As interest rates rise will there be continued interest in deep tech investing?

upward moving arrow over person wearing glasses and numbers

The fed continues to slowly increase interest rates; with the federal funds ticking by another quarter of a point. And while this seems small in comparison to historical interest rates, it could portend a broader shift of capital away from riskier assets.

2021 was a banner year for private markets. More deals were done at higher valuations, and more capital was poured into more funds.

It’s worth keeping in mind that there is always a tradeoff between risk and return. The zero percent interest rate policy of the past few years has only served to incentivize investors to step out far on the yield curve and chase riskier assents, targeting their desired returns. One such asset class is venture capital.

For institutional investors, pension funds and endowments bring with them liabilities in the form of fixed payments. Those liabilities are generally more expensive to service when interest rates go down. This is because current assets will not appreciate as much overtime while obligations will remain constant. 

Simply put, present value goes down. It isn’t just a financial thing.

So what’s the point?

To draw an overly simplistic example regarding asset allocation, consider this:

In an ideal world, you would use fixed assets to hit fixed obligations. When that’s not a possibility, your attention turns to things that are mismatched in time frame, characteristics, etc. For example, if you need to pay 5% per year but your bonds/fixed income earners are at 1% return, you’ll start going for stuff that is much further out on the risk curve—such as 7-10% just to try to sustain volatility, and hit your 5% target, etc. 

If it’s very mismatched, you’ll need to have a lot more return to also make sure you hit that 5% since, rain or shine, you are obligated to pay that 5% – since these are, after all, your “obligations”. It doesn’t matter if returns in your portfolio were awful that year or not. 

This is partially what has led to an influx of funding in private equity and venture capital as an asset class. However, this phenomenon will be on the decline if interest rates continue to rise, making fixed assets more preferable again.

What impact does this have on early-stage startup financing? 

It’s important to keep in mind is that money raised by VC funds doesn’t just dry up. Firms that raised funds in 2021 will have capital to deploy, and we are seeing evidence (both data and anecdotal) evidence suggesting the high valuations that we saw in 2021 across many sectors are coming back down to Earth. This is most visible right now in the later stages of private financings.

On one hand, there is an argument suggesting that the fundraising environment for venture may begin to contract going forwards, mostly because there will be a decreasing need to chase the risk premium. 

Counter to this, however, there are several reasons to support continued investment growth in the VC/PE asset class: investors may less bullish on real returns in equities, performance in VC/PE has been strong – and persistent – for top performers, there’s an ongoing need to diversify with a largely uncorrelated asset class. On top of all this, sheer institutional inertia makes it hard to pull back. 

Making predictions is hard…

…especially about the future, as the saying goes. Making economic forecasts or predicting the future isn’t something we’re interested in doing. We do, however, remain optimistic about technological developments and their ability to address societal problems.

Furthermore, deep tech investing is here to stay. Many of the problems that deep tech companies are addressing, and especially the ones that we are focused on, are not simply going away. In fact, many of the core structural issues that we are facing as a society – such as rising labor and healthcare costs, and the effects of climate change – have become even more significant in the current environment.

So if you’re a founder building a company, it’s good be aware of the macro environment, and in particular its impacts on fundraising and the availability of capital. Yes forecasts are fallible, but that doesn’t mean they should be ignored. The important thing is to balance them with the ever-ongoing needs of hiring, building, selling, and financing the business.

Regardless of what the future holds, we remain committed to supporting innovation and the long-term economic growth and opportunity that it brings. 

**Thanks to James Wang for the helpful discussion on this post.

Leave a Reply