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Venture Capital

Preqin Special Report: The Future of Alternatives in 2027

In this article

Written by Michael Patterson

October 5, 2022

Macro factors to weigh on venture capital performance

The venture capital market is to face significant headwinds but our longer term outlook is still positive
Since our previous Future of Alternatives report published in December 2020, a very challenging macroeconomic environment has emerged. The impact of post-pandemic stimulus measures has waned and stubborn inflationary pressures have come to the fore. In response, central banks are pivoting away from providing support in the form of zero interest rates and accommodative QE, toward a more hawkish stance. The ultra-low cost of capital has disappeared as rising interest rates hit markets, weighing down our current outlook on fundraising and performance for the asset class.

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For venture capital, with its high-equity beta, significant headwinds will continue to play out. Equities tend to perform poorly during periods of high inflation[1], and this is likely to persist in public markets and implicitly in venture capital valuations. Our forecasts show that real assets are well placed to take some of the inflows from higher-risk asset classes such as venture capital, which has seen fervent fundraising over the past couple of years. We expect inflation-linked infrastructure strategies to help steer some of the incoming capital away from venture capital in the medium term, as asset owners look to hedge against inflation.

Longer-term global outlook remains positive

Even with the challenging macroeconomic outlook, venture capital is likely to continue as a core allocation for returns-seeking investors – especially once the valuation adjustment process is complete. We see this asset class leading over our forecast period, with performance set to reach an annualized return of 14.6% between 2021 to 2027, trimming 0.68% from the last five-year period between 2015 and 2021, when annualized return was 15.3%. In aggregate, private equity will narrowly fall behind venture capital performance. Having said this, if the macroeconomic outlook remains challenging for a sustained period, then this may constitute a material downside risk to our view.

We forecast AUM will sustain a CAGR of 19.1%, higher than all other alternative asset classes by a significant margin. AUM growth for venture capital will be fueled by a recovery in fundraising, albeit at a slower pace. We forecast global fundraising to increase from $195bn in 2022 to $302bn in 2027, representing a CAGR of 9.1%. This constitutes a slowdown from the 20.5% CAGR for 2015 to 2021.

As exit multiples come under pressure, performance is also expected to decline. We expect global venture capital to return 14.6% per year from the end of 2021 to 2027, compared with a stellar 23.1% between 2018 and 2021 (Fig. 2.6). Moreover, we expect the more challenging exit environment to prompt GPs to extend holding periods, which will boost unrealized value. We expect this to propel unrealized value for global venture capital from $1.2tn at the end of 2021 to $3.5tn by the end of 2027. AUM is expected to reach $4.2tn in 2027, up from $1.5tn in 2021 (Fig. 2.1).
Dry powder will continue to trend downwards as a proportion of total AUM. We are forecasting dry powder to fall from 19.7% of AUM as of the end of 2021, to 15.8% of total assets under management by the end of 2027, as GPs to continue to find ample opportunity to deploy capital, and as the pace of fundraising growth slows. In absolute terms we expect dry powder to increase from $288bn at the end of 2021 to $659bn by the end of 2027.

We expect venture capital to occupy a greater proportion of private capital, growing from 15.7% of total AUM at the end of 2021 to 22.7% by the end of 2027. Despite slower fundraising and performance, the return from venture capital strategies is expected to remain relatively high in relation to other asset classes, which helps explain this trend.

North America continues to be the bastion of venture capital

We are forecasting that the largest absolute growth in fundraising will come from North America. Capital raised is likely to increase from $118bn for 2021 to $223bn in 2027 (Fig. 2.8), growing at a CAGR of 11.3%. This is being driven by venture (other) and early-stage strategies which will constitute 84% of the growth in fundraising for North America. The relatively favorable macroeconomic backdrop and the maturity and depth of the North American venture capital landscape leads us to think this region will continue to soak up most of the capital being deployed globally. Of the funds raised in 2022, 73.2% currently flow to the region. This is likely to tick slightly upward such that 74.0% of total funds raised will be expected to flow to this market in 2027. Growth in unrealized value will still be the main contributor to the increase in AUM, going from $696bn at the end of 2021 to $2.5tn in 2027, with performance across the region driving the greatest growth with an annualized return of 13.8%. Dry powder as a proportion of AUM will fall from 20.8% at the end of 2021 to 14.6% in 2027 as many opportunities will arise for GPs to allocate capital raised across venture (other) and early-stage strategies. Late-stage strategies will be the outlier, with an increasing share of dry powder expected from 18.7% at the end of 2021 to 21.2% in 2027.
We still expect an uptick in late-stage fundraising, but performance will be weighed down by the headwinds facing later-stage investments needing to exit the market in the near term. The deteriorating environment for IPOs will set the precedent for pricing across trade sales (which make up a large portion of exits), too. Our projection for annualized performance for later-stage investments has fallen from 22.2% for 2018-2021 to 13.8% for 2021-2027. The last three years will be hard to beat with the current macroeconomic outlook, and there could be further downside to our view if public market valuations remain under pressure for a prolonged period.

The longer holding periods for early-stage venture will provide some insulation from the current market environment, because most exit transactions in this space are either sales to GPs or trade sales so they are less exposed. Having said that, investors will still look to public market valuations as a guide for valuing their own investments. We expect continued adequate dry powder on the sidelines for GPs to deploy capital. The proportion of dry powder to AUM is healthy at 21.0%, or $66bn, at the end of 2021 and expected to grow to $177bn, or 16.4% of total AUM in 2027. However, performance is expected to fall from 13.9% in 2015-2021 to 12.6% for 2021-2027 as the exit environment slows down the pipeline of early-stage investments (Fig. 2.7).

APAC continues to shine

We removed RMB-denominated funds from our forecasts given that the majority of our global client base views these funds as less investable. We anticipate that APAC venture capital (ex-RMB-denominated funds) performance will be above average in comparison to other regions. While China currently faces structural challenges in the residential real estate market, the longer-term growth story remains compelling. The booming growth of the middle class across Southeast Asia and India will continue to provide an attractive source of investment returns. Strong demographic tailwinds from a large and young population will keep the middle class growing, as well as a large digitally literate population providing fertile ground for technological transformation. This underpins an optimistic outlook on performance for the years ahead.
We forecast that venture capital across APAC will be the only major region in which investment returns improve in the forecast period compared with the previous five-year period. Forecast annualized returns for 2021-2027 will hit 16.0%, only slightly more than between 2015 and 2021 when annualized performance was 15.9%. Having said this, it still represents a sharp decline from the more recent 2018-2021 period when returns reached 23.8%.

AUM growth for the region is expected to be the slowest, reaching a CAGR of 12.2% between the end of 2021 and the end of 2027; growing from $325bn to $646bn (Fig. 2.5). This comes from significant expected net outflows over 2021-2027 which will moderate AUM growth, as well as lower fundraising growth. Geopolitical tensions with China will see investors look to reduce exposure.[2] APAC will be the slowest growing region with regard to fundraising; reaching a CAGR of 2.5% across 2021-2027, and in absolute terms growing from $22bn to $33bn from 2021-2027 (Fig. 2.8). Even with strong performance, AUM growth will be softer than expected from weaker fundraising numbers. Strong net outflows from venture (other) and late-stage strategies will reach $93bn and $10bn, respectively, keeping a lid on AUM growth across 2021-2027.

Early-stage will see a moderate uptick in performance from 2015-2021 to 2021-2027, increasing from 14.0% to 16.5%, making it the top regional performer on early-stage strategies (Fig. 2.7). We are likely to see AUM grow from $111bn to $290bn across the end of 2021 to the end of 2027 (Fig. 2.5). Fundraising will see modest growth here, increasing at a CAGR of 9.7% from 2021-2027 to reach $19bn per year in 2027 (Fig. 2.9). Dry powder will also increase at a modest rate from 16.7% of AUM in 2021 to 18.0% in 2027. Trade sales and M&A will continue to play a big part of early-stage venture exits, sustaining capital distribution with a modest net outflow of $9.4bn from this strategy.
The venture capital market remains relatively less developed in APAC. As a result, late-stage venture capital strategies are likely to retain a smaller share of the total market. We expect AUM to grow from $28bn to $51bn on the basis of meager fundraising; falling from $2.5bn to $2.3bn in 2021 to 2027 (Fig. 2.9). Annualized returns in 2021-2027 are forecast to reach 15.1%, from 17.6% in 2015-2021. This will be mainly due to a less favorable exit environment and lower realized deal multiples.

Venture (other) AUM will in our view exhibit the slowest growth out of any venture capital strategy. We forecast it to grow from $186bn to $305bn between the end of 2021 and the end of 2027 (Fig. 2.5). Dry powder as a proportion of AUM is expected to fall from 16.7% to 14.5%, and fundraising is forecast to soften from $15.1bn to $11.7bn from the end of 2021 to the end of 2027 (Fig. 2.9). Performance is expected stay flat from 2015-2021 to 2021-2027, with annualized performance moving sideways from 16.4% to 16.1% as GPs continue to find opportunities deploy capital and sustain performance.

Inflation-pressured Europe

Europe’s current high inflation and energy prices will hit consumer spending power and are likely to feed into pressure on start-up earnings. This will temporarily curb growth for portfolio companies, as the ECB looks to combat inflation. However, the main impact on performance will likely stem from the increasing risk premium that investors are demanding for venture-backed companies due to slowing growth and higher interest rates. As a result, we forecast that European venture capital will take the greatest absolute cut in performance, falling from 16.3% over 2015-2021 to 14.1% over 2021-2027. Lower investor expectations will curb allocations on the margin, meaning that fundraising is likely to grow at a CAGR of 6.2% from the end of 2021 to the end of 2027, below our global venture capital fundraising forecast of 9.1%. We expect AUM growth to be evenly spread, but the greatest absolute growth will be in early stage and venture (other), the former forecast to grow from $91bn to $204bn, and $76bn to $201bn from the end of 2021 to the end of 2027 (Fig. 2.4).

LPs are still comparatively positive about deploying to European strategies as AUM becomes sufficiently large to soak up significant amounts of institutional capital. We may see more capital flow from the US to Europe in the short term as the strong US dollar entices allocations offshore. The increasing proportion of European-focused venture capital vehicles domiciled in Delaware also indicates a growing interest from US-based investors.[3] The industry has been maturing, as can be seen from the growing pool of investors allocating capital to this space. However, some of the more recent entrants may decide to exit as conditions become more challenging. We discussed the growth of cross-over funds in our 2022 venture capital global report[4] – which may now be in reverse.

We expect early-stage venture capital to see the greatest hit, as the rising cost of capital puts pressure on start-ups and they seek a more pragmatic approach on cash burn at the cost of slower growth. We see Europe early stage taking the greatest hit on performance of any region, falling from an annualized return of 14.0% for 2015-2021 to 10.7% for 2021-2027. This is likely due to Europe lacking the depth of the market seen in North America, and without the demographic tailwinds in APAC. The performance of venture (other) is expected to fall but will be better insulated, maintaining an annualized performance of 17.6% across the end of 2021 to the end of 2027.
Overall, for global venture capital, performance is forecast to be moderated from 2021-2027, which will feed into fundraising, causing fundraising growth to pull back in comparison to 2015-2021. Saying this, the asset class will still see strong relative growth versus other alternative assets over the next five-and-a-half years, even with the current investor caution over capital commitments during the next 12 months.