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The end of cheap equity is the new normal for VCs
We are going through a period of stagflation which origins are manyfold:
- Structural with declining returns on innovation, fossil fuels increasing scarcity, rising demand supported by high population growth
- Transitory with production bottlenecks related to Covid,rising protectionism since 2016 affecting global trade, post-Covid fiscal stimulus packages that massively increased money supply and fueled inflation
Origins of today's high inflation
On a structural level, we are facing a challenge to our current growth model:
- The growth model based on a relatively abundant energy is being challenged by the expected decline of fossil fuels.
- At the same time, strong demographic growth is leading to a supply/demand imbalance, which, in the absence of a major technological leap, will push prices up. This is what the economist Robert J. Gordon called in 2012 the "secular stagnation", observing in particular a slowdown in the speed of technological change and in the performance of R&D.
On a transitory level, several recent events have also fueled inflation:
- The oversized nature of post-Covid stimulus packages. Faced with fears of an economic collapse during the pandemic, states put together a massive stimulus package. The Biden Stimulus Plan was $1.9trillion (a quarter of the 2019 US GDP). During the crisis, other support measures from the Oval Office also led to an increase in household income of 6% in 2020! The EU plan was less ambitious in size (750 billion euros) but was nonetheless historic because it was not funded with existing budgets but from a common debt, thus constituting a "Hamiltonian moment" for many commentators, i.e., the beginning of European fiscal federalism. In any case,these fiscal stimulus packages have poured new liquidity into the economies of developed countries, lowering the perceived value of the currency.
- The protectionist push since 2016 let to a globalization slowdown. The election of Trump has indeed initiated a return to increased tariffs in the US, particularly on steel, against a backdrop of Sino-US competition. These measures were not entirely revised by Biden when he took office. In 2022, 1443 restrictive measures were taken in international trade, compared with only 385 liberalization measures.
- The war in Ukraine has increased energy prices, especially in Europe. By 2021, Russia was supplying 40% of European gas. Increasing tensions and international sanctions led Russia to tighten its fossil fuel supply for Europe which increased energy prices in the EU, especially in the most exposed countries like Germany.
- Bottlenecks in production chains. The covid crisis has disrupted production and distribution chains. For example, the so-called “zero covid” policy in China has resulted in a demobilization of the workforce and in supply challenges.
Increasing interest rates to contain inflation
This situation offers policy makers mostly one solution, which is to slow aggregate demand by raising interest rates to contain inflation.
The world's major central banks have embarked on a policy of successive rate hikes to dry up excessive liquidity. The Fed announced 3 successive rate hikes to reach the highest historical rate since the 1980s, setting it between 3% and 3.25%. The Bank of England has set its rates at 2.25% (situation in September 2022) in an attempt to curb the consumer price index, which in August 2022 stood at 9.9%. The situation in the Eurozone is more complex, and the ECB has been more cautious because of the risk of an "asymmetric shock", i.e., a sudden rise in rates could jeopardize the sustainability of the debt of southern countries, which increased steeply during the crisis. Inflationary pressure also affects EU member states in very different ways. In August 2022, it reached 10.5% in Spain, compared with 5.9% in France. At the Eurozone level, inflation reached 9.1%. This situation was therefore unsustainable and led the ECB to increase its rates despite the threats on the level of public debt. From -0.5% to 0% in July, bank deposit rates have risen to 0.75% in September 2022.
The policy of raising rates is cleaning up the corporate population. In recent years, the zero-interest rate policy of central banks has kept the cost of capital low, which has encouraged companies to take on debt and artificially maintained "zombie firms" alive. They were able to increase their debt because of abundant international savings and the low yields offered on other asset classes (e.g., sovereign bonds). Investors therefore pushed the spotlight onto speculative grade debt or venture capital, which offered more attractive yield prospects. Now, rising interest rates make investing in other asset classes more attractive and increase the level of demand on venture capital firms, which are being asked to be more scrupulous in their investments.
As a result, the dry powder (i.e., money raised by VCs and not yet deployed) of LBO and VC funds has reached historical highs over the last decade. Dry powder reached $826 billion in 2022 in VC, completing a historically high growth trend.
At the same time, the rise of interest rates had an impact on listed tech companies. For example, the NDXT (an index of the 100 largest tech companies) got slashed compared to November 2022. The same downward trends can be observed for the 25 largest listed tech SPACs which on average lost 56% of their value since January 2022 and the Nasdaq lost about a quarter of its value in H1 2022.
Venture Capital funds are forced to increase their level of stringency in their fund allocation criteria. In VC, the issue of profitability wasn’t a primary concern for companies in growth phase. It came second, behind organic growth and the scalability of business models (i.e., global reach and ability to scale at zero marginal cost due to the prevalence of intangible assets). This is no longer the case and funds now either demand a return to profitability or focus their search on the best managed and fastest growing companies ("fly to quality").
The dry powder inherited from this period of low interest rates remains historically high but should be allocated much more severely in the coming years.
The transmission effect from the equity market to private equity came from cross-over funds, which invest in both listed and unlisted equities. The discounts taken on listed stocks has reduced their ability to invest in unlisted stocks and is therefore starting to affect the allocation of money to unlisted stocks. The Tiger Global fund, which had done 321 deals in 2021, has announced that it is limiting its investments for the year 2022 due to its poor results on its equity investments.
The other factor in the slowdown is that VC funds are anticipating difficulties in raising their next vehicle as rising rates make other asset classes more attractive than venture capital and cause LPs to reallocate their portfolios. As a result, they are focusing on supporting their portfolio which they know will have a harder time in today’s environment to raise satisfying subsequent rounds.
