Taking the long view on a golden age of venture capital

There’s no question that we are in the midst of a golden age of innovation and venture capital investment.

In brief

• Alternative asset classes have become more attractive to investors.
• Record levels of dry powder are now available to all players in the venture capital world that didn’t exist 10 years ago.
• With this many companies in the venture pipeline, there is a ready supply of companies that will be raising large scale up rounds for years to come.

It has been a breakout year in venture capital (VC). We are continuing to ride a bull market that has already shattered previous records and could top $275 billion in funds invested by the end of the year. 

There’s no question that we are in the midst of a golden age of innovation and venture capital investment. Just look at how the market barely skipped a beat last year when the COVID-19 pandemic forced many companies to go into lockdown mode. The industry still saw nearly $160 billion invested in 2020 in US venture-backed startups — during a global pandemic.

This is even more stark when you compare that to past downturns in 2001 and 2009. In 2001, VC investment fell by 61% from its previous high of $97 billion when the dot-com era came to an abrupt close. In 2009, VC investment dropped less sharply as a result of the global financial crisis, but still tailed off by over 30%, according to Dow Jones Venture Source. 

So, what’s sustaining this bull run? I can point to three reasons why this market will continue to run hot as investors sink money into VC startups.

1. Alternative asset classes have become more attractive to investors

Our current fund formation environment has been driven by prolonged zero to low interest rates, which has fueled an enormous surge in allocations to the alternative asset class, of which venture is a slice. Once capital is committed to a venture fund, it’s meant to be invested. Record levels of dry powder are now available to all players in the venture capital world that didn’t exist 10 years ago.

According to Q2 2021 Venture Monitor, cumulative dry powder went from $79 billion in 2006 to $165 billion by September 2020.  In addition, over the past 30 years we have seen allocations into alternatives for pension funds go from 7% in 1990 to 29% in 2019 and allocations from endowments had ballooned from 6% to 53%.[i] With investors conditioned to take more risk to get yield, we now have new players like sovereign wealth funds doing direct investments into venture-backed companies. In addition, others that usually only bought venture backed companies at the IPO are now investing aggressively in pre-public rounds.

2. The internet has lowered barriers to entry 

The technology developed since the dot-com era has changed the playing field in the company creation cycle. Entrepreneurs can obtain services from web hosting providers with a swipe of a credit card today that would have cost $15m–$20m of capex spend in the late 90s. These hosting companies are willing to provide free services for some entrepreneurs in an effort to find the next great application that will run on their infrastructure and consume large amounts of their services.

This has made it incredibly easy to launch companies and has lowered the cost to start — especially when combined with the immense wealth that has been created in the technology sector and enabled successful entrepreneurs to act as angel investors. All entrepreneurs need these days is a solid business proposition and good introductions and they can raise the minimal capital required to jump-start their companies. Today, it’s more expensive to scale a company than in the past. In this environment, the number of US venture-backed startups has ballooned, with more than 32,000 currently in existence seeking capital to grow and sustain operations, according to Pitchbook. With this many companies in the venture pipeline, there is a ready supply of companies that will be raising large scale up rounds for years to come.

3. Technology driving significant change and innovation – the internet laid the foundation.

The pandemic-induced lockdowns forced many companies to embrace technology last year, pulling many businesses forward into the digital age by 5–10 years. Technology fueled by artificial intelligence and other innovations has prompted major upgrades in many industries that were previously neophytes in this space. During the dot-com era, this was limited to e-commerce or retail, but now entire sectors, such as automotive and transportation, internet-based banks, and insurance companies, are emerging to attract new money and disrupt traditional players.

When will it end?  

That’s not to say that this market will continue indefinitely. All bull markets eventually come to end. Still, even though this market bears some similarities to the exuberance of the dot-com era, I don’t think we are headed for a hard landing.

For one, many of today’s venture-backed companies are older, better funded, have a solid customer base and have built out infrastructure. We can speculate that companies are older because the number of exits remain static while total population is on track to almost double by end of 2021, according to Pitchbook. In the dot-com era, many companies were quite young, had only been in existence for a few years, lacked sustainable customers and infrastructure, and were looking to go public quickly to provide capital to build scale and moats. We don’t have that scenario today, as many of the unicorns have chosen to stay private longer.

Second, technology and digital transformation have truly come of age and are impacting countless industries — banking, insurance, transportation, healthcare, energy, consumer goods, foods and more.  COVID-19 has accelerated digital adoption, and those industries not feeling the effects today will do so in the near future. 

Add this all up and even if the market were to take a turn, there is so much momentum that I believe we would continue to see large amounts of capital being put to work to help VC-backed companies realize their full potential. 

The views expressed by the author are not necessarily those of Ernst & Young LLP or other members of the global EY organization.

Numbers included are from EY analysis and based on Crunchbase data unless noted otherwise. 

1. “Public to Private Equity in the United States:  A long-term look“, Counterpoint Global Insights, August 2020