What Now, Fed? Most VC Firms In Holding Pattern

As cash-strapped startups struggle for survival, venture capital firms are still biding their time for an all-clear signal that could be days to weeks or months away. The Federal Reserve Board’s confirmation in January that inflation is slowing could be just the sign they were looking for.

“For the first half of the year, I don’t think you’re going to see many strategic changes, especially for venture capital. They are going to continue to be very mindful of their investing companies and will be paying close attention to their cash flow,” said Dean Kim, equity researcher and head of research product at the Playa Vista-based investment advisor firm William O’Neil + Co. Inc.

Kim said the Jan. 13 Consumer Price Index report showing a 6.5 percent annual increase in inflation could prove a critical inflection point for the financial sector throughout this year. The report’s finding that inflation had actually dropped over the course of a six-month rolling basis is particularly heartening, he said.

“Looking beyond six months, we should see inflation starting to come down, if not this year, then fairly soon. We’ve seen hints that it’s coming down,” said Kim. “If that happens, it’s going to be great for venture capital and private equity folks.”

The news may be a light at the end of the tunnel for distressed fintechs, spurned SPACs (special purpose acquisition companies) and declining digital currencies, but some likely won’t make the distance before significant support arrives. According to the data research website Crunchbase, global venture funding in 2022 reached $445 billion, marking a 35 percent decline from the $681 billion invested in 2021.

‘Wait and see’

David M. Grinberg, a partner at Sidley Austin LLP’s Century City office and a member of its mergers and acquisition practice, said institutional investor clients advocated for a “wait and see” approach around the end of last year. While the good news from the Fed may motivate some toward action, those funds won’t mobilize overnight.

“What’s interesting is once you take out the FAANG [Facebook, Amazon, Apple, Netflix and Google] stocks, the Teslas, the market is actually already doing well because the underlying breadth is quite strong. Everybody is looking to everybody else to make the first move. Valuations have come down – not all, but many,” said Grinberg. “If people are willing to take chances, it may soon be the time, but they’re looking at these companies over a longer period of time.”

Grinberg projected that as a middle-market capital of the world, Los Angeles industries would likely fare well overall, highlighting in particular its expanding beauty and cosmetic, transportation, aerospace, media, tech and content hubs as industries that were particularly well positioned to reap the benefits of the recovery.

Deal activity among clients remained relatively slow in the lead-up to the New Year, Grinberg said; however, by the fall of 2022 things started to pick up. But he stressed that funding arrangements take months to work out even in stable times, and only time would tell if the negotiations bear fruit or fizzle out amid more instability.

“Those deals are still going. Within a month or so, we’re likely going to see if they have legs,” said Grinberg.

Kim offered a similar take, projecting that by year’s end deal activity would be firmly in an upswing.

“People believe now that the Fed is going to back off, and that’s when we’ll see lowering rates. That’s when (venture capital) will go all out, raising additional funds the second the environment looks better.”

Strong headwinds

Still, 2023 is generally expected to be a down year for venture capital companies.

Aside from the higher interest rates and inflation, one strong headwind is the perception that a recession is likely during the year. VCs understandably may be reluctant to bankroll untested and adolescent companies in a perilous economy – in addition to an economy with those higher rates.

That implies that only exceptional companies will lure VC funding.

Mar Hershenson, the managing partner of Pear VC in Menlo Park, was quoted in Forbes last month saying, “Generally in a recession the lack of money forces people to be more creative, solve only problems that people are truly willing to pay for, and be more frugal, only spending on things that move the needle.”

Another problem: In such a trouble-laden economy, the money behind VC funds, the limited partners or LPs are expected to tighten their purse strings.

Elizabeth Clarkson, a partner in Sapphire Partners in Austin,  told Crunchbase, “I do generally expect to see increased LP churn in 2023 and potentially into 2024.

“If history is any guide looking back from the 2000 dot-com bubble bursting and the Great Recession of 2009, I think we will see a reduction in 2023 in the total number of venture funds raised, and possibly into 2024,” she added. 

“The narrative for the (venture capital) industry continues to change dramatically,” according to an Ernst & Young report in October. “Companies are now adopting a more defensive posture as entrepreneurs and investors are learning how to navigate through a vastly different landscape than what came before. Market volatility continues to persist due to inflationary pressures, rising interest rates and recessionary fears.”

At the same time, the Ernst & Young report said, it’s important to remember “that we’ve been through downturns like this before.”

One potential bright spot: there’s plenty of “dry powder” capital on the sidelines because money was raised early last year before funding of companies slowed down. Therefore, “Entrepreneurs capable of putting together compelling business models will continue to raise money,” the report said.

And despite the overall cooldown, some sectors are hot – particularly clean energy. “Two of the top five deals (last year) were in this sector, led by a $1 billion investment in an electric vehicle charging infrastructure company. Other top energy deals include sustainable nuclear and clean energy and materials.

“We are also seeing tremendous interest in climate-related technology, such as electronic vehicle charging and other green energy products,” the Ernst & Young report said. “Investors are now more willing to focus on Clean Tech 2.0 as companies address climate change and develop differentiated energy sources.”