Ian Ratcliffe, managing partner of Sands Capital Ventures,1 recently spoke at the University of Virginia Investing Conference, which focused on how the investment landscape has changed since the start of the global pandemic. Following are highlights of his conversation with Professor Elena Loutskina, the Peter M. Grant II Bicentennial Foundation Chair in Business Administration at the university’s Darden School of Business.
What do you see as the major trends shaping the venture capital (VC) space right now?
The VC space has changed dramatically over just 10 years, thanks to genuine innovation driving technological advances. Technologies that once seemed like distant goals are now reality. For example, we have functional gene therapy, nanotechnology, and cancer immunotherapies that save lives.
This innovation has created enormous value, which technology companies and individuals have used to create more value. For example, much of the value created by the U.S. tech giants—Microsoft and the companies formerly known as FAANG (Facebook, Amazon, Alphabet, Netflix, and Google)2—has been recycled into buying new technologies and technology companies. That has created more wealth that gets recycled into more technology.
You can see this pattern over the past several decades, as the success of mainframe computing funded personal computing, which funded the internet and web. That, in turn, funded mobile technologies and the cloud, and from the success of those two innovations, money is now piling into artificial intelligence/machine learning, financial technology, and cybersecurity.
The areas in which money can be made are broadening. For example, earlier, most of the money made from investing in life sciences came from therapeutics, but now tools and diagnostics are just as promising.
Across all sectors, three times as many rounds of investment are happening, and they’re happening very quickly, before private companies go public.
Companies are also growing faster, and they’re becoming larger companies before they go public. Firms that have reached $1 billion in valuation got their nickname of “unicorns” because they were once rare. There are now herds of them—more than 600, with 292 created in 2021.
The aggregate market capitalization of these global unicorns is $2.2 trillion. That may soon exceed the aggregate value of the Russell 2000 Growth Index, which was $2.4 trillion as of August 31, 2021.
As more private funding has gone into late-stage companies, the valuation of IPOs has also increased substantially—more than doubling from 2018 to 2021.
Four factors have spurred the large sums of money invested in private companies, in our view. The first is fear of IPO failure, as there are concerns that smaller companies might not do as well in public markets, which are notoriously fickle. The second is concern about the public markets’ short-term focus. The public markets punish companies that don’t hit their growth projections and earnings numbers, and that reaction can artificially reduce a business’ value. The third factor is the wider availability of private capital and the need for companies to achieve scale because, in many tech markets, the fourth key factor is that it’s a “winners-take-most” environment.
All these factors also explain why the IPOs are happening much later in companies’ lifecycles. In many cases, companies today have already scaled and commercialized their businesses and become profitable long before entering the public markets.
Companies that have already proven their business model can work can be much more confident that their IPO will be successful and perhaps even oversubscribed. Today, venture capital investors are typically fighting for access and allocations.
This competition means that long-term investors are trying to provide companies with much more than money to grow. We’re not alone in this at Sands Capital, but we are a partner that can offer companies much more than our capital. As public market investors, we have considerable experience and can advise companies on how and when to go public. We also know a great deal about financial modeling and investor relations, so we can provide guidance on how companies can tell their story to investors. Finally, we can be a large-scale, long-term investor in a business. We are also well-known in the industry, so investments from us and other major venture investment firms act as a signal to other investors.
Have the investors who participate in the venture capital market changed?
Yes, over the past few years, many of the large financing rounds for tech and biotech companies are being led by hedge funds and other nontraditional private equity sources. It’s no longer mainly the long-only mutual funds and similar investors providing large amounts of capital.
These firms are almost continuously raising money, and they often lead many of the rounds of investment in companies with very large checks. That seems to have started with SoftBank when it announced its $100 billion Vision fund in 2017.3
There are now many very well run and experienced investment firms that are investing at a remarkable rate, with deals often being done—from term sheet to close—in less than a month.
Another relatively new entrant into the market has been registered investments agents (RIAs) built by banks for high-net-worth individuals. They have aggregated large sums of money that can be allocated to venture funds to invest on their behalf.
All these new sources of capital for private companies have made access to deals much more competitive. It’s also handed a lot more leverage to the founders and entrepreneurial executives, who are far more experienced today. For many of the management teams, it’s the third or fourth time they have built a company, so they know how to work the venture capital system.
We’ve talked about how the competition in this space has intensified, companies’ valuations are going up, and the required speed for deal completion keeps increasing. Given all of that, how is it possible that some venture capital funds are still seeing triple digit returns?
Cheap capital has played a part. The cost of borrowing for large corporations has been low for a very long time. Many of them have extraordinarily strong balance sheets that allow them to borrow money at almost Treasury rates, so they can afford to buy companies at much higher multiples than before.
In the winner-takes-most environment, it is also probably less risky for large public entities, both from a time and money standpoint, to invest in these established businesses and maybe even pay more for them, than to try to build that same capability themselves.
Is this also made possible by the willingness of commercial banks to lend to these companies?
That is certainly true in biotech. The big banks love lending to the big pharma companies because their revenues are predictable. These are very profitable companies. You can see what their revenue streams will be well into the future because of patent protection and clinician-buying behaviors.
Today, the majority of the big pharma companies have basically outsourced their research and development because they invest in the biotech companies that have developed a new market. A similar scenario is playing out in tech.
Do you think this trend of big companies buying smaller tech companies will persist?
Consider the mega-cap tech companies, and then look at some of the companies that have already gone public or may go public soon. These are large, capable companies that could become formidable competitors to the incumbents in their space.
Many of these companies don’t need to be bought, and often the founders and people running them don’t want their companies to be bought — consider Elon Musk, Mark Zuckerburg, Reed Hastings, and Jack Dorsey. I think we may see a lot of fast-growing businesses with a lot of capital that cannot be bought because their company stock has voting rights provisions that will prevent the founder or head of the company from losing control of the business. I don’t think it’s a foregone conclusion that the industry will keep consolidating because there are likely to be companies that break out and deserve to remain independent.
Everything we read about today seems to be about investments in fintech, AI, or data science-related innovations. Is that an accurate perception of where venture capital money is going?
Recently, a lot of the money has been going to biotech. That may be a function of the pandemic. It’s been front of mind, and it is what has saved us. COVID-19 vaccines came to fruition because of technologies from the biotech industry.
In 2021’s second quarter, the amount of U.S. venture capital that went into biotech and fintech was twice the amount that went to AI, enterprise software, or ecommerce. It remains to be seen whether that level of investment is sustainable, but I do think the next 10 years could be the golden age of the biotechnology and the life science industries.
Five years ago, the amount invested in technology companies was six times the amount put into life science businesses. Today, the amounts are more balanced, and it’s impossible for anyone to predict how long that will last. However, if investors keep realizing robust returns from biotech companies, it should continue.
What other sectors are hot now, and are there any industries that could be at risk, especially if we experience an economic shock or recession?
There are so many companies in the enterprise software space that the market may be reaching saturation. Ecommerce is another space where people have invested a lot of money, but it has shaken out as Amazon and then everybody else.4
I don’t think people are going to stop investing in technology because these companies can deliver growth rates that no other type of business can really match. For the tech companies, the marginal cost of adding an extra customer or selling another product is so low. They can create a lot of capital and that can be continuously reinvested.
What is the biggest threat to the venture capital industry?
It will be a challenge to maintain fiscal control and ensure that money is not wasted. You used to find deals announced with very specific numbers, like $148 million or $172 million. But now so much money is being invested and the competition is so intense, people are rounding up to, for example, $200 million, and not earmarking every dollar for a specific purpose. That can lead to inefficiency.
There also may be a decline in valuation discipline because investors are competing to get access to deals and allocations. With the kind of returns we have been seeing, some people have been willing to sacrifice some of their strictness. They’ve been willing to pay more on the front end because they’re expecting so much on the back end with these returns. But that creates a vulnerability if there’s ever a constriction of capital or a reversion to the mean of historical returns.
The success we have seen has broken venture investors’ old mindset of looking for two or three big successful companies that could more than make up for their investments in average companies or even a few losing propositions. In this environment, some people have had five to seven success stories out of every 10 companies they invest in.
From the mid-90s through 2015, venture capital increasingly funded later-stage companies with angel and seed funds. Are you seeing a reversal of that trend over the past five years? Are venture funds going to fund earlier deals?
Investors that used to get involved at the IPO or with later rounds are now making Series A investments. Recently, we made an investment in a biotechnology startup, and two large mutual funds put in a term sheet in combination.
This Series A investment was $100 million, and that is also remarkable. You used to see investments in Series A in the single digits of millions of dollars, but this biotech startup raised $100 million. It was also 40 percent oversubscribed.
The returns on these early-stage investments have sometimes been great. It’s a trend that we don’t believe is likely to stop, and these early-stage investments will get more competitive.
Has the pandemic changed the way the industry operates in any way? For example, historically in the United States, it has been concentrated in Silicon Valley. Is that changing?
One thing we’ve all figured out is that we can work from anywhere. Especially for tech and investment companies, they can operate their businesses from anywhere. Obviously, that isn’t true for manufacturing organizations or for companies in the service economy. In biotech, people need to go into labs to prove out the science that drives their companies.
Some industries are probably better suited to working in an online environment. Financial technology can be done anywhere, and the number of such companies has exploded globally. We have also seen the rise in cryptocurrencies during the pandemic.
The shift to virtual workplaces has created new hubs. Some of them are cities where the tech companies had already established presences before the pandemic—like Nashville, Denver, and Austin. Many people at the large tech companies in those locations are starting new companies and asking friends and colleagues to join them. Investors are following them, with venture investment firms setting up offices in cities like Austin. Internationally, the same scenario is playing out in cities like London and Berlin. They have become hotbeds of technology investing, and venture capital firms are establishing offices in them to get close to the latest opportunities first.
Since the second half of 2020, there have been dramatic increases in private capital investment in almost every corner of the world, including regions that might surprise some, like Latin America and the Middle East.
How has the growing emphasis on ESG affected this industry?
In the United States, the primary concern for many investors has been G—governance, particularly with issues like companies having dual share classes and different shareholder voting rights. Investors want to know if there will be adequate supervision and representation of investors’ interests at these venture capital-backed companies. Many of these large investors from the private equity and growth space don’t take board positions at companies for the obvious reason that they want to be able to trade without being contaminated by material nonpublic information. Our limited partners in many investments are asking legitimate questions about who is supervising governance at these firms.
However increasingly in the United States and predominantly in Europe, limited partners, or LPs, are beginning to focus on the E—environment, for obvious reasons.
1 References to “Sands Capital”, the “firm”, “we” or “our” are references to Sands Capital Management and its affiliates, collectively, including Sands Capital Ventures, LLC (“Sands Capital Ventures”), which is a registered investment adviser that provides private market investment strategies, including its Private Growth Strategy to its clients. As of October 1, 2021, the firm was redefined to be the combination of Sands Capital Management, LLC and Sands Capital Ventures, LLC. Both firms are registered investment advisers with the United States Securities and Exchange Commission in accordance with the Investment Advisers Act of 1940. The two registered investment advisers are combined to be one firm for GIPS® purposes and are doing business as Sands Capital. Sands Capital operates as a distinct business organization, retains discretion over the assets between the two registered investment advisers, and has autonomy over the total investment decision making process.
2 Apple is not an SCM holding.
3 SoftBank is not held in any Sands Capital strategy.
4 Amazon is held in Global Growth, Select Growth, and Technology Innovators.
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