The private equity and venture capital sectors face a lot of questions in 2017 as they come off a year marked by huge fundraising even as dry powder continued to pile up.
Among them, will all that money prompt fund managers to loosen their disciplined approach to investment as they try to put their money to work?
How will investors react if unicorns do not generate significant liquidity through IPOs or big M&A deals in 2017?
How will high entry prices for assets affect future returns? This is a top concern of private equity managers and investors, according to a new report.
As 2016 drew to a close, PitchBook asked its editorial staff to review the year in private equity, venture capital and M&A, and to look ahead at the coming year.
Following are their predictions for 2017.
Adley Bowden, Vice President, Market Development & Analysis
Bowden saw two outstanding trends take shape in 2016. Both private equity and venture capital raised vast amounts of money on top of already massive stores of dry power, even as deal volume and investment amounts remained at relatively modest levels, mainly because of high valuations.
And unicorns (startups valued at $1 billion or more) for the most part were able to raise money or push their business models toward profitability and extend their runways.
These trends play into what Bowden considers the biggest questions marks for 2017:
Can investment managers maintain the discipline they have so far exhibited (assuming there is not a change in the business cycle), or will all that capital burn a hole in their pockets? Bowden anticipates a weakening of discipline as firms find new strategies and routes to put the capital to work, though not a total lack of discipline. “I do imagine some interesting structures and head-scratching deals will happen,” he says.
Bowden says unicorns represent a new asset class, so he wonders, will the late-stage, private, high-growth-company asset class prove it’s here to stay or will it blow up in the face of VCs, hedge funds and mutual funds in spectacular fashion? He predicts that the best unicorns will prove they are for real and capable of generating vast investment returns for the bold. But many will also fail, causing investors to rethink and better target in the future the right companies to take into “Unicorn Land.”
Andy White, Analysis Manager
White predicts that venture fund returns will fall. VC investment activity in the U.S. has soared in recent years, with valuations increasing dramatically and forcing VCs to pay more for each investment regardless of whether the valuations were warranted.
Although more recent fund vintages produced solid returns through the middle of 2016 — with the median IRR at 15.3% for 2009–2013 vintages, compared with a median IRR of 5.2% for pre-2009 vintages — those returns exist only on paper, White says. The very vintages with strong IRR figures still hold a massive proportion of the fund’s value in active portfolio companies. For reporting purposes, this value is factored into the fund IRR calculations, propping up returns.
White thinks it is unlikely for all the investments still held to reach an exit, and it is also unlikely that many of those still held will reach an exit at the value they received at their last funding round. “So unless the winners far outshine the losers, we will see IRRs drop.”
Nizar Tarhuni, Senior Analyst
Tarhuni says he agrees with the suggestion that 2017 fundraising figures will subside, but predicts the decline will be softer than anticipated. He points to sovereign wealth funds, which have been hit by volatile commodity prices. These will seek higher-earning assets to replenish some of the money they have spent to fund social programs — and might very well look to private equity. Moreover, bigger LPs will continue to support large vehicle as a way to secure advantageous fund terms. Both this and managers marketing more products with longer lifecycles could drive bigger commitment check to private equity, he says.
Garrett James Black, Senior Analyst
Private companies will strive to deploy dry powder into targets that are both worth top dollar and can potentially service debt the three interest-rate hikes planned for 2017. Black predicts that overall private equity activity will at best stay flat at levels seen in 2016. “It’s not a matter of demand, it’s a matter of supply of worthwhile targets,” he says.
Venture investors are hopeful that outliers can inject a note of optimism into the industry as a whole, but Black is dubious. He says venture’s investing side looks OK because of cash on hand and managers continuing to grapple with the slow reset in founder expectations around financing sizes and valuations that persisted through 2016. In addition, managers will continue to tighten risk assessments around each financing stage’s benchmarks.
Liquidity is another matter. Black says many unicorns will have a hard time getting ready to go public in 2017. Some will delay doing so, and newer ones will have no reason to go public unless the IPO markets breaks open — and that is subject to political concerns that pushed volatility in 2016 and will likely do so in 2017. “So VCs will likely have to continue looking to M&A for liquidity, which should ameliorate matters somewhat.”
Elizabeth Armon, Analyst
This year saw the most $500 million-plus venture-backed exits in more than 10 years, led by big M&A transactions in the health care sector.
In recent years, public companies have watched the Silicon Valley drama play out from the sidelines, according to Armon. Now, these companies and private equity firms are likely to add aging venture-backed companies to their portfolios to fill gaps. “In 2017, a larger M&A deal pipeline will continue as Fortune 500 companies look to buy innovation, which will both augment and/or grow their current strategies.”
Dylan Cox, Analyst
Private equity valuations soared this year, driven by competition from strategic acquirers and a dearth of buyout-ready targets coming to market. As well, private equity firms have raised tons of capital during the last few years, and are now looking to deploy that dry powder.
Cox predicts that pricing pressures will eventually unwind, though probably not in 2017, as corporate buyers continue their growth-by-acquisition focus and financial acquirers continue to deploy capital at a similar rate. Higher purchase price multiples will push down future returns and dampen fundraising.
Evan B. Morris, Analyst
Morris predicts that in 2017, banks and other financial institutions will aggressively invest in initiatives to further implement technology into their core businesses in the form of both formal partnerships and strategic M&A in the fintech sector.
In addition, he says, digital currencies will become more widespread as legal tender, initially in undeveloped economies. “Cryptocurrency markets will remain robust given demand for capital outflows and demonetization in some of the largest emerging economies.” Kyle Stanford, Analyst
Since 2013, deal sizes have experienced tremendous growth, and likewise the actual number of yearly financings — until this year. Stanford says the low deal count in 2016 may owe to venture firms simply being smarter about their investments, and not be part of a doom-and-gloom prophecy.
Venture firms are focusing on strong metrics and key performance indicators before embarking on a deal, which may lower the number of investments and require more capital per deal. In the long run, Stanford says, this could help firms assemble portfolios designed for multiple strong exits, rather than one or two massive ones.
Mikey Tom, Senior Financial Writer
In the coming year, Tom expects a continuation of some 2016 trends: a focus on operating sustainably and a push toward profitability. This will likely result in more layoffs as startups work to decrease spending and, in the process, elongate their runway. There may also be more flat or down rounds — as well as exits via M&A — as companies that secured lofty valuations in 2015 discover that their metrics cannot support an attractive valuation in the current market.
With the high levels money VCs raised in 2016, Tom expects capital invested to hit healthy levels. But whether that results in many startups being funded remains to be seen, he says.
Kevin Dowd, Senior Financial Writer
Dowd points out that three of the four biggest buyouts concluded during 2016 were deals agreed to in 2015, which was unlikely either a coincidence or solely a factor of timing. Private equity firms appear to have lowered their sights in recent months, forgoing massive acquisitions and instead focusing on deals of a more modest scale.
Dowd sees several factors at play, ranging from an absence of attractive and available assets to the ease (or difficulty) of acquiring debt. He says that whether more deals exceeding $5 billion emerge in 2017 could serve as a bellwether for the industry’s health as a whole.
— Check out The Year in Alternative Investments: What Happened; What’s Coming on ThinkAdvisor.