Obviously, 3Q22 was a very difficult quarter in the capital markets. Of the 115 global stock, bond ETFs, currencies, and commodity indices tracked by the Wall Street Journal, only 13 of them showed gains, paced by the not surprising 24.7% gain in the New York Mercantile Exchange Natural Gas index. Sadly, the Ukrainian hryvnia declined by 20.0%, slightly out ahead of the oxymoronic Lean Hogs index which dropped by 18.2%. The S&P 500 Health Care index dropped by “only” 5.6%.
The venture capital industry was not insulated from this turbulence which underscores a general “risk-off” investor sentiment that has settled in as inflation and interest rates both continue to rise. The level of venture investment activity in 3Q22 totaled $43.0 billion invested (a nine-quarter low) in an estimated 4,074 companies (a seven-quarter low) according to Pitchbook. While activity slowed across all stages, it was particularly acute in the later stage rounds as crossover investors walked away. Late-stage investments declined to $24.9 billion in 3Q22 from $64.7 billion in 3Q21.
Notwithstanding a collapse in exit activity in 3Q22 to $14.0 billion (in 2021, exits totaled $781.5 billion), fundraising for U.S. venture capital funds has already set a new record with $150.9 billion raised by only 593 funds through 3Q22. Notably, the average fund size raised in 2022 is $254 million, dramatically larger than the average fund size of $129 million in 2021. And 2021 was the second greatest year for fundraising with $147.2 billion raised by 1,139 funds. Fewer firms are raising larger funds.
How venture capitalists behave over the next few quarters will meaningfully influence the health of the innovation economy over the next three to five years. Undoubtedly much of the decline in venture investment activity over the past quarter was related to funds triaging existing portfolios, determining which companies merit additional financial support, developing action plans to weather the pending economic storm, and a general heightened sense of anxiety – all of which can be quite distracting. In spite of that, 3Q22 investment activity simply returned to the quarterly investment levels experienced in mid-2020, a mere two years ago.
Barron’s recent Big Money poll flagged that 22% of the 107 largest U.S. investors ranked cash as the most attractive asset class today. A sense of malaise seems to have set in with public stock investors now that we have witnessed three straight quarters of negative returns for the S&P 500 index, which has not occurred since 2009.
Data: Yahoo Finance; Chart: Erin Davis/Axios Visuals
Year-to-date the S&P 500 index is down 24.8% while the NASDAQ is down a disquieting 32.4%. Not to be outdone, Bitcoin declined 59.3% and now trades at $19,222 per token, a country mile from the nearly $70,000 reached less than a year ago. The price of a Bored Ape Yacht Club NFT has dropped 25% just this month. Interestingly, a Financial Times analysis of data compiled by Dealogic concluded that nearly 75% of the more than 400 “Covid” IPOs (companies that raised more than $100 million via a public offering between 2019 – 2021) are trading below their IPO prices and that the median return since being public is a negative 44%. Clearly, 2021 will be looked upon not so fondly as an outlier now that capital is harder to come by and no longer free.
Data: Yahoo Finance. Chart: Tory Lysik/Axios
In such an environment one might expect two developments: an increase in M&A activity and/or a spike in “zombie companies” – neither of which has yet to occur. According to Refinitiv, global M&A activity declined by 34% year-to-date to $2.8 trillion, which is the largest decline since 2009, in part exacerbated by an extraordinary level of M&A activity in 2021. According to S&P Global Market Intelligence data, 3Q22 M&A activity in the U.S. was the lowest quarterly amount since 2Q20, with just under 4,700 transactions and a total value of $255.5 billion (average deal size of ~$54 million). Transaction value dropped 58% year-over-year. The lack of robust M&A activity likely reflects increased executive suite anxiety and the dramatic spike in the cost of capital.
Goldman Sachs defines “zombie companies” as those companies which have not been able to fully service their debts for three consecutive years (interest coverage ratios of less than 1.0) and concludes that approximately 13% of U.S. companies are the walking dead. This has consistently hovered between 12% – 14% over the last decade. Admittedly, this definition includes a swath of exciting high growth technology companies leading Goldman Sachs to focus only on those publicly traded companies with stocks that have underperformed by 5% or more relative to the S&P 500 benchmark for two straight years. Through this lens the number of “zombie companies” drops to below 4%, well below what many might have suspected, but quite foreboding should there be a recession in 2023.
Speaking of the living dead, the SPAC (special purpose acquisition company) market has been slapped back to reality from a blistering pace set in 2021. In large measure due to the abysmal stock market performance of SPACs, the number of SPACs in all of 2022 may not even equal the 3Q20 level, which was just prior to the explosion of SPAC activity in 2021 when there were 613 SPAC deals. Of course, the broader story is the shuttering of the U.S. IPO market with only 22 “traditional IPOs” year-to-date 2022, according to PwC data. In 3Q22, $2.0 billion was raised by a measly five IPOs, levels not seen in years. So far this year, more than 60% of announced IPOs have been withdrawn due to market conditions.
How will this landscape impact venture investment over the next few quarters? Many venture-backed CEOs, founders, and boards are grappling with potentially painful re-sets in valuation and many likely now have less than one year of cash. Like navigating various stages of grief, companies will deploy a predictable set of strategic maneuvers: trim costs (often around the edges, often too late), explore venture debt, look to existing investors to extend the last round to preserve a legacy valuation, and maybe then explore financings with terms that optically preserve that legacy valuation. Many of these steps will not be fruitful, at least not until there has been a genuine re-pricing of the company, particularly for late-stage companies. Boards unwilling to re-price will explore M&A alternatives should the company not be able to raise capital on acceptable terms.
Arguably, while we are somewhat early in the cycle of repricing companies which raised capital at high valuations in 2021, there is already evidence of a significant impact on valuations. Late-stage company valuations have declined from close to $700 million in 2021 to $582 million year-to-date 2022. Pitchbook calculated that only 6% of financings in 1H22 were down rounds, suggesting a dramatic acceleration of down rounds in 3Q22.
In any given year, 10% – 15% of all financings are down rounds according to Pitchbook. In fact, more than 3,000 companies have closed down rounds over the past decade. The pressing question before boards now is what the path forward after a down round financing might look like. A retrospective Pitchbook analysis from 2008 – 2014 of over 1,400 companies showed that 70% of those companies went on to raise additional capital while 13% were unable to raise capital or complete an exit; the remaining companies successfully were sold obviating the need to raise more capital. The median decrease in valuation for down round financings across all stages was approximately 35% in 2021.
An increasingly important tool in the tool kit for boards to extend the cash runway is to take on venture debt, even though it may limit degrees of freedom in the future. Against a backdrop when U.S. gross national debt eclipsed $31 trillion for the first time ever earlier this month, venture debt financings have seen significant activity this year with $22.8 billion of loan volume across 1,925 financings. Average annual loan volume for venture debt over the past four years has been greater than $31 billion. In fact, average early-stage and late-stage venture debt rounds have spiked in size from $10.6 million in 2021 to $14.0 million in 2022 year-to-date, and from $17.0 million to $20.8 million, respectively. The decrease from 2019 to 2021 likely reflects the increase in equity investments in lieu of debt.
During this quarter, portfolio companies will look to lock down operating plans for 2023. As management teams and investors stare at this new reality, one would expect more moderate growth plans, anticipating expected difficulties in accessing capital on attractive terms. And while it does not feel good in the moment, scaling a business in such an environment will institute greater discipline and focus on bringing to market only what customers will readily pay for.