More Than $1 Trillion Of Capital Is In The Market
Well over $1,000,000,000,000 in committed capital sits in the accounts of private equity and venture capital funds worldwide. This is almost equal to the recently approved spending bill of the United States. We'll give you a minute to wrap your mind around this figure.
The unprecedented amount of dry powder "is a testament to how much PE and VC have evolved as asset classes, and how much further they have to go". We're dedicating our upcoming VC lesson this week to the difference between venture capital and private equity, which is critical to understand in order to become good at managing either of them.
Let us remind you that “dry powder” is the amount of cash available to a venture or private equity firm to deploy as new or follow-on investments. Dry powder should ideally be spent over a fund's lifetime, so fund managers are obligated to invest this cash sooner rather than later. This, however, creates a whole bunch of different issues.
The most worrisome of these issues — even though old — is the problem of “too much cash chasing too few deals”. It is now too big to ignore, and means fattier checks of later-stage funds and higher competition for startups among early-stage investors.
As a consequence, the valuations of investees can be inflated deliberately (as happened with Softbank's investment in Wag) or not, which generally results in the market being at its least healthy (this type of situation is where we start talking about another tech bubble). It also creates pressure for fund managers, who now have to adjust their current strategies or design new ones, so that they don’t disappoint their limited partners.
Why Did It Happen And What's Next?
In venture capital, this situation has happened mainly because more and more venture firms are raising funds of over $1 billion in order to compete with each other, or with the behemoth of the market — the $100 billion Softbank Vision Fund. There are also rumors circulating about them rising another similar giant.
However, with reaching record dry powder figures, the industry entered uncharted territory, where new game rules need to be established. To illustrate this — five years ago, after achieving a certain maturity and valuation ceiling, a tech company would have already been listed at an exchange. Instead, because so much capital is available in the market, such companies, aka "unicorns", are electing to stay private and are raising venture capital dollars instead of going public in order to continue fueling the company’s growth. This situation certainly demands new approaches by fund managers.
A record dry powder amount is not only a result of the evolution of private markets but is also an accelerating factor in that evolution. Let’s take a look at an example of this:
The VC mega-fundraising boom is led by Sequoia Capital, which is raising between 6-8 billion dollars for its new global growth fund — the biggest among other top-tier venture capital firms — which will focus almost exclusively on late-stage rounds for existing portfolio companies.
It seems like the firm would benefit a lot from the carried interest and management fee of such a fund. Not to scare limited partners away, however, Sequoia offers unprecedented for a top-caliber firm LP-friendly terms. The firm is not going to charge any fees on committed capital, there is only a 1% fee on called capital. The 20% carried interest remains typical for the market, although the firm has charged higher than that in its smaller funds. Still a good bonus on already existing portfolio, but this is how market has changed.
In other news:
This month, the Securities and Exchange Commission (SEC) called the blood testing startup Theranos a “massive fraud” and charged it for raising more than $700 million from investors through “an elaborate, years-long fraud in which they exaggerated or made false statements about the company’s technology, business, and financial performance.” Instead of going after the company — which is private, so all the available cash would come from investors who the SEC is protecting — the regulator went after the CEO, Elizabeth Holmes, and Theranos's former president, Sunny Balwani. Ms. Holmes paid a $500,000 penalty, was stripped of her controlling shares, and was furthermore barred from serving on the board of a public company for 10 years.
Lawsuits against portfolio companies have been very unusual in Silicon Valley. The first big precedent with the intervention of the SEC took place last year, when it fined insurance company Zenefits and its co-founder Parker Conrad for deceiving investors. That “unicorn” paid a penalty of $980,000.
We already know that the SEC also announced it had opened “dozens” of investigations relating to cryptocurrency and “initial coin offerings”, and are taking a hard look at one of Silicon Valley’s hottest obsessions.
All this means that more investors and shareholders will be prepared to go to court when their loyalty is betrayed. This also means that one of the long-standing informal Silicon Valley principles "fake it until you make it" will not just work anymore. Even if companies find a way to stay private, it won’t help them avoid scrutiny and they’ll be charged according to the lies they have told. Investors on the other hand, still ought to do their due diligence properly, and not just read through the list of current investors and advisors, which was pretty much the case with Theranos.
Elizabeth Holmes is the daughter of Christian Holmes IV, a former member of the George H.W. Bush administration, whose wealth is reportedly connected to the Fleischmann Yeast company, which was financed by J.P. Morgan himself. Expectedly, the company's board was filled with a bunch of Washington VIPs who had lots of connections, but little relevant experience, and Tim Draper was very certain about Theranos's technology back then...
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There is an opposite opinion: venture as a business doesn't scale.