State of Tech - Reflections on the current state of tech investment, M&A and expectations for the near future

State of Tech - Reflections on the current state of tech investment, M&A and expectations for the near future

The Delta Perspective

Juan José Río - Partner
Nuno Gonçalves Pedro - Partner
Daniele Pe - Senior Principal
Gustavo Navia - Senior Consultant

State of Tech - Reflections on the current state of tech investment, M&A and expectations for the near future

2016 promised to be an “annus horribilis” for the tech industry, but was it?

“The bubble will burst” – many cried, but although the tech investment industry closed 2015 with a significant slowdown in both the number of investments and the underlying valuations of the companies which received these funds, 2016 was for the most part, a good year. It was a year in which many companies that were going through large burn rates had to become leaner in order to survive. Moreover, it was also a year in which some of the best growth prospects in the start-up world continued fundraising, as if nothing had happened.

Venture Capital (VC) deal making did experience a slowdown in 2016, albeit a moderate one (11%)1, with it having some positive impacts within the sector. For one, it pushed start-ups, particularly early stage ones, to become leaner and to define a clearer path to profitability. Secondly, it had a positive effect in re-adjusting some valuations, although sentiment suggests that there is still room for additional adjustments, in particular when it comes to large unicorns or even larger “decacorns” (companies with valuations above $10 billion). It is important to note that the VC investment downshift was not due to a shortage of capital - VCs have ample reserves of committed capital. In fact, VC fundraising spiked in 2016, with $64 billion raised by businesses1. So, why did the investment slowdown happen? From meeting with several VC funds and in our own investments experience, it seems that VCs are simply disbursing funds more cautiously, focusing on making their existing portfolio more successful, fortifying investments in their existing ‘winner’ card stack, being more selective in new investments and of course, fundraising for their own funds.

Like investments, exits value has also experienced a drop in 2016, but not a dramatic one(-14%1). The drop was mostly driven by IPOs (-42%2), while M&A showed more resilience (-6%2). A fall in IPOs can be ominous, as it may signal that tech entrepreneurs and investors do not feel confident enough in their company’s valuation to face public scrutiny, but the positive side is that the smaller chunk of companies that went public in 2016 performed well. And indeed, valuations had seen a growth rate of 42% over the IPO prices by December 20162.

There were further additional positive developments in 2016, particularly the diversification of funding in terms of geography, investor and vertical types. Geographically, investments are becoming less Silicon Valley centric and more globalised, with a larger share of VC capital being disbursed in Asia (31%) and Europe (12%), fostering the emergence of growing numbers of unicorns in these regions. The tech investor scene has become less dominated by traditional VCs due to the growing presence of corporate investors - not only tech giants, but also large businesses from all sectors - who are increasing their exposure to tech investments via M&As and Corporate VCs (CVCs have contributed to 15% of the deals). In terms of verticals, funding is shifting beyond established investment themes such as E-commerce, SaaS and Cybersecurity to newer frontier technologies such as Virtual Reality, Augmented Reality and Artificial Intelligence, which now represent close to 20% of software related tech investments5.

To summarise, 2016 ended with a more resilient tech scene with seemingly more rational intuitional (VC) investors, leaner start-ups, somewhat more realistic valuations and a large capital overhang (VCs alone sit on $121 billion of committed capital available for investments3).

So what’s next?

We do not expect 2017 to bring back the investment levels of 2014 or 2015, but in the first quarter we have seen several encouraging signs that suggests that 2017 could be a good year for tech investments. Despite the fact that VC investments in Q1 were only moderate (+13% versus Q4 2016, but -20% versus Q1 20164), the investment climate is significantly more optimistic and the number of large deals that took place in the second half of Q1 (e.g. Airbnb raised $1 billion, Grail $914 million, SoFi $454 million) proves this case. Additionally, corporate activities in technology seem to be growing ever stronger - CVCs participated in almost 17% of all venture-backed deals globally, which is an all-time high.

We expect these signs to translate into investment numbers growing throughout the rest of the year, to then accelerate in 2018. The large capital overhang will be a key driver of funding growth, as well as the expanding interest of corporations from all industries in technology. That said, we do expect that a lot of this overhang will be channelled to follow-on investments either on prior funds or reserved ones within the new funds that have been raised.

Given the positive results that tech IPOs have witnessed in 2017, one would expect a larger number of companies to go public this year. However, so far we have only seen the high-profile IPO of SNAP and two other issuances taking the stand. The total of three US tech IPOs is still an increase compared to Q1 2016 - when there were no tech IPOs at all - but this cannot be labelled as a full-rounded recovery. We believe this year will continue at a similar path with moderate activities, higher than 2016, but far from the issuance levels we have seen back in 2015. A full recovery may only be realised in 2018 once technology companies complete their efforts of getting leaner and a solid track record of positive tech IPOs is built up. However, this does not imply that exits will remain dormant this year. The rest of 2017 will likely be the year of M&A, driven by renewed corporate interest in the tech field as a means to pursue innovation. In fact, the first quarter of 2017 has been a strong one for tech M&As: Q1 2017 tech M&As exit value is up 3% versus Q4 20166,and Private Equity (PE) tech acquisitions have surged by 26%7.

The main uncertainty for 2017 (and 2018) lies around whether investors will proceed with the cautious approach we have seen in 2016, and hence whether the industry will keep stabilizing, or the large VC capital overhang, combined with the growing presence of non-VC investors (corporates, mutual funds, sovereign wealth funds, and others) will push quick, somewhat less rational deployment of capital that will boost valuations and bring back a 2013-2014 like situation.

There is little doubt about VC cautiousness continuing: fundraising will likely stabilise this year as investors’ demand exits, and although VCs are sitting on large buckets of committed capital, we expect them to heavily continue focusing on follow-ons and selectively funding new companies. However, corporate and other funding dynamics are harder to foresee, and their growing weight (40%+ of tech investments) can significantly impact the ecosystem. Nevertheless, we remain optimistic and believe these forces will not disrupt the correction that is taking place in the market.

If 2016 was the year of rebalancing and funding rationalisation, we expect 2017 to be a transitional year of small growth towards a strong 2018, where investment and exit amounts get closer to each other. If we are correct, the tech industry may have well found a way to reengineer itself from its bubble stage, without an actual burst!

1 Source: Venture Pulse, Pitchbook and Crunchbase
2 Source: Pitchbook
3 Source: Delta Partners analysis based on Bloomberg data
4 Source: Pitchbook
5 Source: Venture Pulse, Pitchbook and Crunchbase
6 Venture Pulse and Pitchbook
7 451 Research’s M&A KnowledgeBase