The AI sector, once awash in easy capital, now faces a sobering reality check.

According to a recent report from Stanford’s Institute for Human-Centered Artificial Intelligence (HAI), which closely monitors AI trends, global investment in AI experienced a decline for the second consecutive year in 2023.

The report highlights a downturn in both private investment—such as venture capital funding for startups—and corporate investment, including mergers and acquisitions, within the AI industry compared to the previous year. Data sourced from market intelligence firm Quid reveals that AI-related mergers and acquisitions plummeted from $117.16 billion in 2022 to $80.61 billion in 2023, marking a significant 31.2% decrease. Similarly, private investment saw a dip from $103.4 billion to $95.99 billion. When considering minority stake deals and public offerings, total AI investment contracted to $189.2 billion last year, marking a substantial 20% decline from 2022.

Nevertheless, certain AI ventures continue to draw substantial investments, such as Anthropic’s recent multibillion-dollar infusion from Amazon and Microsoft’s $650 million acquisition of Inflection AI. Additionally, more AI startups are securing funding than ever before, with 1,812 announcing funding in 2023, representing a notable 40.6% increase over 2022, according to the Stanford HAI report.

What’s driving this shift in the AI investment landscape?

Gartner analyst John-David Lovelock suggests that investment in AI is diversifying as major players, like Anthropic and OpenAI, solidify their positions in the market. He notes that the era of billion-dollar investments may be waning, with large AI models requiring substantial funding. The market is now witnessing a stronger influence from tech companies utilizing existing AI products and services to develop new offerings.

Umesh Padval, managing director at Thomvest Ventures, attributes the overall decline in AI investment to slower-than-expected growth. He emphasizes that while the long-term potential of AI remains immense, the initial enthusiasm has been tempered by the challenges—both technical and related to market adoption—that will take years to overcome.

Other factors contributing to the downturn include a diminished appetite among investors for new players in the AI space, as observed by Greylock partner Seth Rosenberg. He highlights the heavy capital requirements of foundation models, contrasting them with the relatively lower capital needed for AI applications and agents, potentially explaining the decline in funding on an absolute dollar basis.

Aaron Fleishman, a partner at Tola Capital, suggests that investors may be reconsidering their reliance on projected exponential growth to justify sky-high valuations of AI startups. He points to examples like Stability AI, which, despite a valuation exceeding $1 billion in late 2022, reported modest revenue in 2023 compared to its high operating expenses.

Despite the overall slowdown, there are bright spots, notably in generative AI—the branch of AI that creates new content. Funding for generative AI startups surged to $25.2 billion in 2023, nearly nine times the investment in 2022 and about 30 times the amount from 2019. Generative AI accounted for over a quarter of all AI-related investments in 2023.

However, skepticism persists regarding generative AI’s ability to deliver on its promises of efficiency gains and revenue growth. Some high-profile venture capital firms have steered clear of generative AI investments, and corporate customers express concerns about potential mistakes and data compromises associated with generative AI-powered tools.

Ultimately, whether skepticism and the accompanying financial downturns are positive or negative depends on one’s perspective. Padval views the current correction in the AI industry as necessary to temper bubble-like investment fervor, signaling a move towards a more sustainable investment pace in 2024 and beyond.

The trajectory of AI investment remains promising, but only time will tell how the industry navigates the current challenges and emerges on the other side.