The state of global venture capital: India must avoid Western pitfalls

Venture capital (VC) has been a fascinating industry to observe. It has delivered the best returns of any asset class over the last 30 years, but also has the highest dispersion of returns. The success of VC is one of the building blocks of the endowment model, which takes on illiquidity for higher returns. The investment success of the Yale endowment has been driven in large part by its bet on VC. Being in the asset class has made sense if you are invested in top-decile funds, where returns have been outstanding. If you are not in the top-decile funds, returns are more like those of public equities, and you may not get paid for the illiquidity. 
 

Take the last 10 years as an example, the Nasdaq 100 delivered a return of 5.2 times, with the top 10 technology stocks delivering a return of nine times. Only a handful of VC funds have been able to beat that, and then you are illiquid for a decade or more in the funds.
 

The industry, however, seems to be at a crossroads, with many funds’ lifespans being extended and distributions at all-time lows. Investors are questioning their long-term allocations, and new first-time funds are finding it increasingly difficult to raise capital.
 

The industry has gone through its own boom-and-bust cycle, with new VC investments rising from $100 billion in 2014 to a peak of $700 billion in 2021. Today, new investments are around $350 billion — while this is half of the peak, it still represents a historically healthy level of investment. The issue is more with exits, which have collapsed to less than $75 billion per year in the US after peaking at over $700 billion 2021. 
 

Exits are down as private equity interest has been subdued due to higher rates, and the tougher regulatory regime in both the US and the EU makes it difficult for large technology behemoths to buy smaller startups. The initial public offering (IPO) market for new technology listings has also collapsed. Amazingly, since calendar 2022 onwards, there have been only 14 technology listings in the US, averaging fewer than six per year. Even during the depths of the global financial crisis and after the technology bubble of 2000, new listings still ranged between 15 and 20 per year. We’ve never seen such a subdued environment for new technology listings!
 

The cause is both demand and supply. Founders today can execute large secondary sales of their private stock to VCs and growth equity firms, ensuring liquidity not only for themselves but also for seed investors and employees. This takes away one of the primary drivers for going public and doing an IPO. With many of the marquee VC firms expanding their assets under management, moving further down the capital stack and no longer just early-stage investors, there is enough demand for these large unlisted secondaries, especially for well-known startups. They can also raise billions in fresh capital at unprecedented valuations while still private — for instance, OpenAI is raising capital today at a $150 billion valuation. This select group is thus able to stay private longer. If you can get liquidity for your unlisted stock , raise fresh money at better-than-public market valuations and your board is supportive, it is easy to see why founders would prefer to remain private. They can avoid the regulatory burden and disclosures of being a listed company.

On the demand side, it is true that as active fund management has struggled, many smaller fundamental stock-picking funds have closed. These funds, many of which were mid-cap specialists, were the primary buyers for smaller IPOs. The larger fund houses that have survived and consolidated the industry have limited appetite for small IPOs, and the bar to go public in terms of minimum issue size and revenue has gone up. Since the end of 2019, despite the Nasdaq being up over 120 per cent, unprofitable technology companies and SAAS ( software as a service) companies are up only 20 per cent. These two categories represent the closest parallel to the unlisted unicorn universe. Their poor performance is holding back public market funds from aggressively backing new listings. Many funds are still stuck with high-flying IPOs they bought in the last few years, which are still trading below issue price. If we look at the record of all technology IPO listings in the US since 2020, they have, on net, destroyed $140 billion in market value, with the median IPO down 40 per cent from its offer price. (Source: Coatue)
 

Thus, we have today almost 1,500 unicorns (unlisted companies with valuation over $1 billion), there are more unlisted technology companies with a valuation of greater than $1 billion than listed tech companies! This is an IPO backlog of over 25 years! Obviously, many of these companies will never list, nor are they actually worth billions.

Due to the continued high rate of VC investment and very poor exits, the industry is today running a record cash negative, with the lowest distributions back to their investors on record. This has not always been the case; from 2010 to 2021, cash flows were positive every year except one, meaning the industry paid back to investors more than it invested.

These record low distributions are creating a cash flow squeeze for many of the endowments, foundations, and pension plans that have historically been the largest investors into VC. Except for marquee firms, it is hard to raise a new fund for venture capital today. The industry has a problem if funds that would typically repay investors fully by year seven or eight now take more than 13 years to return capital. Even if the funds do as well on an absolute return basis, the additional time taken to return capital lowers the internal rate of return (IRR) for investors.

India is obviously in a very different position. Our IPO markets are wide open, with over 250 listings in the last three years. India is probably the best place to list for a startup today. Most startups are quickly flipping back to an Indian incorporation to enable them to list in our markets. With the flow of retail money into funds and also the continued success of active management, there is enough demand for new listings. However, we must ensure that the pricing of new VC-backed listings is reasonable enough for investors to make money; otherwise, they may choose to stay away. 
 

The VC stalwarts also need to keep the pressure on founders to list, ensuring that the liquidity needs of founders and employees cannot be fully met through secondaries. Boards must also ensure that founders understand that in most cases the end goal is a public listing. Remaining private forever is not an option!
 

We have a good thing going in India. The VC ecosystem and startup environment is robust. We must learn from the West and avoid repeating their mistakes of short-circuiting the IPO exit route, which has constrained distributions back to end investors. The end investors must see a good IRR to ensure their support for future funds. Unless further VC funds can be raised, our funding environment will not remain robust. This is also a virtuous cycle that must remain in motion to ensure startups get the support and capital they need.

The author is with Amansa Capital