Is VC Experiencing a Bubble?

Practical Summary:

• US VC fundraising is set to exceed $100B this year, which would be a record.
• In fact, US VC is actually about the same size as it was in 2015 or 2008 when compared to overall capitalization of the US stock market … and substantially smaller than in 2001.
• Record exits for US VC-backed listings and M&A over the past 12 months mean that “net inflows into US VCs” will likely be lower in 2020 and 2021 than they were in 2015-2019 in absolute dollars.
• The venture asset class has a lot of growth ahead of it, especially when it can solve some of the major problems holding capital back – liquidity, transparency.

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If you follow the venture capital industry, you have probably seen headlines stating that the amount of capital invested into tech startups will hit a new record this year. The general tenor of these stories is that US VC fundraising set a new high-water mark in 2020, and after nine months in 2021, US VC is about to eclipse that record again, closing in the $100B mark, with a few months left in the year. 

The stories then go on to talk about some of the drivers of this growth … huge new funds (e.g., Tiger’s new $6.6B fund), many more “mega deals” of $100M or more (Pitchbook counts 597 of them this year), inflows from non-traditional new investors (e.g., hedge funds, corporate VCs, PE funds, and sovereign wealth funds, who presumably don’t know what they’re doing), or huge new valuations.

Eye-popping new fund sizes … bigger than ever!

Soaring valuations.

Clever analogies to tourists driving up prices at popular hotels and resorts. 

It all sounds like we are in a bubble that’s about to pop.

Figures 1 and 2 below show some of these trends in recent years that – when stated out of context like this – suggest that US VC must be headed for a reset.

Figure 1. VCs Close in on $100B of New Capital (Source: PitchBook)

Figure 2. Valuations for US Startups (Source: PitchBook)

Is US VC a Bubble That’s About to Pop?

But before concluding that US VC is in a bubble, we should question why all of these popular headlines and charts seem to express the industry in nominal dollars … that is, without adjusting for inflation … or present these US VC inflows in the context of the size of the overall financial markets. 

Right?

I mean, what if I told you that the New York Yankees payroll last year was “a record” $200M in 2021, after an “eye-popping” $195M in 2020? And that the entire 25-man payroll of the famous Murderer’s Row team from 1927 “made only” $250,000?

Would you conclude that we are in an unsustainable bubble for player salaries that will eventually burst?

Of course not. You would at least adjust these payroll numbers for the cost of living – after all, an apartment in NYC back then cost less than $100 a month, so players then got a lot more bang for their buck. You might also consider their compensation relative to other professions, mindful that on a relative basis, Babe Ruth made more than President Herbert Hoover did in 1930. And why not? For as he told reporters, he had a better year.

You might also allow for the effects of free agency, television, larger audiences, the expanded season, and competitive pressures caused by basketball, motorsports, and the other opportunities available to elite athletes.

Where Is US VC, Adjusted for Stock Market Capitalization?

So let’s compare the total amount invested by US venture capital companies annually to the total market capitalization of all US publicly listed companies. The NYSE and NASDAQ, after all, are the ocean into which the VC river exits.

In 2021, based on my projected numbers, US VC investment will be approximately 0.31% of the market cap of all US-listed companies. That’s about what it was back in 2015, and also exactly where it was when the public markets bottomed in the first quarter of 2009.

Between 1999 and 2001, the US ratio of VC investment to market cap stood at over 0.4% and peaked at double today’s level. This year, the ratio of VC to market cap stands at 0.31%.

Figure 3 below shows the relative level of VC fundraising compared to the market capitalization of all US-listed companies. You can see that VC activity over the last few years appears elevated versus prior years, but 2021 certainly doesn’t look like a “bubble” in the sense of an unprecedented or dangerous peak to me.

Figure 3. US VC Investment, Adjusted for US-listed Company Market Cap (Sources: Siblis Research; Statista)

Impact of Exits: Net Inflows

One other factor to consider about the amount of VC fundraising and whether or not it’s sustainable is net inflow. Remember, cash flows from LPs are a two-way street: LPs giveth and LPs also taketh away. While LPs have indeed been providing record amounts of capital to venture funds over the past 15 months, VC exits (and eventual distributions back to those LPs ) have been keeping pace recently. 

That means that net inflows into VCs – the amount of money raised from LPs, less the distributions back to them – is a lot lower than the headline numbers from FIgure 1 suggests.

FIgure 4 below shows that exit values for VC-backed public listings in the US have never been higher. In 2020, overall exits were a record $289B per Pitchbook. IPOs were the bulk of that, with some of the largest ever recorded. For instance, Airbnb, DoorDash, Palantir, Unity Technologies, GoodRx, Zoominfo and Snowflake each generated over $1B for their VC backers. In 2020, 480 companies went public, a 106% increase from 2019.

While 2020 was a huge record year for exits, 2021 so far has absolutely dwarfed it. Nine months into 2021, that record has already been obliterated with $580B in exits so far. There has been an additional slew of IPOs this year: Coinbase, Bumble, Freshworks, Affirm, Roblox, Applovin, UIPath, Coupang, Marqeta, etc. Huge acquisitions such as Credit Karma, Paidy, MailChimp, AfterPay, and Yahoo have all returned additional capital to VC LPs. 

The result is that net inflows in 2020/2021 into VC may well end up being lower than in the 2015-2019 period. 

FIgure 4. Exit Value for US VC-backed Companies (Source: PitchBook)

Conclusion

The US VC industry, like other alternative asset classes, has been carried along by a lot of tailwinds. Robust US stock markets and exit valuations have increased returns, which make the asset class attractive, and that’s led to two years in a row of record fundraising, in nominal dollars. 

There may also be a down cycle coming, where inflation, tighter monetary policy, and changes in fiscal policy turn those tailwinds into headwinds. 

However, if you understand the US VC inflows as you should – relative to the size of the US economy – then this industry hasn’t really grown since 1999, despite years of outperforming public indexes and generating alpha. At PVC, we think that the industry is still in the early innings of a multi-year expansion, and that there are many years of strong growth ahead if we can solve some of the major drawbacks to being an LP: a lack of liquidity in LP interests and relatively low transparency on valuations and financial information on the part of venture-backed companies.