Venture capital becomes second private capital class to hit $2tn AUM

Rapid growth has propelled venture capital AUM through the $2tn barrier. But is the party coming to an end?

Venture capital (VC) assets under management (AUM) recorded by Preqin has passed the $2tn mark for the first time, hitting $2.03tn as of September 2021, the most recent date for which the calculation is possible (Fig. 1). The VC segment is still a third of the size of private equity, which had AUM of $6.03tn as of September 2021, but has grown faster, with a compound annual growth rate (CAGR) of 20.2% since the end of 2012 (9.75 years), compared to 11.5% for private equity. The proportion of private equity & venture capital (PEVC) AUM in venture capital has risen from 14.0% in 2012 to 25.2% at the end of 2021.

There has been a significant acceleration in growth in recent years, with VC recording a CAGR in AUM of 40.4% since the end of 2019 (2.75 years), against 23.7% for private equity. The big question is whether this growth will continue or whether it might slow or even reverse, given that the calculation predates the slide in technology stocks and that the sector faces significant headwinds.

Preqin’s calculation of AUM in private capital has two components: dry powder and unrealized value. Dry powder is an up-to-date number, calculated as the amount of capital that has been committed to funds minus the amount that has been called by GPs for investments, and has risen from $387bn in September 2021 to $496bn on 6 May 2022. Unrealized value is a lagging indicator representing the residual value to paid-in (RVPI) and can only be calculated as quarterly reports, valuation, and performance data when it's collected by Preqin from GPs and LPs.

So how will the correction in public technology stock valuations affect VC AUM and is it still more than $2tn? At close on 6 May 2022 the Nasdaq Composite index stood at 12,145, down 25.1% from its high of 16,212 in November 2021. The one-year forward price/earnings (P/E) ratio is down 30.5% from a high of 36.81 in November 2021 to 25.57 on 6 May 2022.

While private company valuations are tied to public markets and are thus likely to have fallen, we would expect a smaller fall in our unrealized value total. The valuations that fed into September 2021 will have been calculated between March (the forward P/E is now 23.0% less than it was at the end of March 2021) and September (foreword P/E is down 26.0% from the end of September), this will begin to feed into lower valuations on unrealized investments through the year. From an AUM perspective, any reduction in value will be to some extent offset by the $109bn increase in dry powder.

A tougher trading environment
While fundraising in 2022 has remained robust, concerns over asset valuations, competition for assets, and the Russia-Ukraine conflict contributed to a moderate decline in deal numbers and value in Q1 from the preceding quarter, as reported in the Preqin Quarterly Update: Venture Capital Q1 2022. Stock market conditions led to a sharp decline in the number of IPOs in Q1 and, while this does not yet seem to have spread to trade sales, a prolonged period of market weakness will lead to reduced acquisition demand from trade buyers.

Most venture-backed companies have limited debt, so rising interest rates do not pose an immediate financial threat. Having said that, an increasing portion of venture backed companies are in the cash-burn stage of their development and have spent the last few years comfortable in the knowledge that ample additional financing is available at low cost should they need it before achieving self-sustaining profitability. However, the valuation multiples that the market is prepared to assign to venture capital companies is in principle highly sensitive to discount rates. This may impact the future availability of funding, especially if company management has to accept the prospect of a down round. Companies that are well capitalized will likely fare well in this environment, as will those that can quickly pivot to a sharper focus on profitability.

Ultimately, the growth of venture capital will be determined in the long-run by earnings growth. If fund managers continue to deliver growth and returns, then investors will continue to put money into the asset class. While a quieter exit market would slow distributions and capital recycling, perhaps leading to longer hold periods and the need for more capital, the speed of technological change and adoption across industries creates an environment ripe for disruption and the emergence of hyper-growth companies.

The future of performance
So, does past performance of venture funds give us a view of how the current crop will fare? There are differences between the current market and the dot-com years, but it’s still worth looking at performance over the past few decades.

Performance through the dot-com boom and bust was poor, but since 2004 (0.3%) median net IRRs have climbed slowly but steadily, hitting 10.6% in 2010 and rising to 37.2% for 2018, the most recent vintage for which data is meaningful (Fig. 2). 

During the 1990s venture capital funds displayed a higher level of variability by vintage year, most likely because there were fewer funds, but averaged a median net IRR of 23.2% for the period 1990-1997. Funds that invested at the height of the dot-com boom struggled to return capital to investors, with median net IRRs slipping to 7.8% in 1998, -2.2% in 1999, and 0.1% in 2000. Returns did not creep back into double digits until 2008.

It's not possible to accurately measure the performance of private capital funds before they have been closed, and Preqin’s vintage year IRRs change as funds mature and more investments are exited. One-year horizon IRRs provide a snapshot of more recent performance – and these have risen sharply, hitting 50.9% for the year to September 2021 (Fig. 3). This does not, however, mean that more recent vintage venture capital funds will necessarily perform well. Horizon IRRs during the late 1990s hit the heady heights of 128.2% in 1999 and 174.3% in 2000, a pair of vintages that on aggregate lost money for investors.

The market correction and economic conditions will likely slow the growth in AUM of venture capital in the shorter term. Aggregate capital raised in Q1 2022 was $54bn, up from $49bn in Q4 2021 but down from $57bn in Q1 2021. Whilst trade sales held relatively firm in the first quarter, a sharp fall in IPOs led to a lower exit value of $87bn, down from $115bn in Q4 2021 and $143bn in Q1 2021, which will slow the flow of capital back into new funds. In the longer-term, the consistently strong performance, opportunity set for transformative technology-based businesses, and dynamics of institutional investors pursuing higher returning assets should be enough to for the asset class to sail into the wind. 

For more on the prospects for venture capital, read the 2022 Preqin Global Venture Capital Report, and keep an eye out for our updated AUM forecasts, which will be released as part of our Future of Alternatives series later in the year. And to see how including venture capital affects your portfolio, read the latest in our Portfolio Optimization series.