As public markets experience continued weakness due to concern around rising interest rates, inflation, and ongoing geopolitical tensions, we are increasingly hearing from advisors asking for what this may mean for private markets, and the $2 trillion venture capital market.1
The illiquidity of these strategies is a feature of the asset class that generally means positions are only marked-to-market monthly or quarterly, meaning impacts on valuation are typically delayed. That said, we can look to elements such as fundraising and valuations to visualize the potential impact and potential opportunity.
Not All Venture Stages Are Created Equal
A recent venture capital valuation report from Pitchbook2 noted that during the first quarter of 2022, deal sizes and valuations remained relatively constant across all stages – angel-, early- and late-stage ventures. However, the report noted that pre-money valuations for late-stage companies declined in the first quarter relative to 2021 but remained higher than 2020. The typical rationale is that late-stage companies are closer to the public markets and are therefore impacted more by their movements and the movement in the broader economic landscape.3
Ginger Chambless, Head of Research for JPMorgan Chase Commercial Bank, recently noted that despite the distance from the public markets, while early-stage companies have been insulated by valuation declines, there has historically been a one-to two-quarter lag between public market corrections and corrections in private markets. Therefore, one could assume that if we continue to experience public market weakness, we could expect to see valuations soften across all stages of the venture capital lifecycle.
Can Dry Powder Snuff Out Weakness?
Given the record fundraising in 2021 across private markets and within venture specifically,4 Preqin estimates that as of May 2022, there is an estimated $308.3 billion in dry powder in venture capital waiting to be deployed. This dry powder must be deployed by General Partners (GPs) over the investment period for the funds, which can be 1 to 3 years, giving venture firms ready access to a source of capital to extend their runways. Additionally, companies can reduce their cash burn giving them an additional source of capital to use to weather the current market environment.
There are two potential opportunities from weakness in venture capital valuations, both of which may reward patient capital and investors take this opportunity to deploy capital into weakness – more favorable terms and a resetting of expectations.
Firstly, it may allow investment into companies at more favorable terms. Beyond investments in companies at lower valuations, investors can take advantage of more favorable capital structures, such as payment-in-kind dividends and liquidity preferences.
Additionally, it may also reset the expectations of both start-up founders and asset managers. If early-round valuations are too high, it might be exceedingly hard to meet milestones, and therefore to close future funding rounds, where incremental value is typically logged – think successive Series closures at higher pre-money valuations. A wholesale reset of expectations may relieve the pressure of achieving ever-increasing milestones, and therefore valuations.
To conclude, venture capital is not immune to the broader market weakness despite its infrequent marks. The delayed impact of lower valuations on the back of risk-off sentiment may impact venture markets should the current market conditions continue. If they do, there is the potential for investors to benefit from investing in venture capital at more favorable terms and at a reset level of expectations following a period of rationalization, both of which may provide a differentiated return experience from a full market cycle exposure to venture capital.