Will 2023 shape up to be a strong vintage for the venture capital industry?
The post-financial crisis boom years have been a mixed blessing for the private markets sector. Assets under management have soared as capital has flooded in, drawn by impressive returns (global VC funds with a 2009-2019 vintage delivered a median net IRR of 22.7%) made more attractive when compared with traditional 60/40 public market portfolios.
But success has brought its own challenges. With interest rates at rock bottom and ever more money chasing deals, valuations had become dangerously stretched.
That is now changing.
A cooling environment
As Providence Equity Partners Senior Managing Director Davis Noell observed in Private Equity Wire’s Global Outlook 2023 report: “The heated auctions with constantly increasing valuations in 2021 gave way to a dearth of new deal opportunities and a reset on price expectations in 2022. This also drove some multiple contraction in the private markets, albeit not to the same extent as the public markets.”
Higher interest rates have led to lower valuations for risk assets across the board, noted Preqin’s 2023 Global Venture Capital report. According to Preqin, venture capital is among the asset classes most exposed to the current market turmoil, with a challenging near-term outlook, especially for funds that deployed a significant amount of capital in 2020 and 2021. “Valuation multiples are now going through a difficult adjustment period as investors reset what they are prepared to pay for riskier companies in this macroeconomic environment.”
Given private market valuation adjustments typically lag those in public markets by nine months or more, further valuation pressure is likely over the coming months.
2023 reset opportunities
The prospect, warns the Preqin report, is for a slowdown in global venture capital performance and fundraising over the next five years – although the sector is expected to see higher longer-term performance compared with other asset classes. “Once interest rates have normalized and valuations have adjusted, it may prove a very promising time for investors to allocate to the asset class,” it added.
Preqin reckoned the coming year in particular may turn into a very attractive vintage over the longer term. “Entry valuations have already come down significantly and competition for deals has softened as more investors hold off on capital deployment,” it said.
That view is echoed in the Private Equity Wire Outlook report by Keirsten Lawton, Co-Head US Private Equity Research with Cambridge Associates. Recession-era vintages, invested at more moderate valuations, “have historically outperformed growth expectations and achieved multiple expansion at exit,” she noted. “So, while today’s environment could hurt current portfolios, the 2023 vintage could benefit from the valuation reset.”
Powder at the ready
And many VC funds are well-positioned to take advantage.
PitchBook data indicates that, as of the end of Q3 2022, global venture firms were sitting on $585.5 billion of capital raised but not allocated, making VC the only private investment strategy on course to see its dry powder rise from 2021 levels.
Fundraising remained resilient during 2022, with global venture firms raking in $223.6 billion through Q3, according to PitchBook. Meanwhile, the pace of investment has slowed considerably. “Venture firms have become more selective about which companies they want to invest in amid last year’s market turbulence and falling tech valuations,” said PitchBook Senior VC Analyst Kyle Stanford.
After the frenzied dealmaking of recent years, that caution makes sense – provided it doesn’t swing too far. Valuations have come down, and while interest rates continue to tighten, many economic fundamentals are starting to stabilise.
VC funds have capital to deploy. And investing during times of market stress are when the biggest returns are often made. The challenge for venture firms will be to identify assets that offer true opportunities. And for investors to pick those funds and investment strategies that can perform best in this shifting environment.
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