Navigating the megafund craze

In 2017, the buzz in venture capital was over the proliferation of seed funds, that emerging plethora of several hundred seeking to back the next generation of tiny startups.

A year later, the metamorphosis came from the opposite end of the spectrum: 2018 was a year of megafunds elbowing for position against the giant $98.6 billion SoftBank’s Vision Fund.

At least nine funds of $1 billion or more were raised during a year when $50 billion of overall fundraising set an 18-year record. Sequoia Capital alone raised or is said to be raising more than $9 billion.

Rohit Kulkarni, SharesPost.

“I call them unicorn funds,” said Rohit Kulkarni, head of research at SharesPost. “The dry powder these people are sitting on is at a generational high.”

The question is what comes next. To many, the logical answer is more of the same. With a mountain of capital to deploy, venture capital in 2019 may look a great deal like it did in 2018: flooded with money and channeling large sums into highly priced late-stage rounds.

“These funds are the best and most important leading indicator of what’s to come in venture capital over the next five years,” Kulkarni noted.

What this suggests is more unicorn births, more premium valuations to the public markets and significant challenges earning venture returns in the years to follow. Swollen checkbooks might even take the edge off an economic downturn, if one were to occur, as cash props up startups facing a temporary decline in orders and growth.

Another near record year, but perhaps not for the best of reasons.

Most obvious on the list of expectations are massive financings. Last year proved such is possible. The year was one of private IPOs, with 177 rounds of $100 million or more raised through November in the United States, according to Silicon Valley Bank.

And with $91 billion invested overall through mid-December, which is also a post-2000 annual record, the momentum is there for a repeat.

That’s because freshly raised funds face a mandate to spend, and their capital is likely to be deployed through economic thick and thin, with investors seeking growth-company-like value creation and hoping for bigger hits down the road.

VC Seed Investor
Jeff Clavier, founder and managing partner, Uncork Capital. Photo by Eric Millette for Uncork Capital.

“We’re seeing a crazy amount of capital being invested across the board,” acknowledged Jeff Clavier, a managing partner at Uncork Capital. “Large rounds are taking over.”

One consequence of this spending is likely to be greater capital concentration, as a generation of “haves” become armed with enough cash to dispense a growing number of “have-nots.” Evidence for this showed up in 2018, when the median company that raised a round of $100 million or more had previously raised an already substantial $128 million, according to SVB.

The new norm of big rounds targeting a smaller number of companies suggests a return to the “old world” is unlikely, concurred Nick Sturiale, a managing partner at Ignition Partners. “This will be the way it is for the foreseeable future.”

Another possibility for 2019 is more extended valuations. Over the past three years, private growth company valuations have more than doubled as investors displayed unrelenting support for companies that performed. The SharesPost Private Growth Index, made up of private companies having raised substantial capital, rose about 149 percent over the period through mid-2018.

Last year alone, the median pre-money valuation in late-stage deals jumped by 51 percent and in early-stage deals climbed 28 percent, according to PitchBook data through the third quarter.

With the amount of capital available, it is hard to imagine valuations that don’t rise in step with round size.

“Certainly valuations are high and driven in part by the abundance of capital,” said Bob Blee, head of corporate finance at SVB. “And yet there are more strong, scaled companies that warrant this kind of investment than we’ve ever seen.”

Still, valuations might be tested in a way 2018 never did. The test bed will be the IPO market. In 2018, IPOs for young companies revived, with 66 venture-backed deals in the first nine months and proceeds of $10.4 billion, according to Renaissance Capital. About two-thirds of the total were technology and biotech deals.

The window that opened up in the first three-quarters of the year led numerous new companies to draft plans for 2019. Included on the list of known and expected filers for the new year are high-profile unicorns Lyft, Uber, Palantir, Pinterest, Airbnb and Slack. Their success, or lack of it, could offer a telling moment on the sustainability of venture valuations.

A less obvious outgrowth of 2019’s abundant capital could well be a permanent expansion of the investment ecosystem. Venture has already seen investing spread beyond the coastal hubs of Silicon Valley, New York and Massachusetts to second-tier regions and states, such as the Midwest and Colorado, and to lesser know localities, including Atlanta.

More of this should take place as the nation’s talent pool broadens and investors with money in their pockets seek the leverage of low-cost environments. This might be accelerated by an ongoing shift down market, as growth and other later investors flee high valuations and shift to earlier rounds. Proprietary deal flow may require casting a broader net.

What’s also possible is the present wave of innovation may lift invested capital to a new plateau as technologies, such as artificial intelligence and big data, continue to spread to new areas of the economy, such as agriculture and space. Over the past five years, the average amount of capital invested annually has grown to $70 billion, 50 percent more than what was invested in 2007. The innovation economy may have permanently expanded to absorb this influx of capital as part of an investment cycle that may last for a decade or longer.

And yet, there are good reasons to be cautious. An international trade war appears to be heating up, and economic good times could be challenged.

Nick Sturiale, managing partner, Ignition Partners. Photo courtesy of the firm.

“My gut instinct is we’re at the end of a cycle,” Sturiale said, singling out the concentration of investment dollars.

Whether that means 2019 will be the top is hard to know. But what’s clear is that earning venture returns on the wealth of capital now in the system will be no easy task.

The challenge facing the age of megafunds is exactly this, said Paul Madera, a managing director at Meritech Capital Partners. From a historic venture returns perspective, “I don’t believe it can handle the amount of capital being raised.”

This year isn’t likely to resolve the dilemma.

To access additional data in PDF form, click on the links below:

Later-stage valuations spike

Mega rounds spike to half of investments

Unicorn count grows

Venture fundraising hits 18-year record

Venture investing near two-decade peak