The writer is the founder of Portico Advisers
Venture capital blossomed from an artisanal strategy into a behemoth over the past decade, raising $163bn last year in the US alone. But the run on Silicon Valley Bank is raising questions about the industry and its prominent voices.
While levitating on the vapour of tantalising valuation mark-ups, many of these leaders mistook the advantages of low interest rates and globalisation for their skill, and anointed themselves prophets of innovation.
In truth, the wall of cash in recent years led many VC funds to rely less on discrimination and judgment and more on playing a numbers game, investing in an array of start-ups in the hope that one delivered a vertiginous return. This has always been part of the VC playbook but it became more gamified, descending into an undisciplined play on the momentum of industry and market trends. The standards of due diligence deteriorated.
Rising rates and the collapse of SVB have laid bare that reality. Yet some persist in the belief that VC’s problems may disappear if we return to a world of declining interest rates and cheap money — that the assets in VC portfolios will return to their high-water marks; that a buyer will pay a price as dear as SoftBank’s Vision Funds have done in the past.
These sentiments are delusional. The real problems are broader. We are living in a world of deglobalisation, geopolitical competition and the elevation of resilience over efficiency. These conditions demand rapid advances in science and technology, for markets that are sub-global in scale. For many US VC firms, executing a pivot is not so simple.
Why? First, the industry over-indexed on capital-light software and consumer start-ups, which rose from 39 per cent of capital invested in the US in 2012 to 49 per cent in 2021, according to PitchBook data. The attractions of software were obvious: large markets, de minimis marginal costs. This orientation benefited from tailwinds in a world where the globalisation of services and intangibles, such as data, was accelerating. Software will remain very important, particularly with the development of artificial intelligence. But, alas, we already see a splintering of the internet, and governments are likely to exercise greater control over the flow of data and intellectual property across borders. The European Commission’s recent decision to ban its staff from using TikTok over security concerns is but an early example.
In addition, while software may have eaten the world and disrupted many industries, most software is riddled with bugs and vulnerabilities. Cyber crime has exploded. The FBI has revealed that financial losses from cyber crime quintupled to $6.9bn between 2017 and 2021. In a heightened threat environment, companies and countries are likely to emphasise information security and assurance over efficiency. This is likely to shrink the potential to sell across markets while increasing the development costs for many software products.
Second, VC firms wishing to reorientate towards critical sectors such as agriculture, computation, energy and life sciences are likely to fail. Many eschewed such sectors: only 12 per cent of the deals completed in the US over the past decade were in the “hard” sectors of energy, hardware, biotech, and pharmaceuticals. Ironically, analysis from In-Q-Tel reveals that two-thirds of the funders for US growth-stage hardware companies between 2015 and 2017 were foreign.
Many US VC firms lack the expertise and networks to originate and evaluate deals in deep tech. They mostly do not have relationships with universities and technology transfer offices that can facilitate the commercialisation of groundbreaking scientific discoveries. Nor do they have the experience navigating labyrinthine regulatory pathways to bring novel technologies and therapies to market. Moreover, their value-creation tool kits are deficient for capital-intensive businesses.
Finally, the sources of early-stage and growth capital are likely to shift. States are likely to expand concessionary financing to start-ups in priority sectors, creating competition for deals. And valuation multiples are likely to be hit by restraints on deep-pocketed foreign investors. In addition, dual-use technologies — particularly those in aerospace, biology, computation, and materials — are likely to face more stringent export controls.
Venture capital prospered in a magical decade that placed a premium value on storytelling — perhaps because the price of money had none. If it wishes to retain relevance, VC will need more than a software update.