Back to Earth: Are Venture Capital’s Rockets Stalling?

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It’s hard to start any article this year without mentioning the raft of punches that global markets have had to endure. Growth stocks have tumbled, central banks are scrambling to get inflation under control, and all-round pessimism has put a damper on sentiment.

Just look at our five biggest funds, for example. All of the strategies featured in that analysis have seen negative returns overall this year. And people are fleeing most markets; investors withdrew over £4.3 billion from UK funds last month, and there could be more upsets ahead.

The few companies that have done well lately have been comfortably sat on the value side of stock markets. So how much of a hit have growth stocks really taken – and, for clarity, how are the smaller, unlisted companies faring? Morningstar PitchBook has the answers.

In a report, PitchBook has taken what it calls a “way-too-early look” at venture capital fund returns – and it’s spotted some pretty significant turbulence.

Pandemic Growth Boom

VC funds have delivered exceptional outperformance over several quarters; in 2021, these sky-high returns attracted a fundraising record of $242.1 billion globally, and total AUM was nearing $2 trillion. Returns were the highest for venture funds since before the dot-com crash, and the pooled horizon for VC outpaced all other private fund categories.

According to Zane Carmean, quantitative research analyst at PitchBook, venture capital, or VC, looks like the most obvious target for a correction within the private fund market.

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

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“Anecdotal accounts are suggesting that VCs are tightening their belts, tech firms have commenced hiring freezes and layoffs, and overall sentiment on growth companies has materially shifted.

“Venture firms have reportedly been warning their founders of the current environment. And with the growth-heavy Nasdaq well into bear market territory and interest rates rising, the comparable sets for cash-burning startups suddenly indicate a reset in valuations is warranted.”

VC Funds’ 2022 Tumble

So what does this mean for partners and investors? This will depend on the global financial environment going forward, but PitchBook believes the preliminary data suggests the portfolio pain has started.

Some numbers: 68.1% of reporting VC funds saw their TVPI (Total Value to Paid In, the value of investments plus the value of all distributions) drop from 2021 peaks. Of these, the median decline is -7.8%, the lowest mark since the 2008 financial crisis.

On average, 62.1% of quarterly returns during the pandemic (Q2 2020 to Q3 2021) have come from unrealized values ​​– value that only exists in paper form, which by definition is at risk of not coming to fruition if the marks assigned to holdings turn out to be overly optimistic. PitchBook has calculated the total unrealized value in VC funds to be over $1.4 trillion.

This means a sizeable, sustained drop in valuation multiples could result in billions of dollars in value being wiped away from portfolios. A recession and wide-scale bankruptcy wave don’t have to take place for value to be destroyed either; interest rate normalization leading to a new regime for discount rates could be enough to trigger that on its own.

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Start-up Valuations are Resetting

How much VC funds will lose to a potential recession is tougher to predict. Small companies will be preparing to weather a storm with existing capital, and deals might become more investor-friendly rather than favoring start-ups – for the first time since early 2020.

But, in the report, Carmean notes that if current expectations are overly pessimistic, then a stabilization and return to growth may come sooner than many fears.

“Our view is that a US recession is still relatively unlikely, though tail risks are undoubtedly present and increasing worries,” he says.

There is still a meaningful gap between labor demand and available supply of workers, despite layoff announcements, and if the Fed spots any signs that inflation is slowing, they could be easing off on measures.

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

“Once macroeconomic and geopolitical headwinds are past, there is little doubt that VC will be able to repair its wings and take to the skies once more.”

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www.morningstar.co.uk

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George Holan

George Holan is chief editor at Plainsmen Post and has articles published in many notable publications in the last decade.

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