How low will high-flying tech investors fall?
The free money is gone. Yesterday’s valuations are a fiction. The markets have sold out the companies of the future.
That’s the assessment many tech investors have made in an uncoordinated information campaign of presentations, video calls and blog posts aimed at portfolio companies. What played less of a role were the sober prospects of their own results.
In recent years, venture capital funds have had a phenomenal run. The asset class has recorded an IRR of 30.5% over the past three years, according to the last numbers.
Many of these gains were only on paper, a fact that will become evident as corporate valuations decline. Fund returns for the first quarter are starting to kick in, and they’re ugly.
Venture capitalists, who have inflated valuations in line with euphoric public markets, may have some explaining to do.
“Since the dot-com reset, we haven’t seen such aggressive behavior in portfolio margins,” said PitchBook analyst Zane Carmean. “Something in the mindset has changed, which has given venture capitalists the confidence to give hyper-optimistic numbers.”
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The increase in the size of funds in recent years has created piles of cash that have prompted increases in the size and prices of checks. These extra-large funds remain in vogue: the majority of venture capital fundraising this year has been committed to vehicles over $1 billion, and increases from previous funds are at industry highs. decade.
Ultimately, however, tech fund managers have a ready defense for LPs who may wonder where those markups went. Fleeting gains were reasonable when real interest rates were negative and public markets were hungry for growth companies.
Not anymore. Venture capital-backed IPOs are down 54% this year, underperforming the Nasdaq and even lagging companies that merged with SPACs, according to our index.
Which mark should mark down
About half of the performance reported by venture capitalists in 2021 has not been achieved. Markdowns are happening, and the handful of funds that reported for the first quarter demonstrate how quickly gains can be wiped out.
Things will get worse before they get better, as no one knows how far valuations will fall from recent highs. Our data shows a decrease in the prevalence of down cycles in recent months – faced with the prospect of falling valuations, companies are avoiding raising new cycles altogether.
The ability of the public market to quickly lose value is in some ways a blessing. Private markets have to bear the pain of falling prices over the months.
The common thread of the sale is to devalue future cash flows. This means that any company that spends more than it earns deserves a haircut. And unlike previous crises, there will be no help from above, as fiscal stimulus would be unthinkable until inflation is under control.
A ruthless stock market means late-stage tech companies will need funding from cross-investors who support both public and private companies. But these investors may be more difficult to attract, given the relative bargains in the public markets. And tourism investors’ commitment to venture capital will face a real loyalty test for the first time in more than a decade.
Corporate mergers and acquisitions can also be a tough sell, as depressed stock prices reduce their purchasing power. This leaves buyout firms, who have their own portfolio to manage, and an interest rate perspective that makes debt-fueled transactions are riskier.
The limits of partners
The relationship between LPs and GPs will soon be tested.
Since 2018, more money has flowed into private funds than has flowed out. This left LPs feeling overwhelmed with commitments to alternative assets, and to venture in particular.
Venture capital accounted for almost a third of all capital closed in the first quarter, according to preliminary data. When distributions increased last year, it appeared that LPs were justified in chasing the returns of venture capital.
LPs try to keep a target percentage of their portfolio allocated to different asset classes. The stock market correction triggered what is known as the denominator effect, causing the value of private assets to represent more than their fair share of the portfolio.
GPs will face a tougher fundraising environment as well as difficult questions about the value they bring and the logic of their performance metrics.
To save face, VCs are encouraged to delay markdowns as much as possible. But ultimately, companies have to raise money, and their shrunken valuations can no longer be denied.
Fundraising will be more difficult for underperformers and emerging managers with no track record. Already, the disparity in closing times is widening between those who can raise funds quickly and those who cannot.
The venture capital ecosystem as a whole has north of 500 billion dollars in dry powder it will help him through the bad times. He will need it.
Featured image by Drew Sanders/PitchBook News