How far will high-flying tech investors fall?
That’s the assessment many tech investors have made in an uncoordinated information campaign comprised of decks, video calls and blog posts aimed at portfolio companies. What has gotten less play is the sober outlook for their own bottom lines.
In recent years, venture capital funds have enjoyed a phenomenal run. The asset class recorded an IRR of 30.5% over the past three years, according to the latest figures.
Many of those gains were on paper only, a fact that will become obvious as company valuations are marked back down. Fund returns for the first quarter are starting to trickle in, and they’re ugly.
Venture firms, which pumped up 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 markups,” said PitchBook analyst Zane Carmean. “Something in the mindset shifted that gave VC firms confidence to give hyper-optimistic numbers.”
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Ballooning fund sizes in recent years created piles of money that lent an incentive to bid up check sizes and prices. These extra-large funds remain in vogue: The majority of VC fundraising this year has been committed to $1 billion-plus vehicles, and step-ups relative to prior funds are at decade highs.
Ultimately, though, tech fund managers have a ready defense for LPs who may wonder where those markups went. The ephemeral gains were reasonable when real interest rates were negative and public markets were ravenous for growth companies.
No longer. VC-backed IPOs are down 54% this year, underperforming the Nasdaq and even trailing companies that merged with SPACs, our index shows.
What marks up must mark down
About half of the performance reported by VC firms in 2021 was unrealized. Markdowns are now happening, and the handful of funds that have reported for Q1 are demonstrating how quickly gains can be gutted.
The picture will get worse before it gets better, since nobody knows how low valuations will go from recent highs. Our data shows a decrease in the prevalence of down rounds in recent months—faced with the prospect of a valuation decline, companies are avoiding raising new rounds altogether.
The public market’s ability to shed value quickly is in some ways a blessing. Private markets must bear the pain of falling prices over the course of months.
The common thread in the sell-off is to devalue future cash flows. That means any company that spends more than it earns deserves a haircut. And unlike prior crises, there will be no help from on high, as fiscal stimulus would be unthinkable until inflation is under control.
An unforgiving stock market means that late-stage tech companies will be in need of funding from crossover investors that back both public and private companies. But these investors may be more difficult to attract, given relative bargains in the public markets. And tourist investors’ dedication to VC will face a true test of loyalty for the first time in more than a decade.
Corporate M&A may also be a tough sell as depressed stock prices reduce their buying power. That leaves buyout firms, which have their own portfolio pain to deal with, and an interest rate outlook that makes debt-fueled deals more risky.
The limits of partners
The relationship between LPs and GPs will soon be tested.
Since 2018, more money has gone into private funds than come out of them. This has left LPs feeling overwhelmed with commitments to alternative assets, and venture in particular.
VC accounted for nearly a third of all capital closed in Q1, preliminary data shows. When distributions spiked last year, it appeared that LPs were justified in chasing VC returns.
LPs try to keep a target percentage of their portfolio allocated to various asset classes. The stock market correction has triggered the so-called denominator effect, causing the value of private holdings to account for 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 have an incentive to delay markdowns as much as possible. But eventually companies must raise money, and their lowered valuations can no longer be denied.
Fundraising will be hardest for underperformers and emerging managers that lack a track record. Already, the disparity of time to close is widening between those who can raise funds quickly and those who can’t.
The venture ecosystem overall has north of $500 billion in dry powder that will help it roll through the bad times. It’ll need it.
Featured image by Drew Sanders/PitchBook News
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