Will Venture Capital Repeat the Post-TMT Bubble Experience?
Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
We do not expect a rerun of the 2000s for tech and venture capital. The similarities between the late 1990s and today are concerning, but the differences are even more sweeping. Today’s era of tech dominance may well end differently (and less painfully) than the last one.
Over the last decade, the information technology sector grew to be the largest in the MSCI All Country World Index (ACWI).As of December 3, 2018, MSCI implemented changes to Global Industry Classification Standard (GICS) definitions in its indexes. The index providers have made these changes to broaden the definition of communications to include anything that sells and/or distributes information, data, and content to reflect the evolution of the sector. As a result, a portion of the information technology and consumer discretionary sectors was reclassified as communication services. Based on this new GICS construction, financials is the largest sector in the MSCI ACWI, followed by information technology. 1 As in the 1990s, investor interest in the sector is high. Venture capital (VC) firms are raising larger funds, and fundraising cycles have compressed. The number of founders starting companies, new VC firms being formed, crossover investment activity, corporate venture capital, and new LP interest have increased significantly. VC valuations have reached new highs (notably at the growth stage/large-cap end of the market); and expectations are lofty, with “dot-com” mania replaced by all things artificial intelligence (AI).
Despite these similarities, there are critical differences. The VC industry has matured, and technology has become more integrated into the global economy. Unlike the 1990s, today’s public technology firms generate significant profits in diverse businesses across many economic sectors, while private tech companies are generating significant revenues.
Access to technology has increased at a staggering pace. Over the past two decades, the percentage of the world’s population with internet access has exploded from 4% to 55%. The widespread availability of mobile devices and cloud computing have allowed large technology-enabled businesses to disrupt traditional industries, such as transportation, hospitality, financial services, and media and entertainment. Companies like Uber, Airbnb, and Spotify have only been around for the last decade or so, but have shifted consumer behavior considerably. At the same time, healthcare is transforming in this information age, stemming in part from a maturing biotech industry.
Valuations for public tech shares today are more rational than in the 1990s: valuation multiples are lower and stronger business models drive higher profitability. Though today’s high profitability supports valuations while it lasts, this raises questions about eventual mean reversion. Given the high operating leverage that many tech companies experienced as sales increased (e.g., Amazon, Alphabet, and Netflix), will the eventual revenue and profitability downturn for these companies be accentuated during the next recession? Large tech companies have offset some cyclicality by taking market share from legacy competitors, which can persist for a while, but not indefinitely.
The technology landscape has also become increasingly complex. Different countries have divergent views on data privacy, security, and regulation—both in tech and in the life science industry. To date, Facebook has borne the brunt of many of these concerns, while Europe has led the charge on consumer data privacy rights. China has made remarkable strides in AI technology, aided by its access to data and heavy governmental involvement. However, it is unclear how its technological capabilities will progress amid potential supply chain disruptions and limitations on technology transfer. Complexity presents investment opportunities, but also highlights the regulatory and geopolitical risks investors need to consider.
On balance, while we do not expect a repeat of the post-TMT bubble experience, we regard the tech sector as vulnerable in the next bear market. Further, we suspect that market leadership will rotate from the tech sector to other sectors in the next expansionary cycle. With regard to venture capital, the flood of capital available and stiff competition in the market will likely compress returns on average. However, we still see investment opportunities, particularly in some less trafficked segments. In the United States, we favor smaller funds focused on early-stage investments, opportunities outside the Bay Area, and healthcare. We also like opportunities tied to the convergence of tech and impact investing, such as improving access to healthcare, financial products, education, and workforce development. Tech is increasingly enabling the economic viability of business models that address these social issues. Chinese venture capital remains a relatively young market with considerable uncertainty, but a large addressable market that offers significant upside in both tech and healthcare. The tech markets in Europe and Latin America are both relatively small, but worth investors’ attention. Despite some challenges, don’t count venture capital out as an important driver of future returns.
Celia Dallas, Cambridge Associates’ Chief Investment Strategist
Theresa Sorrentino Hajer, Co-Head of Venture Capital Research
- As of December 3, 2018, MSCI implemented changes to Global Industry Classification Standard (GICS) definitions in its indexes. The index providers have made these changes to broaden the definition of communications to include anything that sells and/or distributes information, data, and content to reflect the evolution of the sector. As a result, a portion of the information technology and consumer discretionary sectors was reclassified as communication services. Based on this new GICS construction, financials is the largest sector in the MSCI ACWI, followed by information technology.