Today, we’re cutting through the headlines to understand the current state of venture capital.
It’s no secret that VCs are doing far fewer deals than they used to.
But why?
- Are VCs capacity constrained by weak LP fundraising?
- If so, where is all this flashy AI cash coming from?
- And why are LPs so hesitant to commit new capital?
Along the way, we’ll find out which sector is raising the most money (spoiler: it’s not AI) and where investors may find overlooked opportunities.
Let’s go👇
Table of Contents
Venture capital is in a weird spot
In the first quarter of this year, VC activity in the US dropped 30% YoY, both in terms of completed deals and capital deployed.
Meanwhile, fundraising from limited partners (LPs), the passive investors who provide 95% of the capital for VC funds, continues to disappoint.
After hitting a six-year low in 2023, LP fundraising is expected to drop to under $200b this year. That’s a 50% decline from the heyday of 2021.
With weak deal activity and poor fundraising efforts, you might suspect that VCs don’t have a ton of cash for new investments.
And yet, AI investments are all the rage, showing that VCs are willing and able to back ambitious startups.
I think [2024] is the year we start seeing AI commercialization at scale. Every category we know of today: developer tools and infrastructure, search, the collaboration and productivity suite, games and entertainment, the creative suite, biology—to name just a few—will be transformed over the next decade by AI innovation.” — Stephanie Zhan, General Partner at Sequoia
This year’s biggest AI deals include:
- Figure, the AI-powered robot maker who has raised $675m
- Coreweave, the GPU-cloud provider ($1.1b)
- Anthropic, the chatbot provider ($2.75b)
But one of the most important trends in venture to understand isn’t the investments that are getting made — it’s all the investments that aren’t.
VCs have record amounts of dry powder
Remember: not all the cash in a VC fund is actually used to make investments. Instead, some of it lies dormant as dry powder.
Dry powder is basically the ammunition VCs have to make new investments with existing fund money.
Now, it’s not uncommon for VC funds to have some dry powder. After all, it takes time for VCs to source and identify sufficiently attractive startups.
But if these opportunities never come around (or if VCs are overly ambitious with their fundraising efforts) the pile of dry powder can grow rapidly.
This is exactly what we’ve seen over the past few years.
The level of dry powder in VC funds has now reached an unprecedented level, totaling $311 billion at the start of the year.
Why are VCs so hesitant to invest?
Judging by the performance of startup investments in the past few years, it’s not hard to see why VCs might be more cautious about deploying capital these days.
Yes, this asset class is idiosyncratic. But in 2022, overall returns for VC funds were as low as -20%, followed by another multi-point slide in 2023.
These negative returns are directly connected to the big jump in interest rates over this period, which impacts startup valuations like crazy.
Add in the collapse in the exit market, which makes liquidity harder to generate and gains harder to realize, and you’ve got a perfect storm for VCs hesitating to use dry powder.
Globally, VC exit activity (i.e. IPOs and acquisitions) fell to $75.9b in Q1 — the lowest quarterly level since Q4 2016.
So, this helps us answer the big questions:
- While a decline in fundraising may impact the ability of VCs to make future startup investments, it’s not the limiting factor here.
- Instead, the decline in activity is all about caution (especially when rates are 5%+ and the exit market is tepid.)
- Although VCs are getting more selective, when they do smell an opportunity (like AI), the level of dry powder means they still have the means to seize it.
Contrary to what the headlines might indicate, though, AI isn’t the only bright spot in venture capital right now.
In fact, one area is drawing a surprisingly huge amount of funding – biotech.
Healthcare is the biggest VC sector right now ⚕
While AI gets all the attention, the fact is that biotech is drawing the most dollars.
In Q1, the US tech sector received $8.04b in total VC funding, largely driven by AI.
Healthcare, meanwhile, secured $9.81B in funding — with biotech helping make healthcare the biggest sector in VC for the first time since Q4 2022
It might seem like an artificial distinction that biotech gets classified under healthcare (it’s literally called biotech). And all the more so, because biotech firms use AI-powered tools as part of the research process.
But the deals we’re discussing here completely differ from what’s happening in the tech space.
Instead of chatbots and cloud computing, we’re seeing big bets on drug development and targeted medicine:
- Xaira is pursuing AI-driven drug discovery. They emerged from stealth in April with $1b in funding.
- Mirador, which announced $400m in funding in March, is working on novel treatments for autoimmune conditions.
- And Uniquity Bio, which just emerged from stealth with $300m in funding from Blackstone, is also focusing on autoimmune conditions.
It’s no coincidence these last two are both targeting immune-related diseases. Autoimmune diseases are on the rise globally.
(Concerningly, no one’s quite sure why. Explanations range from climate change to the Western diet).
Healthcare is also fairly recession-proof, which could be a powerful motivator for risk-averse VCs.
Finally, biotech is one of the few areas with an active exit market. In Q1, biotech IPOs raised over $1.3b, up more than 300% YoY.
While still well below the pace of a landmark year like 2021, which saw $15b raised, the market is starting to catch up with pre-pandemic levels.
(If you’re curious about the latest biotech developments, we’re doing a special issue on Australian biotech next month.)
Fintech struggles (but may make a comeback) 💹
Despite the overall decline in deals, we’ve talked a lot about the areas that VCs are investing in.
Now, let’s turn to one area they’ve pulled back from — but which I think might have interesting opportunities soon.
Fintech investments have taken a hit recently, with global VC funding falling 42% in 2023.
This year hasn’t been much better, with funding sliding another 16% in Q1. It’s now at the lowest level since 2017.
The decline in fintech funding is most likely due to high rates depressing speculative activity.
Fintech deals are down 72% YoY, and ”boring fintech” like proptech and insurance tech were the only ones to see growth in 2023.
But the tide of retail activity looks like it’s starting to change. And this could trigger the start of a fintech comeback in the second half of 2024.
- The rise in crypto prices has renewed VC interest in the space, with crypto startups raising more money in Q1 than they did in all of 2023
- As we pointed out in March, institutions are starting to launch serious tokenization projects
- Sports betting is through the roof (to the chagrin of many)
- The short-lived resurgence of meme stocks like AMC and GameStop (and, arguably, funds like DXYZ) points to a comeback in retail enthusiasm.
- Big banks have recently upgraded price targets on public fintechs like Robinhood using the same speculative comeback theory.
And while rate cuts this year look increasingly questionable, growing evidence of a soft landing is great news for such a cyclically-sensitive sector.
So far this year, most of the funding in the fintech space has gone to institutionally-focused providers like Ramp ($150m) and Altruist ($169m).
We don’t expect retail fintech to return to its former glory overnight — but if there’s one area that VCs might be overly pessimistic about, it’s this one.
In 2H 2024, keep your eyes peeled for startups offering novel trading or investment solutions for the retail market, especially in areas like private share investing and tokenization.
(Psst: Here at Alts, we’re raising a small round to accelerate Altea. It’s at a very reasonable valuation. Smash reply if you want to join.)
Energy: The dark horse ⚡
Finally, let’s look at an under-appreciated and intriguing area of VC investing: energy tech.
Energy seems to be flying under the radar right now, largely because there just aren’t a ton of deals to talk about.
In Q1 2024, energy accounted for just 3% of all US VC activity by deal count, but drew 12% of US VC dollars.
This is the highest ratio of dollars-to-deals among all sectors.
Many of the biggest deals in this space are focused on renewable energy:
- Generate Capital, a sustainable infrastructure developer and operator, raised $1.5b in January.
- Pine Gate Renewables, which focuses on solar energy generation & storage, raised $650m in April (with funding provided partially by Generate Capital).
- And Recurrent Energy, also focused on solar, secured $500m in January.
It’s unsurprising to see renewables so heavily represented – this proven technology will only become more important as regulations incentivize sustainable energy production.
But some of the more interesting deals this year are backing truly innovative tech, that can revolutionize the way our energy system is structured:
- Koloma raised $245m to pull hydrogen straight from underground deposits (which could be much less energy-intensive than the common electrolysis approach).
- Fervo raised $244m to deploy drilling technologies from the oil & gas industry to develop next-gen geothermal power.
- And Antora raised $150m to superheat carbon blocks as a form of thermal energy storage for industrial processes.
VCs are usually focused on asset-light businesses like software, which are the easiest to scale up.
But the potential gains from an energy breakthrough are so huge that VCs clearly can’t ignore the space.
And while the joke is that nuclear fusion is always “just 20 years away,” other tech appears far closer to realization — and could play a pivotal role in the global energy transition.
Down rounds, exits, and the near-term future
So yes, there are some bright spots within VC right now. AI, biotech, and energy.
But this trend toward fewer deals and lower fundraising isn’t without consequences.
One consequence is down rounds, which occur when a startup raises money at a lower valuation than it had previously.
Down rounds are at their highest level in a decade.
An increase in down rounds means companies are increasingly desperate for cash. Still, VCs won’t provide it at higher valuations.
For the time being, VCs have plenty of dry powder in their arsenal to secure deals. But considering the state of fundraising, that won’t last forever.
LP fundraising is forecast to grow just 2.9% annually through 2028. That’s less than half the rate of the newer kid on the block, private credit.
People often forget that VCs compete against other alternative investment opportunities for LP dollars. But thanks partly to higher interest rates, private credit is increasingly stealing “market share” from VC.
LPs aren’t just shunning venture capital due to poor performance, but also because of rock-bottom distribution rates.
Distributions represent the actual cash VCs return to their LPs. And despite all the hype around VC, the fact is that right now, VC funds aren’t generating much cash at all!
In Q4 2023, VC distributions fell to just 5.6% of fund assets — a level not seen since the financial crisis.
There’s an odd tension here, since VCs have plenty of dry powder they could distribute to LPs. But since most VCs charge fees on uninvested capital, there’s not really an incentive to do so.
(Plus, it’s awkward and unprofessional to return cash you were supposed to put to work.)
To generate liquidity, some VCs are launching what are known as continuation funds, a common tool in the private equity world to cash out LPs who can’t wait any longer.
However, these imperfect vehicles create big concerns over fees, conflicts of interest, and regulatory uncertainty.
We don’t expect these issues to improve until the exit market becomes more active, especially for IPOs.
While we saw some signs of life this year with Reddit and Astera Labs going public, things are still pretty stagnant. Until then, expect continued pressure for VCs to pursue non-traditional exit avenues.
One big trend is with newly created funds buying shares of private companies through a secondaries market.
Secondaries can even be wrapped in public structures and made available for retail purchase, like what DXYZ has done. (But DXYZ is a whole other topic)
Much more to say on that soon.
In the meantime, that’s all for today!
Reply with comments. We read everything.
See you next time, Brian
Disclosures
- This issue was sponsored by Sweater Ventures
- The ALTS 1 Fund has no holdings in any companies mentioned in this issue
- This issue contains no affiliate links
