Perhaps the biggest story in venture capital from 2012-2015 was the rise in late stage valuations. That was fuelled in large part by new investors coming into the private company market. Because of Sarbanes-Oxley and other factors, companies have been staying private longer and mutual fund and hedge fund investors who didn’t want to miss out on the late stage growth at companies like Uber, AirBnB, and Snapchat started investing in late stage private company rounds. Hence the growth in the number of hedge funds investing in tech startups that you can see in the chart above.
Because there aren’t that many unicorns (still) and the amount of money in hedge funds and mutual funds is 500-1000x the amount that VC funds raise every year the new entrants to venture market acted were ‘hot-money’ that distorted the market driving valuations up way past comparable public companies – as you can see in the chart below.
That’s clearly not sustainable and the catalyst for change came when auditors at Fidelity and other new entrants to the VC market started writing down the valuations of their private company holdings in late summer last year. At that point investing in unicorns suddenly became a lot less attractive. That’s what the down slope on the far right of the chart at the top of this post shows.
Mutual funds and hedge funds exiting the late stage venture market has had trickle down effects to earlier rounds driving down valuations and increasing the time it takes to get deals closed. So far that has felt like heat coming out of the market rather than a collapse, but the really interesting question is what happens next. Investment data for Q1 suggested the decline might have flattened out, but then data for April was less positive, with CBInsights suggesting that the public market woes in February might have precipitated a further contraction in the venture market.
Against this backdrop the folks at Industry Ventures, a Limited Partner that invests in VC firms, spoke with 40 mutual fund and hedge fund managers to find out what they are thinking. You can read about their findings and conclusions in detail here, but reading between the lines and factoring in what I’ve heard elsewhere my view on the situation is:
- As long as companies are staying private longer, mutual funds and hedge funds will want to invest in private companies. Otherwise they will shrink their universe of opportunities and miss out on many of the best growth opportunities.
- However, they are still learning how to invest in our sector. The dynamics are very different to IPOs or public market investing. Each deal is in effect an auction where mutual funds and hedge funds have less information and less time than they are used to, the risk-return profile is different, and there’s less liquidity. Meanwhile, auditors are increasingly forcing them to adjust valuations quarterly when private companies don’t manage themselves to deliver quarterly improvements the way public companies do. So lots to figure out.
However, this is a positive view. If I’m right then mutual and hedge funds will be back investing in private companies before too long and what we are experiencing now is a correction not a crash. The catalyst will be when public and private price/sales ratios come back into line.