Venture Capital: Growth or Decline
The rise of Venture Capital
Venture capital is a type of funding provided by investors to start-ups, early stages of a company or emerging companies with high growth potential. The emergence of investment firms fuelled the growth of the venture capital industry. During the 1970s, groups of private equity investment firms shifted their focus to venture capital. As the number of new firms were growing, venture capital firms emerged as an asset class. Through the 1970s and the 1980s, investors have successfully funded some of today’s biggest market players such as Apple, Microsoft and FedEx. The emergence of venture capital continued with more than 290 active VC firms in the US managing $17 billion in 1985. The mainstreaming of the Internet and personal computer usage led to a boom in the 1990s. This increase in activity funded other now successful companies such as Netflix, Amazon, and eBay. Venture capital has become an essential driver of the economy and a vital source for high potential growth start-ups over the last 30 years. In fact, 20% of public companies were backed by venture capital in 2015.
What is it and How does it work?
Venture capitalists invest in companies that they deem are able to generate quick cash flows in exchange for equity or an ownership stake. As it is riskier to finance companies with a lack of security and liquidity, investors seek a high compensation and returns. The investment process consists of five main stages: sourcing, deal screening, due diligence, investment, and deploying capital. First, venture capital firms present a proposal to investors for initial review to determine whether the company fits their investment criteria. Following the selection of the pitches, venture capitalists could meet with the entrepreneur alongside members of the management team to conduct due diligence and review the business plan. The firm will then negotiate a deal agreement and will study the variability of the market, industry experts’ forecasts, company size, and growth rate of the market to determine the start-up’s potential. As well, information about competition, product life cycle and other determinants are collected in the process for a complete analysis. As for due diligence, investors screen the company for their financial history, financial statements such as assets and liabilities, and its management. A final approval, containing the terms and the investment proposal, is made and submitted for the investor and the board of directors. If approved, an investment process begins, and start-ups secure their required fundings.
Where is Venture Capital at now
In recent years, venture capital investment has doubled in the US and the European Union. Despite this incredible growth, venture capital accounts for a small fraction of the total private equity market. In fact, venture capital’s fast growth has yet to reach its peak since deals in this space represent 10% of the total private equity market in the EU and about 3% in the US. This method of funding is starting to become even more popular as major investment firms incorporate venture capital into their portfolios. For instance, European venture capital was involved in financing 80% of companies in the EU and US venture capital for 90% of domestic deals. This rapid corporate venture capital growth can be explained by a favourable stock market in 2021 that allowed for start-ups to become independent and for investors to earn large earnings that can be reinvested in new opportunities and increase the demand for investments. The presence of venture capital is expanding. In fact, analysts are spotting the formation of an “innovation ecosystem” emerging.
The strategies and trends in the Canadian Market
In order to identify trends and opportunities in the Canadian market, we seek to analyse the investment strategies that have been employed by big Canadian investors.
Corporate venture capital investors have to diversify their investment portfolios as new markets are emerging. CPPIB is one of the largest investors in Canada with over C$539 billion in fund assets as of 2022. In their fiscal 2022 performance, they presented a growing trend in cross-border deals involving venture capital. Their investment strategy involves diversifying their global profile outside of America. For instance, the firm’s global portfolio consists of a growing 26% of net assets in Asia Pacific which is the second largest investment region after the US. By analysing the CDPQ, the second largest pension fund in Canada that manages $401.9B in net assets, we can also see a growing global portfolio that shows that 35% of their investments are outside America. This diversification strategy is growing as the investment group mentions that it enables them to capitalize on growing economies and mitigate risk. Another Canadian pension fund adopting this trend is the Ontario Teachers’ Pension Plan. Their strategy involves having completed more than 50% of private investing outside of America. As well, they have adopted a global growth plan targeting $300B by 2030.
Investment sectors have evolved over the years. As of 2006, CPPIB’s portfolio consisted of investing in secure companies that provided fixed income and real assets. In recent years, the fund has diversified its portfolio to invest in several emerging sectors such as real estate, technology, and credit companies. Similarly, The CDPQ has diversified their portfolios in similar sectors. Their venture capital investments are oriented towards new technology as they have funded $70B in 2022. They’re seeking to develop long-term commitments to starting technology companies as they are aware of the growing trend of the digital economy. In parallel, the Ontario Teachers’ Pension Plan expanded their investments into real estate, infrastructure and natural resources. They believe that these investments are sustainable in the long-term and will provide stable returns.
Given the macro trends present, large companies are adopting venture capital as a new investment pattern. This creates space for tremendous growth in venture capital across different industries, such as technology and natural resources, as well as globally especially in Asia and Europe. The presence of venture capital has yet to reach its full adoption potential and is expanding in the coming years.