Back to Earth: Are the venture capital rockets out of order?

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It’s hard to start an article this year without mentioning the series of punches global markets have had to endure. Growth stocks have fallen, central banks are scrambling to rein in inflation and widespread pessimism has clouded sentiment.

Take a look at our top five funds, for example. All of the strategies featured in this review have had broadly negative returns this year. And people are fleeing most markets; investors withdrew more than £4.3bn from UK funds last month, and there could be more upheavals to come.

The few companies that have done well of late have been comfortably seated on the value side of the stock markets. So how badly have growth stocks really been affected – and, for clarity, how are smaller, unlisted companies faring? Morningstar PitchBook has the answers.

In a report, PitchBook took what it calls a “far too early look” at venture fund returns — and it spotted some pretty significant headwinds.

Pandemic growth boom

Venture capital funds achieved exceptional outperformance over several quarters; in 2021, these dizzying returns attracted a fundraising record of $242.1 billion globally, and total assets under management approached $2 trillion. Returns were the highest for venture capital funds since before the dot-com crash, and the pooled horizon for venture capital outpaced all other private fund categories.

According to Zane Carmean, quantitative research analyst at PitchBook, venture capital, or VC, appears to be the most obvious target for a correction in the private equity market.

“Now a return to Earth finally seems in the cards,” Carmean says.

“Anecdotal accounts suggest that VCs are tightening their belts, tech companies have started hiring freezes and layoffs, and the general sentiment towards growing companies has changed dramatically.

“Venture capital firms would have warned their founders about the current environment. And with the high-growth Nasdaq well in bearish territory and interest rates rising, comparable sets for energy-intensive startups suddenly indicate that a reset valuations is justified.”

Venture capital funds plummet in 2022

What does this mean for partners and investors? That will depend on the global financial environment going forward, but PitchBook thinks preliminary data suggests the portfolio pain has begun.

Some numbers: 68.1% of reporting venture capital funds saw their TVPI (total value payable, the value of investments plus the value of all distributions) fall from 2021 highs. median drop is -7.8%, the lowest rating since the 2008 financial crisis.

On average, 62.1% of quarterly returns during the pandemic (from Q2 2020 to Q3 2021) come from unrealized value – value that exists only in paper form, which by definition risks not materializing if the ratings assigned to holdings turn out to be overly optimistic. PitchBook calculated that the total unrealized value of venture capital funds was over $1.4 trillion.

This means that a significant and sustained drop in valuation multiples could cause billions of dollars in portfolios to be lost. Nor does a recession and a wave of large-scale bankruptcies have to occur for value to be destroyed; interest rate normalization leading to a new discount rate regime might be enough to trigger this on its own.

Startup ratings reset

It is more difficult to predict how much venture capital funds will lose due to a possible recession. Small businesses will brace for a storm with existing capital, and deals could become more investor-friendly rather than favoring start-ups – for the first time since the start of 2020.

But, in the report, Carmean notes that if current expectations are too pessimistic, stabilization and a return to growth could come sooner than many fear.

“Our view is that a recession in the United States is still relatively unlikely, although tail risks are undoubtedly present and concerns are growing,” he said.

There is still a significant gap between the demand for labor and the supply of available workers, despite announcements of layoffs, and if the Fed detects signs of slowing inflation, it could ease measures.

“Markets are already pricing in aggressive interest rate hikes for the remainder of 2022, so actual rate hikes at or below those expectations could help stabilize asset prices going forward.

“Once the macroeconomic and geopolitical headwinds pass, there is no doubt that VC will be able to mend its wings and get back on the road.”

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