This year has witnessed widespread losses in global equity markets, both public and private. After a decade-long bull run, many venture capital funds have found themselves holding over-valued private equity shares of companies whose IPO prospects have been either eliminated or significantly delayed. The markets have now become skittish, as evidenced by widespread correlation across asset classes. There are certainly structural factors sowing the seeds of pessimism including, severe inflation, a hawkish US Federal Reserve leading a global trend of interest rate hikes; an evolving European energy crisis; the first land war in Europe in seventy years; various supply chain disruptions; an on-going global pandemic; growing global trade tensions and, to top-off the sundae, a slowly-collapsing Chinese credit bubble.
While public markets have priced in some of these headwinds, their severity and duration remains unclear. With respect to the US technology sector, the Nasdaq Composite Index is down sharply (-22%) year-to-date, price-to-earning multiples are at 6-year lows (~22x as of 6/30/2022), and venture funding has slowed significantly (down 52% YoY). Large-cap public technology company revenue and earnings have generally held up well to date but are expected to falter in the coming quarters as a result of Fed induced demand-destruction.
Despite all these current and high-profile pressures, it is our view that the technology & innovation supercycle narrative remains unchanged and many companies within them are poised for growth. Private technology companies are refocusing on fundamentals and valuations are returning to reasonable levels. It is also our view that the current economic conditions create a unique opportunity for venture capital funds holding dry powder to earn once in a decade returns, as was the case for VCs that deployed in the 2010–2014 time period and other periods before that as we shall see below.
A sound investment process analyzes both macro trends and fundamental data to assess the probability of various potential outcomes. We have identified two distinct potential outcomes for the US private technology sector over the next 6–12 months.
Scenario 1: Additional Pain before Recovery
A few weeks ago, Federal Reserve Chair Jerome Powell forecast that the Federal Reserve’s efforts to contain inflation would entail a “sustained period of below-trend growth” that would “bring some pain to households and businesses.” This implies a period of lower range-bound US equity price stagnation over the next 12–24 months. Such an outcome is probable in the near term if the following negative economic and geopolitical developments were to occur:
- Aggressive Federal Reserve. An overly hawkish Federal Reserve in the face of deteriorating U.S. economic conditions could trigger stagnation in the public equity markets and potentially cause another 20–25% drop in public equity prices. Such circumstances would continue to repress price-to-earnings multiples and negatively impact top-line performance. While certain parts of the economy remain strong (at least on a backwards looking basis), it now seems obvious that Fed Chair Powell is having a Paul Volker moment, a single-minded focus on breaking inflation’s back, no matter the consequences of resulting economic pain. Orchestrating a “soft” landing was a “hope” strategy that is proving increasingly elusive. Assuming repeated interest rate hikes over the short- and intermediate-terms, the prospect of long-term profitability for the US technology sector, perhaps counterintuitively, remains strong. A repressed market would likely lead to above-average returns for the tech sector (in particular SaaS & Cloud-enabled businesses) due to its ability to quickly scale without the additional infrastructure and supply chain ramp-ups that will be required by traditional brick-and-mortar businesses.
- Intensification of geopolitical tensions over Ukraine. Over six months into Russia’s invasion of Ukraine, the economic impact of commodity price increases are beginning to percolate throughout Europe. While it is too soon to predict the military outcome of the conflict, it is clear that Europe and the US are morally and financially invested in preventing Russia from successfully annexing parts of Ukraine. Current circumstances suggest a stalemate as a best case scenario, with the Ukraine conflict resembling the Soviet-Afghan War of the 1980s, a protracted war of attrition wherein the West funds, trains and arms local combatants in an effort to stress the Russian economy and thereby force a withdrawal from the region. A threatened and cornered Russia could resort to last-ditch temper tantrums, either including nuclear threats or restricting/eliminating Europe’s access to its energy and commodities resources.
- Intensification of geopolitical tensions around Taiwan. An escalation of the US-China conflict over Taiwan could also have dire consequences. These tensions have further mounted, with a recent visit to Taiwan by US House Representative Nancy Pelosi, the Biden Administration’s recent restriction on sales of advanced microchips to Chinese companies, the recent passage of two US warships through the Taiwan Strait, and President Biden’s impending executive order restricting US investment in Chinese technology companies. An overt conflict in, or over, Taiwan would create a major global semiconductor shortage (since Taiwan controls the majority of global semiconductor production), and would likely cause China to restrict access to its rare earth materials, over which it holds a global monopoly. Such an outcome would have a severe negative impact on the global production of technology hardware and the broader US technology sector.
- De-Globalization. These and other geopolitical tensions around the world increase and accelerate the reversal of decades of globalization. Economies will need to find productivity enhancement in technological innovation and digitization instead of supply-chain and labor cost optimizations. Global geopolitical pressures will continue to provoke a short-term flight to the relative safety of the US$, and US assets. Both of these trends will benefit the US private technology sector.
- Chinese Credit Bubble Collapse. The 2021 credit default of China Evergrande Group, China’s second largest real estate developer, has raised many questions about the depth and breadth of over-leveraging of the Chinese real estate market. After decades of massive expansion and infrastructure spending, an inability to satisfy even a portion of the resulting debt has the potential to send shockwaves throughout the Chinese economy as well as the broader markets. Evergrande’s aggressive expansion took on debt to finance too many new projects in too many disparate areas with insufficient demand. Many unfinished projects have been halted, and are thus unable to generate income to service the interest accruing on a nearly $300B debt burden. Since then, twenty other Chinese property developers have defaulted on their debts. Because of the lack of transparency of the Chinese economy, the full extent of these conditions is unknown. In addition to developers, millions of highly leveraged individual Chinese home buyers and speculators may be negatively impacted. A Chinese credit bubble collapse could threaten the stability of the Chinese banking system at-large (similar to the US in 2008). An unstable Chinese economy and banking system could further lead to contagion throughout the broader global credit and capital markets and emerging economies reliant on Chinese credit and trade. In addition, as discussed above, rising global instability could prompt a flight to the safety of the US markets.
Scenario 2: Broad Economic Upturn
In contrast to the scenarios described above, a low-friction resolution to some or all of the above headwinds could lead to positive economic outcomes and acceleration of the global technology supercycle. As discussed in greater detail below, the US private technology sector is positioned to receive an outsized share of the upside.
- Eased Monetary Policy. In contrast to Chair Powell’s recent statements, the US Federal Reserve could at any point determine that the inflationary trend has been sufficiently stemmed by higher interest rates, tapering of the fed balance sheet, and a general sentiment of weakened economic activity. Some evidence of such conditions already exists, such as the rapidly cooling housing market (supply is increasing dramatically with inventory levels now approaching the 2009 levels) and the fact that consumer sentiment remains historically low, the impacts of which will begin to be observed in the balance sheets of consumer focused companies. Further, as strong organizations implement hiring freezes and weaker companies pursue layoffs, the labor market will rapidly replenish itself and equilibrium will be restored. Wage growth will begin to stagnate, driving a continued drag on consumer spending and prices will begin to moderate across all observed CPI input categories. 10-year US Treasury Note yields may see a resultant drop from its highs, leading to buying signals across all asset classes. Because US private technology valuations have been right-sized and given the ability of venture capital to deploy it’s $290 billion of dry-powder quickly, the US technology sector may find itself poised to take advantage of the changing landscape quicker than other industries and sectors.
- Resolution of the Russia-Ukraine Conflict. Russia and Europe are substantially weakened and will have to eventually sit at the negotiating table. If the US emerges from the November elections with a Republican-controlled congress, it is foreseeable that it could revert to a more isolationist stance, which would place added pressure on our European allies to pursue settlement negotiations. Diffusing this crisis may also lead to a softening of the food and energy markets and accelerate a slowdown and containment of global inflation, the main driver of everything “economy” in the short term, and an amplifier of political and social conflicts around the globe.
- Containment of the Chinese Credit Bubble. The Chinese central bank has been actively employing quantitative easing tactics to allow their currency to depreciate in comparison to the US dollar in an effort to stimulate exports and lower interest rates. In addition, the government has been buying corporate debt to address corporate insolvency. While the size and scale of China’s corporate debt issues is not fully known, it is already clear that it will be difficult to contain. However, to the extent China can isolate the spread of insolvency to real estate developers and subsidize exposed banks and lost tax revenues for municipalities, the economic consequences could be limited to mainland China and emerging economies that rely on access to its credit.
- Easing Political Tensions between China and the US. It is in the interest of both the US and China to reach a peaceful and productive resolution to the mounting political tensions. The US is China’s largest trading partner and both nations benefit from open trade routes. In addition, a global recession would put additional pressure on extracting value from existing commercial relationships. However, the US-China relationship is exceedingly complex, such that a detente would likely play out over the intermediate- to long-term.
We believe that the US private technology sector may have 6 to 12 months before getting back on solid footing, and that during this time frame additional pain is probable. Fortunately, this translates to better valuations and investment opportunities in the venture capital space. Software and technology multiples have reverted to below their long-term pre-COVID average, 6.0x forward revenue in public markets vs. 8.0x pre-covid average and 70% lower than the 2020/2021 peak.We may continue to see compression of multiples and a follow-on round of revenue contractions, which would lead to valuation expectations adjusting further downward. We are firm believers that the innovation economy will continue to be the solution to difficult to find returns in all the above scenarios and that the venture capital asset class still presents a less volatile and more attractive channel for capturing the mega-trends that are going to be defining the next 50 years in sectors like artificial intelligence, robotics, biotech and healthtech, cybersecurity, fintech, edtech, and web3. It is imperative however to have the right tools to make out which of the companies are the most likely to outperform. We have observed a proliferation of more high quality sources of data and information about the private markets, particularly late stage private tech companies. The natural extension of this is the application of data science and quantitative investment approaches to generate more consistent alpha across longer time periods and economic climates.
Venture Capital Funds Generally Outperform Following Periods of Economic Uncertainty
We analyzed historical venture capital vintage performance over the past 42 years and have identified certain factors & circumstances that create ripe conditions for VC outperformance. Below we present the summary of our research and the current set-up that bodes well for an H2 2023 “launch point” for exceptional venture capital vintage(s).
The critical components of the table below are:
- Upper Quartile Venture Capital Performance (TVPI) represented by the light yellow bar graph — we chose to use TVPI (the ratio of the total value of investments and cash distributions in/by a fund to the total amount of capital paid into the fund) as it corresponds to total generated value. This is in contrast to IRR, which can be easily manipulated with large, early exits, or very slow capital calls.
- Trailing 18-mo Return of the Nasdaq Composite Index represented by the bright blue line — this data point was included to highlight the clear pressure on publicly traded technology equity following times of economic uncertainty.
- Trailing 6-mo average UST 10-year nominal yield minus Trailing 6-mo average UST 2-year nominal yield (the axis is inverted) — when the 2-year yield approaches or, in rare cases, exceeds the 10-yr yield, the short-term outlook on the U.S. economy tends to be extremely bleak with significant market volatility expected. However, as the chart shows, these periods tend to be short lived and are followed by a period of economic expansion typically beginning 18–36 months following inversions or near-inversions.
- Dotted Line Arrows — the red arrows indicate periods of increasing economic risk, the green arrows indicate periods of declining economic risk.
- Venture Capital Golden Periods (i.e., periods where the top quartile VC TVPIs exceed 4.0) tend to occur 3–4 years after a yield curve inversion or near inversion. The typical trigger point occurs when the 10-yr yield exceeds the 2-yr yield by ~2.5% (i.e., 1993, 2004, 2010). For instance, a yield curve near-inversion occurred in late 1989/early 1990, the yield spread then stretched back to ~2.5% by 1993, and the 1994 VC vintage went onto deliver a 4.0+ TVPI along with the 1995 & 1996 vintages. The next predicted Golden Period was set to occur in 2004, yet this period was curtailed by the arrival of the Global Financial Crisis in 2008/2009 — this devastating economic contraction decimated small, VC-backed businesses harming what would have otherwise been phenomenal vintage years. The next and final observed Golden Period began in 2010 and kicked off a 5-year period (2010–2014) of extraordinary VC vintages with every vintage (except 2013) delivering a TVPI >4.0.
- 2020 through today is unusual thanks to an excessively aggressive Federal Reserve. A near-inversion occurred in early-2020 as the world began to grapple with the rapidly increasing risk of a global pandemic. Reports out of China were concerning, and those fears were realized as COVID swept its way through Europe and ultimately the U.S., causing a 30%+ drop in U.S. equity markets in just weeks and driving unemployment above 13%. Had the Federal Reserve not stepped in to save the day, the U.S. economy would have careened into a recession (or depression) of historical proportions. However, the Fed chose to instead infuse nearly $5T of economic stimulus into the U.S. economy, lowered interest rates to 0, and thereby kicked-off one of the more ferocious equity rallies ever observed. Unfortunately, the economic stimulus proved to be “too” significant as demand soared and global supply chains struggled to keep up — these factors ultimately drove the Fed to reverse their dovish course and begin raising interest rates in early 2022. Coupled with the previously covered geopolitical events and near term risks, these interest rate hikes have proven to be damaging for U.S. equity markets with 20%+ drawdowns observed in the Nasdaq composite year-to-date, and -9% drawdowns observed over the trailing 18-months through the end of August 2022.
- It will be painful, but another expansionary period in our view is still likely to kick off in H2 2023. Despite the Fed preventing the natural 3-year transition period from yield inversion to Golden Period, we still believe 2023/2024 vintages will indeed achieve Golden Period status. The path to get there will likely be bumpy and involve a final, significant sell-off in public equity markets possibly in excess of 20% from current levels. A sell-off of this magnitude after a 12-year period of economic expansion is a necessity to set the stage for an extended period of economic recovery (perhaps similar to 2010–2017 or 1994–98). If this substantial sell-off comes to pass, those investors with dry powder and high conviction will reap the rewards as the masses sit on the sidelines.
The primary challenge of any investment strategy is in correctly assigning and assessing probabilities based on available information. We believe that the Fed’s paradigm shift towards aggressively breaking inflation’s back at all cost will result in a final significant wave of pain for equity markets; however, this will ultimately set the stage for another VC Golden Period. In addition, we remain convinced that data science and statistical analysis techniques employed by sophisticated, quant-minded venture capital firms are no longer a nice-to-have but a necessity to see through the noise of this volatile period.
Furthermore, the TVPI data presented above was for Top Quartile Venture Capital funds — so, despite our firm belief that the next few years will represent some of the best opportunities to deliver strong vintages, manager selection remains crucially important in any VC allocation decision. Many historical Top Quartile managers have been raising enormous warchests of capital over the past 12 months. While beneficial from a Management Fee perspective, these managers will face significant challenges in their ability to deliver strong returns as their enormous fund sizes (in some cases in excess of $10B) will force them into only the largest of private companies where value is quick to be arbitraged out. In contrast, emerging managers writing smaller more tactical checks and pursuing highly differentiated strategies are likely to outperform these traditional VC giants during this next cycle of business expansion.