Despite a challenging year for venture capital investment in 2012, the U.S. VC-backed industry remains substantial. Better portfolio company exits and returns suggest the slump in fundraising could be over in 2013, according to Ernst & Young’s tenth annual Venture Capital Insights and Trends Report.

According to the report, there is evidence of money flowing into companies that are perceived as lower risk. For example, there is a shift away from social media towards enterprise– the companies that are attracting greater VC interest are those that provide a service and are getting paid for it, rather than those that have a good idea, but have difficulty monetizing it.

Historically, the U.S. venture industry has been dominated by investments in technology and healthcare since in the U.S. more than half of the VC pool consists of companies in these two sectors.

Healthy exit environment crucial

Though U.S. VC investment activity overall declined by 15 percent to $29.7 billion in 2012 compared with 2011, and the number of investment rounds also fell, the drop was not as pronounced, declining by only four percent to 3,363. These U.S. numbers compare to global VC declines at 20 percent in amount invested and eight percent in deals.

“While 2012 was a tough year for global venture capital, the U.S. held relatively steady,” said Bryan Pearce , Director, Venture Capital Advisory Group, Ernst & Young LLP. “However, a healthy environment for venture backed company exits will be crucial for the U.S. VC industry outlook in 2013. Equity markets have started the year positively, which suggests these better exit prospects may materialize.”

Exit activity is also an important pre-condition for an uptick in fund-raising by VC firms.  While global exits of VC backed companies declined by 27 percent in terms of amount raised and by 30percent based on the number of IPOs, the number of VC-backed IPO exits and the capital raised in the U.S. were relatively stable, after adjusting for the Facebook IPO proceeds of $6.8 billion.

Companies exiting via IPO are typically more advanced than those exiting via M&A. The median amount raised prior to IPO of$78.4 million and time to exit of 7.4 years, far exceeds the respective figures of $16.7 million and 5.1 years for M&A exits.

A number of venture capitalists who participated in the recent Southeast Venture Conference (SEVC) in Charlotte, NC, noted that most firms today are going to exit via M&A and should consider that from the very beginning.

VC model is realigning
VC firms are rethinking their investing strategies favoring investing smaller investments, at a later stage and on tougher terms.

This shift reflects two trends – the substitution for VC fund money in early stage companies by Angel investors, incubators/accelerators and corporate initiatives as well as a need to demonstrate a shorter time to exit in order to return capital to their investors, show a track record of success and, thus, start the process of opening and raising a new fund.

“The flow of capital being returned to LP investors has slowed significantly, which in turn has restricted investors’ ability to re-invest in new funds,” added Pearce. “Therefore, investors are showing a preference for the most successful ‘brand’ name funds, seeking out depth of experience and track record. They are also demanding better terms from VC funds, while the funds are requiring portfolio companies to meet stricter milestones and meet tighter time frames.”

Increasing role of corporate venture
Corporate venture investing is on the rise surpassing pre-dotcom levels in 2012. Corporate venture activity is especially strong in the IT sector and being driven by a combination of healthy corporate cash balances and corporate seeking external innovation due to the rapid pace of technological change as the rise of mobile, big data and cloud computing has created a disruptive business environment.

Corporations are eager to invest in venture-backed companies that can help them fill the innovation deficit in their strategy and innovation capabilities. The link between corporate investment and ultimate acquisition, however, is not always present in the U.S. In all sectors in the US only 2 percent of companies were acquired by an existing corporate investor in 2011 and 2012.

“In 2012, corporates cemented their important role in the VC ecosystem,” continued Pearce. “Where they choose to make an investment, typically in the later stage in the U.S., the valuation of the business in that round was usually greater than in companies at a similar stage with no corporate investor.”

U.S. Regional Outlook
As of January 2013, $167.9 billion was invested in 8,288 companies. Investment remains heavily weighted towards Silicon Valley –since 2000, cumulative equity raised in the Bay Area of $62.2 billion exceeds the total raised in New York, New England and Southern California - the next largest hotbeds – combined.

These same areas also ranked top five globally in terms of number of deals. New York witnessed the largest increase of active VC investors, approximately 150 percent in 2012 compared to 2006.

At the SEVC in March, one VC noted that it took substantially more investment dollars to get those West Coast firms to an exit. East Coast firms, he noted, used their capital more efficiently. A number of VCs at the event said they were actively seeking to diversify geographically and specifically interested in regions such as the Mid-Atlantic and the Southeast.

The data in our Turning the corner: Global venture capital insights and trends 2013 report has been sourced from Dow Jones VentureSource.