Will the Venture Capital ‘Dry Powder’ Disappear?
With ~$150 B in estimated reserves, the VC industry has a record level of cash to survive a prolonged economic crisis. But our dry powder will not last without a slowdown in investment pace
This post is a follow-up to the Techcrunch article “When the ‘Dry Powder’ Disappears” which asks what happens to capital flows when VC funds go through a downturn. We attempt to answer this question for founders with our own analysis of recently published data. These findings are also published in The Information.
In the coming weeks the VC industry will report results for Q1, and it will be difficult to know where we are heading in 2020. The impact of COVID-19 on startup financings will begin to show troubling signs and there will be an instinct to project forward and anticipate an even cooler and and more uncertain climate ahead. The last 45 days have brought a global pandemic and unprecedented economic uncertainty across every sector, and it is now fair to ask if our industry might run into its own financial crisis.
VCs are limited in our capacity to predict the future, but we can be incredibly clear about what we know today. Thousands of founders and CEOs rely on the venture capital industry to fund their workforce in good times and bad, and many are now considering substantial layoffs to survive. Early-stage companies that rely on VC funds are worried that our industry won’t be able to support new and existing startups going forward. And we should all have some concern that we’ll slow funding for innovative technologies that are critical as ever in a COVID-19 world, such as personalized medicine, online education, remote workforce solutions, and reliable Internet connectivity.
The U.S. VC industry is now over 50 years old and has weathered many cycles. Understanding our industry structure is important for measuring our stability and capacity to fund companies in a time of uncertainty. When a VC firm raises money, the capital is committed by some of the largest and most diversified institutional investors, and our funds are ~10 years in length. In any given fund, we make new investments in the first two to three years of a fund’s life, and create an equivalently large reserve to make follow-on investments through the end of a fund’s term. As a rough rule of thumb, we have historically reserved $1 for every $1 we invest in an early-stage company. The combination of long fund terms and dedicated reserves helps mitigate the effects of turbulence on VC funds and our companies.
Is the VC industry prepared for a downturn?
The following chart shows the amount of capital raised in the U.S. venture industry during the past 5+ years, from 2014 through the first quarter of 2020 — more than $275 billion in aggregate.
Using data sources and industry reports published by the National Venture Capital Association (NVCA) and Pitchbook, it is possible to estimate how rapidly funds have deployed their capital over the past five years, and how much capital is reserved for a rainy day. Using both a fund-by-fund analysis and averages across the industry, we estimate that the industry has ~$150 billion of “dry powder,” of which likely ~$76 billion is already earmarked for reserves for existing companies and ~$74 billion is available for new investments. Though it’s hard to make predictions about the future, the present level of reserves is strong relative to any recent cycle.
There are many reasons to be cautiously optimistic about a large reserve to help startups through a fundraising drought, but there are also many signs that the industry will need to slow down its investment pace substantially to protect its cash position during a crisis:
- VCs have invested ~$35 billion per quarter in the past two years. If the VC industry alone were to attempt to fund all current VC-backed companies at current levels, we would run out of reserves in ~4 quarters.
- In good times, capital can come from a variety of sources including hedge funds, mutual funds, and wealthy individuals. When the cycle turns, these alternative sources can substantially pause their investing or exit the industry indefinitely, leaving only institutional VCs as a primary capital source to fund promising start-ups.
- Since 2014, There are over 10,000 companies in the U.S. that have been funded and will need to share this capital. Many companies have exited, found profitability, or already have strong balance sheets, but many more do not have alternatives and will rely on this capital. We will all have to do our part to make the most of the reserves.
Founders have many ways to reduce cash burn and extend runway in a crisis, and VC firms can similarly rely on tools such as fund recycling (investing profits from old investments into strong existing portfolio companies), crossover investing (investing from newer funds into older funds), and both formal and informal co-investment vehicles with LPs that can create more capacity for much needed capital. These approaches are not universally employed, but they can mitigate the effects of a downturn and provide a boost to the industry’s reserve capacity to help companies through tough times.
Entrepreneurs and VCs are an interconnected community, and through every cycle our industry has survived and thrived by persevering through tough times. We are frequently asked to do more with less, sustain ourselves through economic turbulence, and do our small part to provide opportunity for those who need it most. All of us are responsible for investing in innovation that can make tomorrow’s world brighter than today, and our role in this environment will be as important as ever.
* Source: NVCA and Pitchbook data reported as of March 31, 2020 for US VC funds >$50 M raised for vintage years 2014–2020. Dry powder reported as estimates from underlying data or from averages across the industry. Complete data source includes >950 unique VC funds and >575 unique VC firms.
