Capturing value in late-stage venture capital investment

With the mixed macroeconomic backdrop seeing more private companies delay plans to go public, liberty street advisors’ christian munafo discusses the specific appeal of late-stage companies over their early-stage peers. Christian also explains why the tougher exit environment can present new opportunities for investors.

14 September 2023

As investors we are constantly aiming to balance risks and potential rewards. Despite some recent setbacks for high-profile venture capital (VC)-backed companies, for investors operating on a two-to-four-year horizon, and with specialist expertise in this dynamic and potentially highly rewarding asset class, we believe the case for late-stage VC investment is as strong as ever.

The main incentive for investing in venture-backed companies is accessing the potential for these assets to deliver attractive returns while remaining in private hands, long before the wider public have any chance to invest following a stock market listing. But it is important to appreciate what late-stage VC companies can offer investors compared to their early-stage peers; while the latter are typically younger companies in the nascent phases of developing and building out their business models and marketing strategies, late-stage VC investments are more mature in many aspects. These enterprises have established business models, typically with sizable customer bases and often already enjoying revenues in the hundreds of millions, if not even more.

Over time, we have seen several important differentiators setting late-stage VC companies apart from their early-stage counterparts.

1. Market validation: Late-stage growth companies have shown there is a real market for their products/services. Be they market disruptors or leaders, they have already built market share.
2. Established track record: These companies’ business models are battle-hardened as they have typically already overcome challenges, delivered solid operational metrics and have undergone multiple funding rounds from institutional investors and via strategic partnerships.
3. Portfolio diversification: Given private sector-led innovation, investing in late-stage growth aims to provide access to an array of innovative businesses. As companies stay private for longer, this earlier access is particularly valuable.
4. Risk mitigation: Many investors believe that favouring late-stage over early-stage companies can potentially mitigate technology, commercialisation and scale risks, among others, while still capturing attractive upside potential.

Analysing data from January 2010 to March 2023 indicates that investing in high-quality, late-stage VC-backed companies before their initial public offering (“IPO”) has yielded superior returns compared to investing at the public offering. A deeper study of 746 IPOs of US VC-backed firms during this period supports this finding. Investors engaging with VC-backed companies in their final private financing rounds saw average price increases of 254% and 243%, and median price increases of 97% and 71%, over the subsequent six- and 12-months post-IPO respectively¹. By comparison, those who invested at the IPO or after the start of public trading experienced much lower price gains, or even losses.

Over the last decade, nearly USD 1.5 trillion has flowed into US VC deal activity², with around USD 1 trillion directed towards late-stage VC and growth investments³. Non-traditional sources like hedge funds, cross-over funds and sovereign wealth funds entered the space due to low interest rates, innovation excitement, capital deployment pressures, the desire for pre-IPO positioning and “fear of missing out” (FOMO). The resulting growing demand has lifted valuations, in some cases to frothy levels, in our view. While capital deployment rates and valuations moderated over the past 12-18 months following a shift in sentiment due to macro concerns, we believe the opportunity set remains substantial.

VC investments stand apart from other private market segments in their risk-reward profile. They entail heightened risk, potentially yielding greater returns, yet substantial variation remains within the VC landscape. Early-stage VC-backed investments often involve emerging businesses, carrying higher risk but with the potential of significantly higher returns.

Although VC is perhaps the smallest subset of the private market compared to buyouts, real estate and infrastructure, VC-backed companies rarely carry meaningful levels of debt, a factor that can help mitigate default risks. 2022 witnessed over USD 246 billion in VC-related deal activity⁴, of which over USD 152 billion involved late-stage VC and growth investments⁵. While the latter has slowed during the tougher macroeconomic environment over recent quarters, we believe investors retain considerable ‘dry powder’ to support the ecosystem. In our view, the trend of prolonged private ownership timeframes has expanded opportunities, with around 75% of US companies generating over USD 100 million in revenue remaining in private hands⁶.

Irrespective of their risk tolerance, a key issue for VC investors should be liquidity. The secondary market for private asset transactions has expanded over the past two decades, offering increased liquidity during the prolonged life cycles we discussed previously. The growing secondary market, which is now tracking at over USD 100 billion in annual deal value, helps provide sellers with the obvious potential benefit of generating liquidity in an illiquid asset. For buyers, potential benefits include shorter holding periods and greater vintage-year diversification. Secondary investors can also leverage dislocations and information asymmetry, potentially enabling them to buy private assets at discounted entry points relative to fair value. Naturally, this does not in itself guarantee any ability to sell in future at a profit.

Periods of volatility and uncertainty can present strategic buying opportunities in late-stage VC assets. As with public markets, private market participants seek liquidity during these more challenging times, potentially creating supply-demand imbalances. Achieving liquidity during periods of illiquidity in the underlying assets is challenging, potentially leading to transactions at higher discounts, while new private financings can be completed on more investor-friendly terms, including lower valuations. In fact, a mismatch between seller expectations and buyer demand has led to a widening range of secondary prices of venture-backed companies. This notable shift from the 2020/2021 company-friendly to 2022/2023 investor-friendly environment has seen active investors gaining real negotiating leverage. The chart below from Forge⁷ shows an analysis of pricing trends during the first half of 2023.

The tougher environment means some companies might postpone their exit plans, remaining private until the market improves to present opportunities to optimise valuation and liquidity. We have seen notable polarisation of the market; high-performing, well-managed companies continue capital raising, while weaker entities face greater challenges. During such times, we have seen tailwinds behind certain sectors, such as artificial intelligence (AI) and cybersecurity. Overall, notwithstanding the market’s ups and downs, we retain our view that companies with differentiated business models, strong operating metrics, healthy balance sheets, experienced management teams and seasoned boards will ultimately reward their investors, even if it takes a bit longer than expected. While it may appear counterintuitive, periods of increased volatility and uncertainty often create attractive investing opportunities, particularly for those with a longer-term view. This is why we have continued to actively deploy capital during this challenging environment, while maintaining discipline, conducting a comprehensive due diligence process and leveraging relationships across the private market ecosystem.

In our view, there is no question that the late-stage VC asset class comes with a higher risk/higher return profile when compared to conventional public equity and fixed income strategies, as well as certain private market strategies. However, given the expected doubling of private market assets under management to more than USD 18 trillion over the next five years⁸ investors with longer-term time horizons could benefit from exploring how opportunities withing this rapidly growing asset class may complement their current portfolio allocation.