Allocate Venture Capital Mid-Year Market Update: Unpacking Today’s Dichotomy
In this third installment of our bi-annual venture capital market update series, we share what we believe will drive the venture capital industry in the near term through data-driven trend analysis and insights.
The VC landscape has undergone dramatic shifts in recent years, particularly as inflation climbed and monetary policy tightened, marking the end of the zero interest rate policy (ZIRP) era. The rapid rise in interest rates and the subsequent decline in returns became evident by 2023. Although the VC market may have bottomed out, investors should approach the coming environment with cautious optimism as we enter the next phase of the market cycle—a tale of two cities.
The ZIRP era, which fueled unprecedented growth in venture capital investments, came to a swift end as inflation surged and central banks tightened monetary policy. Returns plummeted significantly by 2023, prompting a reassessment of market conditions. Institutional investors, many of whom were compensated based on internal rate of return (IRR), are now experiencing a return to more normalized conditions.
During the peak years of 2020 and 2021, the traditional J-curve in venture capital—a period where early returns are typically negative before investments mature and yield positive returns—was notably absent. Rapid markups and massive step-ups between funding rounds accelerated valuations, bypassing the usual maturation period. This phenomenon has now dissipated, leading to questions about whether we are in a recessionary period for venture capital and tech or simply returning to pre-boom norms.
A Tale of Two Cities: Divergence in Market Dynamics
The current venture capital market can be described as a tale of two cities. On one hand, certain sectors remain vibrant with substantial capital activity. Companies and funds continue to raise significant amounts, maintaining robust investment activity. On the other hand, the broader market has experienced a sharp decline in fundraising, reflecting a more challenging environment for many players.
In 2021, U.S. venture capital raised an astonishing $183 billion, followed by $188 billion in 2022. These figures starkly contrast with pre-2014 levels, where total annual capital raised ranged between $20 to $30 billion. Innovations in mobile technology, cloud computing, and emerging fields like crypto and AI fueled rapid scaling with relatively less capital in the early days. However, by 2023, the capital raised dropped dramatically to approximately $80 billion, highlighting the significant contraction in the market.
Emerging Managers and First-Time Funds: Challenges Ahead
Emerging managers, defined as those with one, two, or three funds, have been hit the hardest by this downturn. The share of capital and fund count raised by these managers saw a steep decline in 2022 and 2023.
From 2022 to 2023, there was a significant 60% decline in both capital raised and the number of funds, indicating a return to normalized levels after the exceptional years of 2021 and 2022. But there are funds and companies that are immune to this reality.While there is a slight uptick in 2024, it is partly attributed to big funds announced in Q2, suggesting a potential spike in capital raised later in the year. However, the outlook remains challenging, especially for first-time funds.
During the ZIRP period, many new managers successfully launched first-time funds, attracting capital from high net worth individuals and family offices. This source of capital has significantly dried up, making it as difficult to raise a first-time fund now as it was during the aftermath of the 2008 financial crisis.
AI & The Cyclical Nature of Tech Investment
We've seen this pattern before: an initial surge of enthusiasm, followed by a period of disillusionment, and finally, a phase of realistic, sustainable growth. The late '90s dot-com bubble, the rise and fall of social media startups, the boom and bust of the drone market, and the recent rollercoaster ride of crypto all illustrate this cycle.
AI-focused companies are attracting substantial capital, with early-stage AI valuations surpassing $70 million and mid-late-stage valuations around $100 million, reflecting significant investor interest and confidence in AI technology. This is a huge departure from the non-AI companies, highlighting the dichotomous market that exists today.
AI is likely to follow a similar trajectory. Despite the current hype, not all AI companies will succeed. For every OpenAI, there will be dozens that fail to recoup their initial investments. The inevitable high-profile blowups will likely lead to a cooling period where AI investing falls out of favor. This trough, however, is where savvy investors can find the most promising opportunities. As Mark Suster from Upfront Ventures wisely noted, venture capitalists thrive in the "money-making zones"—not too early, but not too late.
If you're considering investing in AI today, you might already be late to the game. The optimal time was when firms like Khosla Ventures invested in OpenAI, before the hype took off. However, there will be another prime opportunity: the period of disillusionment, when many investors pull out and valuations drop. This is when technology paradigms, like personal computing, the internet, and mobile technology, have historically offered the best returns.
Investing during tough times can be daunting, especially when headlines are bleak. Yet, historically, these periods often present the best opportunities. While timing the market precisely is challenging and often ill-advised, maintaining a consistent, long-term approach to venture capital investment can mitigate risks. Portfolio diversification across different vintage years is crucial, as it spreads the risk and leverages the power law where certain years outperform others significantly.
Conclusion: Cautious Optimism in a New Era
The venture capital market is highly cyclical, with successful investment strategies often involving buying before hype cycles or after they deflate. The current market is focused on AI, echoing past cycles seen with the internet, SoMoLo, and crypto, all of which have gone on to generate significant returns to prudent and patient investors.
As the venture capital market navigates this new era, characterized by both contraction and resilience, investors should maintain cautious optimism. The market's bifurcation into vibrant sectors with ongoing capital activity and broader areas facing significant challenges underscores the need for strategic and prudent investment approaches. Understanding the dynamics of this tale of two cities will be crucial for navigating the evolving venture capital landscape and identifying opportunities amidst the challenges.
In the world of investment, technology has always been a major driver of change and opportunity. The recent resurgence of cryptocurrency and the foundational potential of blockchain technology highlight this point, suggesting that we're on the cusp of another significant wave. Similarly, artificial intelligence (AI) is poised to experience a massive run-up, followed by a potential decline before stabilizing and offering substantial investment opportunities.
Interested in more VC market update content? Watch the Venture Capital Mid-Year update webinar and download the presentation slides.