Hitting the supercycle, today is an investor’s market

If you’re a new company and you’re not in AI or defence tech, chances are it has been tougher to find investors willing to deploy their capital this year than it has been for the past five.

The capital markets are in the midst of a macro contraction – a byproduct of economic changes, rising interest rates and adjustment following the rapid pace of capital deployment into startups in 2020 and 2021. A 10-book non-fiction series could be written on the reasons for why this is happening, but these articles are about 1,500 words, so let’s get into what it means for aerospace innovation.

The knock-on effect of a sunnier period for investment three or so years ago manifests in a number of areas. Most capital invested in that wave is yet to be returned to limited partners (LPs), many of whom are now over-allocated to venture funds. This means less capital is flowing into new funds, while existing funds focus more on allocating capital to sustain their current portfolios versus investing in large new deals. This is certainly being felt in the advanced air mobility sector.

But while many industries fuel their innovation cycle with capital from venture capital (VC) firms, aerospace innovations have traditionally been funded by a more diversified set of specialist investors, although more VCs are focusing in certain sub-sectors and entering the space lately. Aerospace capital has typically come from wealthy individuals with a long-term vision, strategic investors, other institutional asset allocators or public markets (i.e. the SPAC wave).

Like everyone, these investors watch economic patterns and adjust their investments accordingly. In present conditions, they are likely to look for companies that have proof-points in hand and stronger fundamentals against their longer-term potential, which would imply a shorter path to returning capital. As this realisation takes hold, it spreads across investors and can lead to sector-wide contraction.

“I was just at a breakfast with some deep-tech, early-stage VCs,” Peter Shannon, founder and MD of Radius Capital, tells us. “The sentiment there is that for the rounds following where they would typically invest – they come in at pre-seed and seed – there are very few deals happening aside from a few narrow areas, AI being one of those. These guys count on multi-stage firms to come and lead the Series A, but these larger firms are still experiencing the hangover from 2020-2021.

“Those deployments in that period were made in large amounts, very quickly and at relatively high valuations. Essentially, a lot of those investments now look overvalued in their portfolios,” adds Shannon.

While bright spots such as defence tech and AI bring attractive disruptive potential, they are also a double-edged sword. Amidst such rapid innovation and changing assumptions across customers and competitors, the durable value that carries a company to exit is elusive.

That can also be true of investments in aerospace innovation. A lot of startups are doing things for the first time with no direct comparison. Take eVTOL passenger services, for example, the advertised potential is huge, but there is a significant level of risk taken on and how definitive is the timeline on seeing returns?

Has a lack of progress stunted confidence?

What other factors might be slowing aviation investment’s emergence from today’s cold environment? Those familiar with aviation will know delays are commonplace, nothing ever takes as long as someone says at the outset.

Brian Flynn, partner at DiamondStream Partners, believes there was “extreme” hype surrounding eVTOLs. “Most of the ‘new’ investors in aviation failed to learn from grey-haired guys like us,” he tells us. “Many of the valuations are still too high to generate positive risk-adjusted returns. That’s why I predicted at Revolution.Aero London that we’re not yet at the nadir of the valley of despair. Once some of them get certified, it’ll create a moment of hope… until investors discover how hard it is to build a scaled operation with new equipment. I hope I’m wrong since I hate seeing capital misallocated.

“But, I must say, some of the eVTOL developers are making great progress … just slower than the original hype,” Flynn adds.

Part of the question for investors surrounds the timeline from founding an aerospace startup to achieving commercial revenues with a product, says Shannon from Radius.

“How do you shorten that time horizon for a broader set of the opportunities that entrepreneurs can work and innovate on? Example factors could be: What is the size and complexity of the aircraft? What mission? What geography will it operate in? And subject to which regulations? Will that framework need to change or evolve?

“Then on the investor’s side, how many dimensions of risk [tech risk, regulatory risk, market risk, etc.] are investors being asked to underwrite? What factors – regulatory progress, technology maturing, supply chain building out, proof points from the pioneer companies, new markets forming – will reduce this in the future? These factors all need to be considered,” adds Shannon.

The realisation of new milestones could unlock fresh rounds of funding for the leaders and even the wider industry. It seems obvious: Make substantive progress, get more money. But for the eVTOL sector outside of China, the milestone of regular passenger operations remains a promise. The industry hoped there would be demonstration flights operating this summer as part of the Parisian public transport system during the Olympic Games. However, the operator was ultimately restricted by authorities to a small number of demonstrations on the outskirts of the French capital. Greatly limiting public attention versus flying over one of the most visited cities on the planet during a global sporting event.

When a company achieves a milestone such as this, thus demonstrating a maturing technology, that should unlock further funding and potentially attract new investors. It could also help to draw a blueprint for startups to follow.

Is there light at the end for startups?

The term ‘AAM winter’ has been bandied around lately. If you ask industry consultants we are somewhere in the trough of disillusionment as per Gartner’s Hype Cycle. But this describes the reality from the startup’s perspective; from an investor’s (with capital to deploy) point of view, it is a “fantastic time” to be in the game, according to Flynn.

“Great companies that need more capital are abundant,” he tells us. “It’s a fantastic time to be an investor in this space since the valuations have become more investor friendly. We have a vision for how the future will play out for at least six years. That vision has not changed. The future for aerospace has literally never been brighter.”

However, flipping back to the startup’s perspective, even great companies are finding attracting new capital at fair valuations a challenge, says Flynn.

“Right now, there’s a dearth of exits among all categories of VC,” Flynn explains. “The IPO window is closed. The SPAC window is closed. Strategics aren’t buying aggressively. Thus, investors in VCs are reluctant to deploy new capital until they start to see returns from already deployed capital. Valuations have either cratered or been flat for most because they need to attract scarce capital to keep the lights on.

“This will change, as it always changes. I’m not smart enough to predict on which day it’ll change, but it will… because it always does.”

Shannon agrees. “This cycle will work through the system and capital flows will increase eventually – possibly soon – as history teaches us,” he tells us.

Although, as Flynn points out, strategics aren’t buying aggressively. Some, such as Toyota, are doubling down on their investments.

Through its investment arm Toyota Ventures, the Japanese auto giant announced a $500m additional investment in Joby earlier this month, bringing its total funding for the eVTOL startup to $894m. The investment builds on a seven-year collaboration between the companies and indicates Toyota’s confidence in the maturation of Joby’s eVTOL technology. It is possible the industry could see strategics increasingly back their investments behind a consolidated group of leaders.

That is a trend that could be further accelerated by improved regulatory clarity. Something the industry looks to have got this week following the publication of the FAA’s 880-page final rule for powered-lift eVTOL aircraft. A clear framework to achieve type certification and train pilots to fly this new category of aircraft should have a positive effect on investor confidence, especially if the company in question has a plan that aligns with the regulator’s vision.

The super cycle

It is fairly simple to explain what is happening in the capital markets and how it is impacting startups and investors, but it is much more complex to explain why this is happening. The rise of aviation amongst total mobility investments is a good place to start though.

Venture capital and corporate venture capital (CVC) invest in waves over time; it is anything but steady. Over the past five years, aviation’s share of mobility investing has grown rapidly from about 2% to nearly 20% in 2023, according to Flynn.

“This makes good sense because the supercycle in aviation is really only just starting to ramp up,” Flynn explains. “It’ll continue for at least another 15 years. That’s the good news.

“The bad news is that VCs and even CVCs can become too enamoured with a certain type of business. Too many companies are created. Most fail. Few provide positive risk-adjusted returns, but the few that do usually offset the losses from the ones that fail. For example, we predict this will be the case with drones. Thousands of companies have already been created. Some will produce outrageous returns.”

“However, sometimes an idea gets into the heads of investors and they massively over-deploy in that idea, which can lead to none of the companies providing adequate returns. “We’ve tried to warn those who listen to plug their ears with wax as Odysseus did to his men so as to avoid the call of the Sirens.”

Every period is unique, based on unique factors that drive capital availability. However, Flynn and Shannon agree that this time is “different”. Innovations in propulsion systems, AI and autonomy, aircraft designs and some other innovations are setting off a supercycle that’ll be bigger than the first two aviation revolutions. Deploying capital in the right company could produce returns previously unseen in the industry.

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