For a decade, the venture space had been on a steady upward march, and by 2021 the venture capital carousel was rotating at full speed. Deal count reached a record high of 18,521 (39% higher than in 2020), total deal value hit an unprecedented $344.7B (an astonishing 101% increase YoY), and VC-backed exit values skyrocketed to $753B (an absurd 131% increase YoY).
Then came 2022.
Fast forward 12 months and the merry-go-round has not only ground to a halt, but for some parts of the venture ecosystem, the horses flew off the platform. The 2022 deal count was down 14%. Deal value dropped 30%. U.S. VC exit activity was valued at just $71.4B, down an astonishing 90% YoY. Indeed, Q4 2022 was the least active quarter in the last ten years.
What caused such a dramatic shift?
It’s no secret that in a low interest rate environment, venture capital and private equity are magnets for investors seeking yield. LPs pumping money into an ecosystem with a finite number of founders naturally drives up valuations. This has been one of the dominant storylines of the last decade.
As interest rates increase, however, so does the discount rate used to model future value. This means a company’s future value is worth less than it is now, lowering the valuation at which an investor can enter to meet their return expectations. Increasing interest rates also make it harder and more expensive for companies to obtain debt capital, reducing non-equity financing options for companies that would have sought relatively cheaper venture debt in previous years. In 2022, the Federal Reserve raised interest rates an unprecedented seven times.
2022 was also the first time there has been a year-over-year decrease in nontraditional investors being active in the venture space, further contributing to a decline in startup valuations as non-traditional investors have often been the high-bidder in startup fundraising. There was ust $24.1 billion in deal value involving nontraditional investors in Q4 2022—the lowest quarterly value in three years.
Within the venture community, we have observed several traditional venture participants comment that the “tourists” have left the space. While many traditional venture investors seem to welcome this thinning of the LP playing field, it’s an indication that there will be less overall capital flowing into the venture space for the foreseeable future.
Meanwhile, public exits of VC-backed companies fell to just 14 public listings in Q4 2022, demonstrating how drastically even public market investor appetite for venture has been affected.
But perhaps all of this is slowing just a return to some kind of “normal,” no matter how sharp a decline it may seem.
As Crunchbase reported, “This decline can be read as a simple correction following an irrationally exuberant year. For a whole host of reasons—pent-up pandemic demand, low interest rates, a historic public tech bull market—2021 might have been a funding outlier. Plus, despite the unprecedented contraction, 2022 was still the second-best year for startup funding in the last decade. Investors spent $100 billion, or 29% more in 2022 than they did in 2020.”
Venture isn’t alone
This decline in VC activity is no exception. Zooming further out, it is clear that 2022 was a challenging year for many asset classes. A land war in Europe, spiraling inflation, an aggressive rise of interest rates, and the ongoing geopolitical and supply chain aftereffects of COVID-19 saw many asset classes stress-tested. The S&P 500 closed the year down 19% (only the third annual decline since the 2008 financial crisis), the Dow Jones U.S. Real Estate Index suffered a 28% decline, and the Dow Jones Commodity Index made a modest gain of 11% on the year. Although the markets were choppy for most asset classes, venture took a particularly hard hit given its exposure to high growth, unprofitable companies whose public valuations dropped 50-80%. Companies like Stich Fix, Robinhood, and Peleton–former IPO darlings–all tumbled precipitously in early 2022.
Will VC dealmaking pick back up?
Despite all the headwinds, Q3 2022 finished with VCs sitting on $586B in dry powder, a new record. Our conversations with VCs and startup founders suggest that the core issue is that the two sides just can’t agree on terms. VCs, looking at public market comps and wary of looking profligate to their LPs, refuse to give founders the valuations they are looking for. In turn, founders are holding out to try and avoid taking capital in a down round, which can be particularly painful for existing shareholders.
This standoff can’t last forever, though. VCs have finite investment windows in which they are expected to deploy their capital, and startup founders have finite runways where they will either need to raise more capital, get profitable, get acquired, or shut down. The longer this drags on, the more likely these two groups will come to the table and get deals done. While specific timelines vary, generally, startup runways (even with near-universal runway-extending layoffs) are shorter than VC investment windows, so we expect many more down rounds to happen as the year progresses.
As interest rates increase, LPs look for opportunities outside of venture
Over the past decade, one of the key factors driving LPs to invest in venture has been its relatively attractive yields compared to more traditional asset classes. The axiom of “only the top decile of VC firms perform well” was replaced by strong performance across the asset class, driven in part by the steady upward march of valuations due to near-zero interest rates. At first glance, 2022 looks like a continuation of that trend. As the latest Pitchbook-NVCA Venture Monitor reported, the headline number of $163B, 6% over 2021, made 2022 the best year in terms of total capital raised by venture funds, even with all the volatility, uncertainty, and general slowdown.
Digging in a little deeper presents an alternative perspective. As often is the case in the private markets, the slowdown of capital flowing into venture lagged behind the dip in the public markets. If we look at Q4 2022 alone, only $11.7BN (7.2% of the yearly total) was raised. Simply put, capital is no longer freely moving into venture capital funds. The steady and steep rise of interest rates throughout 2022 means there are now far more places LPs can deploy capital to meet their return target goals without accepting the volatility inherent in investing in unpredictable, unprofitable companies.
What’s going on with VC funds?
Looking at where the capital is going, it is not good news for first-time managers. In 2021, a record-setting 270 first-time funds raised a collective $16.8 billion, according to PitchBook data. 2022 saw only 141 first-time fund managers successfully close a VC fund, a 9-year low.
In spite of everything, there were still some bright spots in 2022. The average first-time fund size in 2022 was a record-high $75MM. To us, this suggests that the few first-time funds that did close successfully are likely managed by well-weathered GPs coming out of established shops to launch their own fund rather than traditional unknown, first-time VC managers raising smaller “proof of concept” first funds.
This trend of larger funds goes beyond first funds. The record $163B raised across the ecosystem in 2022 was done so by only 769 funds, putting the average fund size at $211MM, a 74% increase over 2021. Despite the risk, LPs are still deploying capital with either existing fund groups launching a follow-on fund or with first-time managers who can demonstrate a strong track record.
If the last few years have taught us anything, it is that predicting the macroeconomic environment to come is a fool’s errand. What we know is that the venture capital universe is facing truly choppy waters for the first time in a decade. The formerly reliable narrative of a first-time fund manager getting fast mark-ups and progressing to larger funds within just a few years may be the exception rather than the rule for the time being.
However, in our conversations with venture GPs, there is an increasing sense of stability. Macro indicators are overall flat or improving, and, relative to the last few months of 2022, we’ve seen a higher pace of venture managers successfully completing their fundraises in January 2023. It’s too soon to call a bottom on these trends, but absent future shocks, we expect activity to begin to rise slowly in the early part of this year. Managers who held off on fundraising late last year still have low dry powder and cannot wait to go to market. In other cases, GPs held off on fundraising to focus on stabilizing their portfolios or finding graceful exits for their more challenged companies. We suspect these processes should abate over the coming months.
No one has a crystal ball, and the will-we-won’t-we threat of recession still looms. However, we have hope for and believe in the continued long-term value of the venture space. Those who were in the industry through past cycles know what the returns of funds birthed in challenging vintages can be. There are more high-quality companies now than in any past pull-back, and these companies will increasingly be available to invest in at much more reasonable valuations. For the venture manager committed to overcommunicating with their LPs, professionalizing their operations, and marketing a clear story to new potential investors, 2023 has the potential to be a career-making year.