A difficult global investment environment in 2015 and 2016 pushed capital toward alternative asset categories, one of which is private equity. Swelling demand for late-stage startup equity drove up private valuations, while public valuations stalled. This caused startup tech firms to remain private longer, where they received more attractive valuations. As of May 2016, major financial institutions were funneling more funds into the category, sustaining the conditions that some investors might consider a bubble.

Increase in Capital Available

High-net-worth investors faced a challenging investment environment in 2015 and 2016. Fixed-income yields remained historically low in U.S. and global markets. Commodity and energy prices plummeted, creating risks that spilled over into other asset classes. Economic fundamentals were weak in China, Europe, Japan and South America, hurting the global equity outlook. U.S. stocks were no longer considered exceptionally cheap, especially with the threat of a Federal Reserve rate hike that could send U.S. indexes tumbling. As a result, many investors pursued alternative investment opportunities seeking superior yields. Privately held technology firms, especially software companies, were among the largest beneficiaries of these capital flows.

The private capital invested in software startups grew from $26 billion in 2013 to $75 billion in 2015, much of it from non-traditional sources. This increase reflects a general trend that extends beyond early-stage investments in software companies. The Goldman Sachs Group Inc. (NYSE: GS) created a $1.5 billion fund designed to purchase minority interests in private equity firms. These private equity firms are engaged in increasingly diverse activities, moving beyond traditional buyout activities and into categories such as real estate and credit.

Divergent Valuations

The growth in capital earmarked for private equity was not met with a similar expansion in suitable investment opportunities, which drove valuations higher. However, publicly traded technology firms did not experience valuation expansion of the same magnitude. The 2000 dot-com bubble featured global technology sector valuations that reached average valuations at nearly 80 times earnings, which was 300% higher than the average for equities in other sectors. At the end of 2015, the average price-to-earnings (P/E) ratio for public tech companies was only 20, which was 10% higher than the market average as a whole. The technology premium was roughly stable from 2010 through 2015, indicating diverging trends between publicly and privately held firms.

This has led to a record number of billion-dollar private tech firms that are waiting longer to conduct their initial public offerings (IPOs). There were 146 private tech firms valued at $1 billion or more in the United States at the close of 2015, a figure that doubled year over year. Late-stage startups are able to get higher valuations from the private capital markets, as evidenced by the performance of companies following their respective IPOs. From 2012 to 2015, 61 tech companies had IPOs with valuations above $1 billion. The median appreciation relative to the IPO list price was 3% as of December 2015. These returns are significantly weaker than the overall market's. More than 40% of the billion-dollar technology IPOs between 2011 and 2015 were at or below their last private round valuations as of May 2016. It has also become more common for IPO valuations to fall short of those during private raises.

The Private Equity Bubble

The growth of capital earmarked for equity capital has led to a rapid increase in valuations of privately-owned, early stage firms, especially in the tech sector. All of the factors that are driving capital toward the private equity space are still in play, though commodity and energy prices have rebounded. Goldman Sachs' $1.5 billion fund launch suggests that major financial institutions are still dedicating additional funds to the space, so the rich valuations are likely to continue. If the run-up in private equity tech valuations can be considered a bubble, it is still expanding.