Is the Venture Capital industry experiencing record growth due to FOMO?
Venture Capital is Stronger than Ever
“Venture-backed companies have attracted $150 billion in 2021, more than 90% of last year’s record total. Mega-deals of $100 million or more have already hit a new high-water mark.” — Pitchbook
The Venture Capital industry, by funding trends, continues to reach new heights. According to CB Insights, the industry reached a new global funding record in the second quarter of 2021, with funding up 157% year-over-year.
IPOs and SPACs are driving increased exit values of venture-baked companies and nontraditional investors are creating competition that we’ve rarely witnessed in the past, pushing up valuations and increasing funding rounds.
With that, growth expectations are higher than ever, and this is important given the economic backdrop and challenges facing most investors: continuing low yields and despite the recovery from the COVID-19 market shock, lowering future returns in the public markets.
This has made growth a scarce commodity over the past decade, pushing investors into areas of more risk in order to generate more returns. This can no more clearly be seen than when looking at the leadership of a select few companies in the US, collectively known as the ‘FAANG’ stocks.
Why are we discussing publicly traded companies and VC funding trends? They’re not unrelated, and to that point, we will ask the question, “Is the growth in VC funding due to investors having FOMO over missing out on the market leaders over the past decade?”
To be fair, early stage investors are always attempting to discover the next leaders, but we intend to show just how unique the last several years have been in order to understand what risks or role these events have played in the rapid acceleration of VC funding recently.
Facebook. Amazon. Apple. Netflix. Google.
The FAANGS. You may also be familiar with the FANMAGs (add Microsoft to the group, or FANG without Apple). But no matter what you call them, they’ve been leading the market over the past decade given the technological advancements these companies have made that put them at the forefront of the next megatrend for investors (classically we refer to these as the industrial revolution, the age of science, and the rise of digital transformation — and we are now entering what may consider to be the fourth: the age of artificial intelligence).
Not unlike the VC industry, capital has been concentrating in fewer names over the past decade. This, among other things, has created risks for investors who are buying broad market indices that are more and more becoming bets on a select few companies.
However, on the positive side, these companies have created sustainable competitive advantages — and unlike the tech rally to close out the 1990s — and generate strong cash flows, rewarding investors with significant returns.
Has this had an effect on VC funding?
Is it FOMO?
It’s hard to ignore the similarities between public and private markets over the past few years. Swelling valuations, competition, and concentration has flywheel’d into historical metrics across the board.
There’s been a tremendous amount of momentum across the board. Are LPs wisely looking at their entire portfolios and looking for ways to diversify their exposure to FAANGs by adding private investments? Are they looking at depressed bond yields and searching for higher return assets? Or are LPs, in a way, passively investing into VC funds and taking similarly concentrated, premium valuation positions? Are GPs looking at the risks and managing portfolios this way or are they chasing after competitive deals and trying to ensure they don’t miss out on the next-in-line IPO? Is there anything wrong with any of this if it produces returns?
Party Like it’s 1999?
The ever-present question for investors, however, is how sustainable is this? To answer that question, you need to look at the quality of companies. During the late ‘90s, investors were bidding up companies to astronomical valuations (publicly and privately) that had no revenues, cash flows, or even operating models that gave them a chance to get there in a reasonable amount of time.
The FAANGs are different — but what about today’s private equivalents? We saw what happens when you ignore debt and extrapolate past growth in perpetuity (hi, WeWork) or value a real estate company like a tech company (hello, Compass) as just two examples.
Of course, there are plenty of succcesses as well, and to find them, you need to ensure you’re not investing based on FOMO only. Every VC wants to find the next Facebook or Netflix but needs to be cognizent of the fact that each of these companies faced fierce competition and represents the winners among a long list of losers.
Why It’s (Still and Always) About Cash Flows, Even as a VC
Price is what you pay, but value is what you get. The art of investing means getting in at a price that is a discount to what the true, long term value of the company is. Investors who are focused on companies that are rapidly growing are betting that the growth will continue and that the marketplace has either underpriced future growth or not priced in new sources of growth.
This means that companies need a clear pathway to achieving sustainable growth and will be able to expand into new markets — all while eventually generating cash flows (because the value of an asset is nothing more than today’s value of all it’s future cash flows).
- Our series on Venture Capital Due Diligence
- Our complete guides on VC Due Diligence and Valuation Models in the Research Library
- White Paper: Moat:Model Fit
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