 companies, which would still make it the second-most active year in the past decade, although with a marked deceleration.
The amount invested is consistent with what was deployed in each of the last few years, but the median round size across each stage of financing has increased significantly as the level of deal activity has declined. For instance, early-stage round sizes are tracking to be nearly $5.5 million this year versus $3 million in 2013. Just in the past six quarters, seed-stage investing activity has declined dramatically: in the second quarter of 2015, there were 1,547 seed deals, compared with 898 this past quarter. As a percentage of overall activity, seed investing dropped from 55 percent in the third quarter of 2015 to 50 percent in this year’s third quarter.
The direct implication of larger round sizes is to provide companies with greater runway, but this flies in the face of the capital efficiency mantra, something venture capitalists shouted from mountaintops when we were in a more challenging fundraising environment. In the early-stage category, nearly 54 percent of deals in 2016 were greater than $5 million in size, which compares to 32 percent of investments right on the heels of the Great Recession in 2010. Have investors drifted, becoming less dogmatic about hitting interim milestones with as little capital as possible?
One of the emerging storylines in the back half of 2016 is the pullback of late-stage “unicorn” financings: only eight new “unicorns” were created this past quarter. During the quarter, the top-10 largest venture financings in aggregate raised $2.1 billion, which represented 14 percent of overall activity. In the prior quarter that number was 40 percent.
The largest round in the third quarter was $474 million, raised by Boston-based biotech company Moderna Therapeutics. Notably only three of the top-10 companies were software companies, which over the past few years has been the category that represented so many of the “unicorns.”
In general, investment activity is bolstered by investor confidence that a predictable exit environment will continue. In the third quarter there were 162 venture-backed exits, which generated $14.6 billion of value, coincidentally an amount just below how much was invested that quarter. The top five M&A transactions accounted for just about 50 percent of that value.
Notwithstanding the underwhelming IPO market—year-to-date there have only been 32 IPOs, with average proceeds of $67 million—the annualized exit activity suggests that there will be in excess of $50 billion of exit value created. The greatest level of exit activity over the past decade was in 2014, with nearly $82 billion of activity; the annual average for the last 10 years is $39 billion.
Liquidity feeds right into the fundraising conditions for venture fund managers. This past quarter there were 56 new funds that raised $9 billion, for an average fund size of $161 million. This is significantly greater than the $77 million average fund size in the third quarter last year. This fundraising pace is somewhat less than the prior three quarters but meaningfully ahead of the third quarter in 2015, which saw only $4.1 billion raised by venture capitalists.
Interestingly, the top-10 funds closed on $6.1 billion, or 68 percent of all capital raised, indicating a further concentration of investment managers. In the prior quarter, 62 percent was raised by the top-10 funds. Just over 40 percent of funds raised this past quarter were less than $50 million in size.
The projected $43.2 billion raised in 2016 is on pace to be the strongest year since the early 2000s. Notwithstanding this robust pace, the “funding gap” persists (see above), strongly suggesting that non-VCs continue to invest aggressively in startups. According to the recent Preqin Quarterly Update (third quarter 2016), in a survey of active institutional investors in private equity, 71 percent expressed a “positive” perception of the asset class, while 56 percent expected to increase their allocations to private equity (and of those, 59 percent planned to do so before year-end).
So where does that leave us as we enter the final quarter of 2016? The elephant (and donkey) in the room is the U.S. elections, clearly.
Interestingly, this past quarter the European venture capital investment pace fell by 32 percent in the wake of Brexit and was 39 percent lower than the same period in 2015, according to Dow Jones VentureSource. Isolating just the United Kingdom, the news is even more disturbing: U.K. venture firms invested only $58 million in the third quarter, versus $282 million in the previous quarter and $656 million in the third quarter of 2015.
That is what running into a wall looks like—a huuuge wall.
As complicated as the world now appears, the financing of innovation remains attractive and compelling, drawing in both investors and great entrepreneurs, hopefully making many of these issues background noise.
[Editor’s note: A longer version of this post originally appeared on Greeley’s blog, “On the Flying Bridge.”]
