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Posted Oct 11, 2022

The state of venture capital - Q3 update

Eugene Tetlow

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It would be an understatement to say that 2022 has been an eventful year for the global financial markets. The S&P 500 traded at $4,796 on the opening day of the year. By the end of the third quarter, the index was trading at $3,585, a drop of 25%. The average monthly U.S inflation rate through August was 8.3% (see chart), the highest by some margin since 1981, and global inflation is in double digits for the first time since the early 80’s. As a direct response to this, interest rates in the U.S. are increasing at their fastest rate in over 40 years. The U.S. Dollar Index (USDZ) is currently at its highest level since 2002 and the dominance of the U.S. dollar has seen the Great British Pound (GBP) fall to historical lows against the dollar. In Europe, the first land war since World War II is wreaking havoc both on diplomatic relationships and via an ongoing energy crisis. Finally, the supply chain issues remain. Add all this together and we find ourselves in unprecedented waters.

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With this backdrop, it’s hard to predict the long-term effect in venture capital. What we can do is analyze the flow of money in the venture ecosystem to get an idea of investor sentiment and the health of the space. We have identified the below metrics to analyze the state of venture capital at the end of Q3.

2022 Fundraising

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In our July article, reviewing the health of the venture capital space through the first two quarters of the year, we observed that 2022 was on track to become a record year in terms of dollars raised. Although the rate of which money is moving into venture capital has slowed down (only 19% of the $150.9bn raised in the first three quarters was raised in Q3), 2022 will officially be the record year for venture capital with the 2021 figure now officially surpassed.

Q3 has also seen some good news for smaller managers. In 2021, the average venture capital fund size was $129.2M. In the first two quarters of 2022, the average fund size was over double this amount at $292.8M. In essence, more money was flowing into fewer funds which was bad news for newer and smaller managers. Q3 saw a slight reversion to the mean with the average size of a venture capital fund in 2022 down to $254M. One potential reading of this is that investors are redeploying capital into smaller funds aiming to take advantage of niche parts of the investment universe.

Deal Count

The third quarter of 2022 saw an estimated deal count of 4,074 deals, the lowest deal count since Q4 of 2020 and 20% lower than the record deal quarter of Q1 2022, but not nearly as low as many feared. The total deal value in Q3 was $43bn, less than half of the deal value from Q3 2021 and the lowest since the second quarter of 2020. As we address below, although these numbers are trending in the wrong direction, they have potential positive implications for 2023 and beyond.

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Dry Powder & 2023

The lack of deal activity has increased the already record-high Dry Powder levels. At the end of Q2, Dry Powder was estimated to be at $290B, of which Jon Sakoda, founder of early-stage venture firm, Decibel Partners, estimates $163 billion is reserved specifically for new investments. Combine this with the current low valuations and the fact that the investment cycle of many funds expires in 2023, and arguably Q4 of 2022 is a great time to be investing in venture capital. Indeed, as in previous downturns, funds that are able to invest smartly whilst valuations are low can reasonably expect to benefit from outsized returns. This puts the targets of venture capital funds in an interesting position. As dry powder begins to be deployed, valuations can reasonably be expected to increase. If companies are able to hold on until 2023, they are likely to benefit from higher valuations.

Summary

Although the venture capital space has certainly not been immune from larger macro conditions, the continued flow of capital into the space indicates that the long-term health remains positive. Many successful companies have started in downturns and venture capital funds have benefited from investing in these companies during times of low valuations. Although we are still in a time of uncertainty in global markets, the venture capital space continues to be an attractive asset class for investors chasing long-term returns.

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