Skip to Main Content

Are Venture Returns About to Cycle?

Andrea Auerbach

Yes. We do expect venture capital (VC) returns to be negatively impacted in the coming quarters but doubt that impact will be as pronounced and wholesale as it was during the dot-com era. To this day, the US VC 1999 vintage year fund cohort still reports an overall negative internal rate of return and has yet to return cost. It is true that investments completed at recent elevated valuations will likely have to perform mightily to deliver strong realized returns to investors, but today many venture-backed companies have revenue and revenue growth, a stark difference from many funded in the 1999–2000 era. Thus, the breadth and depth of this cycle may not be as severe.

To many, US VC market indicators have been flashing “red” for a while. In 2021, fundraising and investing hit all-time highs and non-VCs out-invested VC managers. Rapid capital deployment has led to accelerated fundraising timelines and, on top of that concern, many venture managers have come back like the mythological Hydra, raising two or more funds, instead of one, with separate and distinct strategies. Short-term returns have been eye popping, underscoring and supporting this historic level of interest and activity. Calendar years 2020 and 2021 are two of the top three of all time, trailing only the aforementioned 1999. Over the last five years, the asset class registered a 29.5% internal rate of return, nearly double the annualized rate over the trailing 15 years.

Rising unrealized valuations have been supporting returns. Valuation growth, however, is not a proxy for actual revenue or profitability growth. Among other elements, it also reflects available capital supply and investor interest, and there was an abundance of both in 2021. According to one public index, the revenue multiples peaked for enterprise software companies at more than double long-term averages. There was a concomitant rise in valuations for US venture investments in the Cambridge Associates Index over the last five years. At the end of 2016, US venture investments were valued at 1.8 times cost; three years later, that multiple was 2.1; and at the end of 2021, they were valued at 3.3 times, perhaps due to the above indicators and then some.

Today, a myriad of macro factors are contributing to waning support for elevated valuations in the public and private equity capital markets. It is no wonder that increased geopolitical conflicts and tensions, continued supply chain woes, rising inflation and interest rates, and economic contraction fears have led to a decrease in investor appetite for risk, which is being reflected in public market valuations. With roughly one-fifth of the market value of the Cambridge Associates’ US VC Index composed of publicly traded companies, those valuations will adjust accordingly.

Public market valuation movements typically make their way into private market valuations across subsequent quarters. The dot-com bubble may have burst valuations quickly in the public markets but ended up slowly deflating US VC vintage year performance over several years, making certain vintage years—such as 1999—essentially irreparable. Today, we expect sustained declines will most impact investments made during this peak valuation period as the underlying companies seek subsequent rounds of outside financing, as well as companies that cannot sustain the revenue or business growth required to achieve an acceptable return and need to be revalued. Even if there is an overall 50% decline in year-end 2021 US VC market values, the theoretical gross multiple on the index would be 1.6 times, well within historical levels and experienced investor expectations.

Should funding sources idle, time will tell if companies can husband their available capital and resources to pursue profitable growth. For example, a growth investment made at a 19.0 times revenue multiple would need to double expected revenue growth to achieve its modeled return if exiting at 8.0 times revenue. Companies aided by a strong management team or investors with value-add capabilities that can continue growing revenue, organically or inorganically, should be able to position themselves to ultimately exit profitably. Manager selection is about to come in handy.

Experienced investors are likely not overweight on a cost basis to investments made during peak valuation periods but rather have capital laddered across a much longer period to offset the peaks and the valleys of US VC investing.