VC's Unique Ability to Navigate Volatile Markets

September 6, 2022

Venture capital (VC) has performed extremely well over the last 5, 10, and 15 years, beating the S&P 500 by more than 700 basis points on average, according to Cambridge Associates.  Across market cycles, we have witnessed certain vintages reward investors with truly outsize returns, and we feel confident that current conditions, no matter how dire the noise around markets can seem, could lead to similarly high-returning vintages. We believe investors with the flexibility to overweight exposures to VC when conditions are ripe can be disproportionately rewarded. As we enter a period that we believe will be defined by less capital raised, smaller fund sizes, slower investment pacing, fewer market participants, and lower valuations, perhaps the time to overweight is now. In this short paper, we’ll seek to explore which of these factors create the environment for an outsize vintage and why the next 24 to 36 months, in our view, could provide just the right mix of market dynamics.

VC Fundraising: Strong But Slowing

VC funds had a banner year in 2021, raising more than $138 billion. While VC fundraising has remained robust in the first six months of 2022, the sustained momentum is due in part to the fact that several large platforms, including a16z and Accel, completed their capital raises in the first half of the year and collectively secured approximately $15 billion in capital commitments.

While we fully expect well-known VC brands to continue to complete oversubscribed fundraises in excess of $1 billion, we believe a number of economic factors will converge to create a much more challenging  fundraising environment in the coming quarters.

• The denominator effect—In general, performance in other, more liquid, asset classes (e.g., public markets and fixed income) has declined more rapidly and materially than in VC. This phenomenon may leave many plans overallocated to VC relative to targets. As such, these plans may be forced to halt or scale back future commitments to managers in the asset class. In a nutshell, the denominator effect decreases
  the available pool of capital from which VC firms can raise.
• Limited liquidity—The current volatility and re-pricing of higher-growth public companies have temporarily closed the IPO window. While large corporates and even private equity buyout funds may opportunistically seek to acquire public companies whose market caps have materially declined, it is unclear how keen they will be to acquire private venture-backed companies. In general, the expectation is that the average time to liquidity for venture-backed companies will extend in the coming years.
• Extended fundraising cycles—In an environment where valuations are declining and could continue to fall in a manner consistent with public markets, most venture-backed companies are choosing to delay capital raises to focus on execution. And they have the cash to do it. In 2021 alone, $340 billion was invested into venture-backed companies, leaving companies with healthy balance sheets and long cash runways. Further contributing to the capital deployment slowdown is the fact that VC firms are seeking to better understand where valuations will ultimately settle as opposed to attempting to “catch a falling knife.” Rather than deploying a fund in 18 months, we expect most VC firms to return to a two-to-three year average cadence.
• Smaller median fund sizes—When the capital available to allocate to an asset class declines, we have found it is disproportionately harder for smaller, less established managers to raise funds. Between 2009 and 2013, when venture fundraising totals fell below pre–Global Financial Crisis (GFC) levels, the median fund size for the industry declined even more rapidly. We expect a similar phenomenon to occur in the coming years.