Venture's 'cauldron of change'

This is a draft of a speech I'll be making at the www.GCVDigitalForum.com on 27 January - feedback much appreciated in comments or email [email protected] and here's the TL;DR:

• Capital is abundant causing returns to be driven by innovation
• This is threatened by geopolitics and conformism
• Intention required to solve challenges of energy, health and ICT

Albert Wenger, managing partner at Union Square Ventures, has been writing a book called World After Capital for six years. In an interview with Climate Tech VC, he said: “The book argues that we are 20 years past the Industrial Age because society is no longer held back by a scarcity of capital.”

It is a smart premise and a core hypothesis why Mawsonia, the publishing company behind Global Corporate Venturing, Global Impact Venturing and Global University Venturing, was set up a decade ago coming out of the global financial crisis.

Abundant innovation capital

In a world where of effectively money is a fungible commodity, outperformance comes from understanding the drivers behind equity growth – human and physical capital and innovation and intangibles – and then being able to use this alpha to borrow more at more favourable terms to leverage returns even higher.

In a perfectly competitive market of course, competition should reduce economic profit to zero as people are trained up (the US’s 20th century economic advantage arguably lay as much in the training provided by its business schools to company managers as in the size of global market it shaped after the Second World War through the Bretton Woods and other global tools and structures), replicated through bringing on more resources and the innovation or intangible assets are copied.

As Jerry Neumann said in his blog, the Reaction Wheel: “The sum of the excess profit from innovation through [to] perfect competition I call excess value. 

“Companies can lengthen the time between introduction of an innovation and imitation, and thus increase excess value, by creating barriers to entry, or moats.”

Neumann notes the best VCs often succeed by identifying entrepreneurs using established technology to tap new markets and who can use the uncertainty about whether it will work to build a moat through contracts and standards.

Venture investors are seeing their own excess value being eroded. Data provider Pitchbook in its review of the 2010s at the end of 2019 summed up the changes as: “Every kind of participant, it seemed, rushed into the market to place their bets on VC and other alternative assets. Hundreds of new VC firms also came on the scene and made a splash.”

Of the $1.37 trillion invested in the 2010s, VCs contributed less than half based on a proxy of the $553bn in funds raised by them according to Pitchbook.

Corporate venture capitalists (CVC) were involved with more than half of the deals by value – driven by SoftBank’s near-$100bn first Vision Fund, according to GCV Analytics. Along with other non-traditional investors, such as private equity firms, hedge funds, mutual funds and sovereign wealth funds, CVCs helped push more money to later-stage deals.

A glance at the 40 or so $100m venture rounds last month alone and the majority of participants were non-traditional investors. VCs followed on where they could but were more rarely lead investors. As Pitchbook in its 2021 US Venture Capital Outlook noted: “Tiger Global and Coatue Management—hedge funds that have raised dedicated venture funds— have instilled VC as a standard investment strategy at the firm. Since the beginning of 2018, these two investors alone have led or solely financed 71 VC deals in the US.”

And debt is following the larger rounds as a potentially cheaper and non-dilutive option to equity. Pitchbook expected this year to see “venture debt issuance continue a string of record years, surpassing 2,600 deals and $25bn originated for the fourth consecutive year”.

Markets blurring

These trends are both part of the blurring between public and private capital markets.

As Pitchbook noted: “As VC firms have pushed for companies to grow faster and remain in the private market longer, non-traditional investors realised they were losing out on valuable growth by waiting until companies completed an IPO [initial public offering].

“Rather than wait, these investors quickly moved to recapture a stake in that growth, investing in private rounds in a part of the venture market that did not previously exist. Now, larger and more mature companies remain in the private markets.”

But with private markets effectively as liquid as public ones, entrepreneurs increasingly can look to decide their future owner of choice. Last year’s relaxation of direct listing rules in the US, so companies can raise capital in an IPO as well as list existing shares, or the spectacular growth in special purpose acquisitions companies (SPACs) to take private companies public through a reverse acquisition as well as a global record $500bn of primary and secondary issuance of shares through more traditional methods indicates a capitulation of sorts to the febrile valuations seen in private markets.

In its 2021 US Private Equity (PE) Outlook, Pitchbook said: “Price multiples in both public and private markets have been elevated for some time, and we foresee no reason for this to change in 2021.

“The S&P 500 now trades at a cyclically adjusted price-to-earnings ratio (CAPE) of 33 [on Yale professor Robert Shiller’s analysis] due to a plethora of factors including monetary easing, widespread risk-on appetite, and the emergence of large growth-oriented companies that trade at high multiples of revenue, let alone earnings. On the private side, the median EV/Ebitda [enterprise value divided by earnings before interest, tax, depreciation and amortisation] multiple for buyouts was 12.7x through Q3 2020, tying its record high….

“Buyout funds are increasingly targeting growth-stage technology companies that tend to trade at a much higher multiple of earnings than the traditional PE target. For example, software specialist Thoma Bravo acquired UK-based cybersecurity firm Sophos for about 46x TTM [trailing 12 months] EBITDA in January 2020, an eye-popping figure that is becoming less infrequent.

“Many of these internet-native businesses have seen bottom-line improvements from the accelerated move to a digital economy during widespread lockdowns. Even if pricing stays the same for most businesses, a higher proportion of buyouts taking place in sectors such as software and biotech should boost the proportion of deals taking place in this pricier range.”

Private equity firms setting up growth and venture units to be eyes-and-ears on disruptive industry trends that might affect multiples and returns on their core buyout assets will be a strategic complement to the returns from the VC bets themselves.

Similarly, hedge funds, mutual funds and SWFs benefit from the insights about entrepreneurs and investors but relatively few have joined up their thinking to explore how corporate venturing and intangibles are deciding between the winners and also-rans in their region and public portfolio, although there are promising signs this is starting to happen.

As Cathie Wood wrote in the Financial Times last month: “In Ark’s view, any company not investing aggressively in one or more of five major platforms of innovation will lose its way. In harm’s way are companies that have engineered their financial results to satisfy the short-term demands of short-sighted investors.

“Those that have leveraged their balance sheets to buy back shares and pay dividends are at particular risk as they will have less balance sheet flexibility to invest in response to the technological shift….

“While risk-free interest rates are likely to remain low, spreads between companies on debt costs could widen dramatically as disruptive innovation — the likes of which we have not seen since the telephone, electricity, and the automobile burst on the scene in the Roaring Twenties — causes dislocation.”

Finding an edge

It is clear that successful CVCs help – or should do - their parent companies’ research and development and mergers and acquisitions as well as venture building and recruitment strategies.

It is the critical edge to understanding stock returns over a cycle and beyond. Increasingly, therefore, investors are looking at multiple ways to access the innovation and growth.

Just as institutional investors bet on multiple VC funds to build diversification, so corporations are stepping up multiple corporate venturing and innovation strategies from direct investing through in-house and more independent units to VC fund commitments.

Covid-19 accelerated the opportunities for institutional and related strategic investors to come together to back an established management team and also free up the pipeline to source investors.

In a nice summary of some VC industry changes over the past year, VC Semil Shah said: “Throughout 2020, the world of venture capital witnessed its own cauldron of change….

“AngelList unleashed Rolling Funds, a software innovation to abstract away the procedural and administrative complexity of raising and managing small venture capital funds, while empowering limited partners to move in and out of funds like SaaS [software-as-a-service] subscriptions. An evolution on AngelList’s SPV [special purpose vehicle] product, Rolling Funds also empower angel/operators to not only scale up their early-stage investments, but also to create a wider on-ramp for aspiring private investors to get their feet wet.

“[Finally], a new wave of ‘solo capitalists’ emerged as VCs, raising and deploying at scale driven by a single figurehead. Back in 2010, this type of model would be an anomaly and likely not pass institutional committees; fast-forward to 2020, and it’s one of the most intriguing disruptions to the venture capital stack.”

Recruitment and retention of quality managers in turn becomes vital to show consistency and track record. Rather than using CVC as a space to park elderly managers before retirement or rotate staff in and out every few years, the use of professional development training institutes and academies will be required. Corporate venturing units have again been ahead of the industry in its diversity and inclusion figures with a majority of the GCV Powerlist, Rising Stars and Emerging Leaders awardees last year coming from non-white, male backgrounds.

Damien Steel, managing partner and global head of ventures at Canada-based pension fund Omers, in his review said: “New VC talent [has been] severely hampered by lack of networking opportunities.

“This is the observation that concerns me the most for our business. Global lockdowns have severely limited the opportunity to bump into someone and hear about something interesting. Associates and analysts at venture funds have been hardest hit by this lack of serendipity. It will probably delay their network building by a year. The smart ones realise they are all in the same boat and are getting very comfortable at cold reach outs to other associates, and to founders, to build networks….

“While I don’t believe many of us will go back to traveling as much anytime soon, I do expect conferences start up again late next year. Personally, I miss face to face networking and look forward to returning to my favourite coffee shops! The focus on seed funds as a natural funnel for deal flow will continue as will the use of data.

Network effects encourages persistence and the 500+ CVCs with more than a decade’s track record are increasingly benefiting while all investors are looking at digital platforms and algorithms to help source entrepreneurs to approach.

As Steel said: “VCs are leveraging data more than ever. Yes, we might have lost all of those important opportunities to meet founders, hear whispers about hot new companies, meet potential co-investors, but it has led to some innovative thinking in our businesses/ sector and many funds (including ours) are looking to AI [artificial intelligence] to help shortcut insight to the hottest new companies.

“Arguably this has happened far quicker as a result of the pandemic and will certainly endure. Good investors have also turned to data to help bridge the gap in diligence created by an inability to meet founders.”

Adding value in the n

Again, the shift to finding good entrepreneurs is coming back to value-add. The traditional support a startup looks for include capital, customers, product and service development, hiring and an exit.

Over the past year the so-called techlash of regulators and authorities limiting permission-less innovation alongside geopolitical restrictions on investments, particularly from China to India and the US, and tariffs between the US and Europe among other regions have caused entrepreneurs to look for more help in these areas. Multinationals are natural partners to understand what societies will permit in future.

The freedom to test, however, remains a primary factor in how we will find our way. The cancel culture or orthodoxy of what is permissionable to test or explore previously only seen in authoritarian societies has been creeping more widely.

Physicist Richard Feynman’s eloquent lecture series in 1963 correctly identified that new ideas struggle in an environment that encourages conformity and a reliance on tradition.

This closedness caused by geopolitics and mercantilism as well as societal norms and values will have limited short-run impact on technologies developed but is more pernicious in the spread and underpinning of science at a critical time.

Finance has been the source of funding and has reached effectively zero cost fuelling the past decade’s unprecedented near-$1.5 trillion investment in innovation and technology.

As Union Square’s Wenger said: “Without financial constraint, we can build new machines, buildings, and infrastructure rapidly - if we put our minds to it. What we are lacking is intentionality and attention.

“The next age, which I call the Knowledge Age, is all about the scarcity of attention. And exhibit A is the climate crisis. We are not paying enough attention to it.”

The same is true in other areas. The primary drivers of human evolution have usually been new, ie cheaper and more abundant, energy forms; living longer, better lives; and more powerful and egalitarian information and communication technologies, such as 5G, AI and semiconductors and quantum computing.

What we choose to invest in now will decide our future.