In early February 2022, I moved back to the Bay Area, biting the Omicron bullet. In retrospect, it paled in comparison to what happened afterward: ventures fell to pieces, Ukraine was invaded, and the biggest war Europe has seen since 1945 commenced, FTX was revealed as a fraud, and SBF followed Elizabeth Holmes’ footsteps dangerously closely. Oh, and let’s not forget Musk’s Twitter takeover alongside Tesla’s valuation falling back into the atmosphere.
Amidst all this catastrophe, VC investments and valuations plummeted — and that is precisely why 2023 is bound to be another record-breaking year.
VC is sitting on a record amount of dry powder…still.
The fuel to generate future deals continues to be robust. U.S. venture capital fundraising has set a new annual high through only three quarters of 2022. U.S.-based VC funds alone have raised $150.9 billion, surpassing 2021’s previous record, taking the 21-month fundraising total above $298.1 billion.
2022 saw consistently lackluster deployment.
Deal activity across all segments of venture continued to decline in Q3. Some would argue that 2021 was an outlier year; in other words, a one-time spike. But that couldn’t possibly be true since there were ample bullets left to be fired — and in a shorter time frame.
$$$$$ + A lack of deployment = inevitable sharp deployment
It’s not a simple formula. There is a lot of fresh money lying around alongside an undeniable lack of investment activities. As a result, we are waiting for an onslaught of investments to happen.
VC also cannot be infinitely “patient.” Sure, it’s easy to justify withholding investment for a while, but GPs typically charge fees based on commitment, not deployment. LPs are going to start dialing up the pressure and asking GPs to justify their fees.
Eventually, GPs will be left with no choice but to deploy. The question remains not if but when.
There’s the ideal world, and there’s reality.
Ideally, VC — and, by extension, founders — would prefer the public market recovers (or at least show a strong indication of recovery) before fully deploying again. No one wants to raise at a depressed valuation if they can avoid it.
This hinges upon The Fed slowing down interest rate hikes. As much posturing as Powell has done, the market seems to believe that rate hikes will soon come to an end, and as depressed as the equity market has been, the market is still overpricing equity based on where the raise is today. There is a lot of positive sentiment that the market will soon return, and everyone seems to be simply waiting for the time to strike. Generally speaking, there doesn’t seem to be much concern about the underlying economic fundamentals as rate hikes continue.
Given that December only hiked at 50 bps, there is a somewhat positive outlook. I don’t believe this to be a strong enough time to put the market on the cusp of turning — at least not enough for VC to start pouring without restraint.
What is more likely to happen is that VC will use the new year as a mental excuse to be “different” and press an imaginary “reset” button — not unlike the sudden spike in gym memberships that happens at the start of every new year. The latest 50 bps hikes have already served as a sufficient excuse for VC funds to “hedge” and start looking at deals again, as opposed to simply focusing on current portfolio companies. Come January, and through Q1, I expect to see VCs beginning to go back into the market again without deploying.
Come late Q1/early Q2, I believe rates will begin to stabilize as the Fed faces unrelenting and increasing pressure to “soft-land.” As inflation begins to ease (and even if employment and wages do not), politics will make it increasingly difficult to continue raising rates at the same pace as in 2022.
Now, when it comes to the public equity market, the actual hike does not matter. Instead, the key player is what the public expects the hikes will be. Based on 2022 sentiments, it is impossible to think the Fed would be able to persuade the public about its hawkish attitude as it is forced to hike more slowly and/or at a lower amount. This is likely to happen sometime in Q2…and therein lies the eventual turning point for VC.
Q2 deals will walk so Q3 deals can run.
All indicators point to Q3 being a summer in which VCs can either take their vacations and miss out entirely or get to work and make things happen. Early conversations in Q1 will likely turn into dealmaking in Q2, prompted by a sentiment of slowed hikes which should start to push public equity (and valuation multiples) up.
Q3 is when we expect the floodgates to open, prompting deja vu as we relive a different kind of 2021.
RIP growth at all costs and the business models that rely on it.
To be clear, there is no expectation that deals will be done in the same fashion as they were in 2021. Wherever the rate hikes end, there’s no decrease or lessening that will happen. Rates are going to plateau and stay at that level for several years to come — or at least that will be an operating assumption of most VCs and entrepreneurs. This means we can safely assume that business models that rely on cheap money will struggle to raise, let alone do well.
Businesses that show great operating margins and the ability to become profitable quickly are more likely to do well. This includes the likes of robotics companies that have won large enterprise contracts, require minimum customer acquisition costs, and benefit from a tight labor market; medical technology companies who have a quick path to FDA approval and readily available reimbursement codes; and climate tech companies with both cost parity and performance. Political and legislative tailwinds, such as the Inflation Reduction Act, will only serve to help these companies prosper.
There is no reason to doubt 2023 will be a mega year for venture capital. What grows out of it, however, will be companies that suit the current and foreseeable economic condition — one that is unlike the last 14 years since the Great Financial Crisis.
The VC who found ways to invest in those companies, and those companies themselves, will be the ones to come out on top.
