2023 Venture Capital Market Outlook
Public market volatility and macroeconomic uncertainty continue to affect the venture capital (VC) market. In such a long-term asset class, forecasting exit environments over 10+ year horizons can prove difficult at best. However, historical patterns and current events can provide guidance for nearer-term projections applicable to upcoming investment periods.
Why manager and asset selection may be more important than ever within venture capital markets today
Based on our expectations, we at Russell Investments believe investors should be preparing for continued adjustments within the VC market opportunity set. Specifically, we envisage an environment defined by more down rounds, increasingly investor-friendly terms and a greater proportion of leaner and cycle-tested startups. Such an environment poses both potential opportunities but also challenges, with successful manager selection required for successful navigation. In fact, now that rising tides are no longer lifting all boats, we would argue manager and asset selection are even more important today than ever. Our own preparations have taken the form of marginal adjustments to our manager selection criteria, some of which we will share as we tie in market views with suggested action items. Our overall approach remains informed, however, by the long-term nature of not only the asset class but the innovation economy to which it is closely tied.
How is the downturn in public markets impacting the venture capital market?
Recent public market movements are clearly impacting the VC market. One consequence is a closing of the exit window, which, if continued, could lead to a build-up in liquidity needs, amongst other impacts. Following significant drawdowns in listed stocks, particularly within the technology sector, VC-backed companies have pumped the breaks on making their public debuts.
Logically, it does not make sense for a company to invite revaluations when markets are trending downwards. As a result of this pause, public listings have fallen significantly relative to 2021, a banner year for public market debuts. In fact, last year saw the number of U.S. IPOs nearly double year over year (FactSet) and global capital raised via IPOs reaching a new record (Reuters). Therefore, comparisons between the pullback in 2022 and the environment of 2021 can paint an overly stark picture.
That is not to say the public market pullback is not meaningful—it most certainly is. However, it’s important to remember IPOs do not represent the entire exit window and we would be remiss not to mention mergers and acquisitions (M&A). M&A offers a viable exit route for venture-backed companies; however, corporate activity thereof within the venture-backed market has also been subdued, at least through August (Crunchbase).
This is due in part to the relative attractiveness of take-private transactions in down markets. As public company stock prices fall more quickly than private company valuations, take-private transactions become more attractive relative to acquiring private startups. With diminished activity within the two most prominent exit paths for VC-funded companies, suffice it to say the exit environment has compressed. However, compressed should not be misconstrued to mean entirely closed. For instance, Mobileye experienced a post-listing pop in stock price in October of this year. Additionally, we often hear from GPs that unspent M&A budgets from 2022 will also be a story in 2023, helping to produce exits. However, we would caution against expecting a wholesale reopening of the exit window for technology companies in the near-term. For instance, despite Mobileye’s price uplift, market value has still lagged prior expectations (CNBC).
How do exit windows impact hold periods?
The reason we are spending so much time discussing exit windows is their impact on hold periods. While private market investments, including VC, trend toward the longer end of the hold period spectrum, extensions beyond expectations are generally undesirable, all else equal. For instance, IRRs can be negatively affected if the extension proves long enough, and the accumulation of board seats can start straining general partner (GP) workloads as prior positions fail to roll off. Additionally, GP fundraising may be challenged as existing limited partners (LPs) face diminished liquidity available to funnel into re-ups. Newer GPs with largely unrealized and therefore unproven track records may see fundraising efforts impacted as investors are unable to evaluate exit capabilities. Should constraints to typical venture exit paths continue, we think it’s prudent to keep an eye on potential impacts to return metrics, workloads, liquidity and fundraising activities.
How do public market movements impact private market valuations?
Public market movements do impact private market valuations. One method of valuing private companies includes reviewing the valuations of comparable public companies. As public company valuations decrease, the enterprise value of VC-funded startups can come down as well. Therefore, market participants should be preparing for a potential increase in down rounds. Down rounds are investment rounds in which the valuation of a company falls below the value marked at a prior investment round. These events can negatively impact founders and employees as well as existing investors. For instance, Klarna, a buy-now-pay-later (BNPL) category-leading company. made headlines with a disappointing 85% markdown in value due in part to the pricing of comparable public companies (Pitchbook). While some down rounds have clearly made headlines, they remain a bit of a rarity to-date (Pitchbook). In fact, down rounds represented just 6% of completed rounds held in the first half of 2022, which is actually better than the banner year of 2021 (Pitchbook). Additionally, our managers continue to report ongoing up rounds for highly competitive companies, including some closing at what could be considered heightened valuations. Irrespective, we at Russell Investments believe a larger proportion of deals are going to represent down rounds as diminished valuations manifest and are solidified.
A protracted negative market environment may additionally lead to an increase in investor-friendly terms, thereby benefiting new VC investors. For instance, venture capitalist firms may choose to support companies at prior valuations in exchange for enhanced rights which can better protect their positions. Supporting companies at the same valuation in a down market can be compared to paying more for a company than what it is perceived to be worth. Some investors may be willing to overpay in order to avoid the negative consequences typically associated with a down round. Others may simply seek to postpone dusting-off the down round toolkit after a decade-plus bull market. Additionally, the acceptance of prior valuations can reflect an acknowledgment that the quality of the company itself has not changed (TechCrunch). In other words, diminished valuations currently reflect diminished valuations, and not a wholesale change in the underlying fundamentals of venture-backed companies. Regardless of the incentive, enhanced rights can help bridge the shortfall between value earned and value paid in flat rounds today. Russell Investments believes new investments in 2023 may benefit from increasingly buyer-friendly terms should supply/demand dynamics continue to adjust.
Are significant changes to prices and terms possible in the 2023 VC market?
We would not expect to see broadly applied nor significant changes to prices and/or terms just yet. The reason lies in the periodic fundraising cadence typical of venture capital backed companies. Specifically, VC-funded startups usually raise capital from investors in discrete rounds. That capital is then reinvested into growth initiatives. The length of runway for capital investment depends on cash raised or generated relative to the rate of spending cash (cash burn). For context, a healthy runway for a seed stage company could approximate 12-18 months (JP Morgan). So a VC-backed company which raised a round of funding in 2021 would not be expected to raise another funding round quite yet.
We believe today’s runways are extended relative to those seen historically, and therefore, pricing and term setting activities associated with new rounds are delayed. The reason for companies extending runways lies in both means and incentives. Broadly speaking, companies today certainly have the means due to the tie-in between money raised and company valuations. Specifically, companies which raised capital at the heightened valuations of recent years received more cash than if they had raised in normative times. Heightened cash balances can translate to longer runways.
The incentive for extension is likewise clear: slower cash burn allows companies to delay or diminish eventual down rounds. For instance, between rounds, an increased focus on unit economics and cost management measures may help diminish valuation shortfall when runway eventually runs out. In other words, the more time to shore up fundamentals, the better. As an aside, Russell Investments believes that companies focused on extending runway by means of enhancing fundamentals and tightening belts implies an attractive opportunity set in the future. Specifically, we could see a greater proportion of deal flow comprising lean, cycle-tested companies. In the meantime, however, investors should be aware of the delay separating today’s opportunity set from tomorrow’s down rounds and increasingly buyer-friendly terms.
Why investors should start reviewing existing partnerships with VC fund managers
We believe investors should begin reviewing existing partnerships in light of deployment period expectations, or more simply put, in light of timing considerations. Timing matters because the impact of down rounds and enhanced terms depends in part on when an investment was made. It also matters for investors seeking to apply the fundamental rule of buy low, sell high.
For instance, investors seeking to buy low may be concerned that deploying too late could lead to missed opportunities, while deploying too early could lead to enhanced J-curves or future down rounds. For instance, the possibility of waiting for the bottom and instead missing the boat altogether is high. A private markets manager must first raise funds (typically contracted to a ~12 month fundraise) before it can begin investing in opportunities. The possibility of deploying too early is likewise high. Abnormally extended runways translate to less companies currently seeking financing rounds. At the same time, there is plenty of competition with record levels of dry powder in the market looking at the same compressed opportunity set and waiting for more deal flow. And of course, falling public market prices implies private companies’ values have further to fall—and no one wants to catch a falling knife. However, we see the current cycle shift as a good opportunity for buying low. For new investors, the multi-year investment period typical within private markets enables increasingly improved entry points via dollar cost averaging into the next cycle. For existing investors, allocation decisions for new investments remains as important as ever.
Remember the long-term nature of venture capital
This brings us to the goal of selling high. Investors should not lose sight of the long-term nature of the asset class. This is most plainly demonstrated by venture capital fund terms—recall they can easily last 10-plus years. For early-stage strategies, hold periods may need to last from the first institutional round of private market funding to the last. Accurately predicting what the market environment will look like in 10 years or at the end of the startup lifecycle is simply impossible—all that can truly be known are entry prices today.
Venture capital’s long-term nature can also be seen through the asset class’s close ties with the innovation economy. While a range of VC strategies exist, the stereotypical focus on technology startups means investors’ capital funnels (ideally) to the sector disruptors of the future. We at Russell Investments view technological progress as a long-term, lucrative trend. Our resulting view of an up-and-to-the-right innovation economy should bode well for the future of long-term VC investors. In other words, regardless of what markets look like in the years to come, buying into sector disruptors at diminished prices, better terms, and following a period of enhanced focus on shoring up fundamentals, may all present attractive opportunities in the not-too-distant future.
What to look for when selecting a venture capital fund manager today and beyond
The opportunity set is not without related challenges. Navigating properly requires not only an eye to deployment-period market expectations but also to existing and potential partnerships. We mentioned this at the beginning, but it bears repeating: manager selection remains of the upmost importance, and arguably more so now that markets have turned away from their decade-plus of an up-and-to-the-right trajectory. Among the many attributes we prioritize in our managers across cycles, a number have been added, subtracted, and modified in light of current market views. Below we provide a few examples of areas of enhanced emphasis.
Given our current market views, we believe dusting off VC toolkits beats creating one from scratch. In other words, managers with cross-cycle expertise should be better equipped to handle a changing market environment compared to newer entrants only exposed to a bull market. Within the subsect of cross-cycle managers, we are placing a premium on individuals whose venture capitalist days extend back to the early 2000s. Investors will benefit from partners with demonstrated success who can apply lessons learned from the last major technology-market downturn in which venture was caught squarely in the crosshairs.
- Relationship management
One key area of expertise involves the line between preserving reputation and taking advantage of attractive opportunities. While relationship management matters across private market asset classes, Russell Investments views it as particularly important within VC. We believe reputation influences not only access to founders, but also plays a role in the self-selection of future syndicate members. We have mentioned the potential for better terms and pricing for new investors. We have not mentioned the cost. In venture capital, improved prospects for new investors can negatively impact those of existing investors and founders. Therefore, we are prioritizing a demonstrated ability to secure best-in-class opportunities today without precluding the opportunities of tomorrow. Besides experience investing as an angel investor or at a venture capital firm, we additionally see operational expertise as incrementally attractive, as well. Venture capital firms with experience as founders or driving the success of a company directly from an operational role not only benefit from enhanced knowledge in deal selection, but in administering post-execution support.
- Post-execution support: We value both hands-on value-additive activities and monetary support following an initial investment. We will explore both in turn, but will first start with hands-on value-add. While venture capital is defined by minority investor positions, influence is nevertheless available via board membership or simply interactions between venture capital firms and founders. Whether managers simply hold calls with their underlying founders or employ extensive toolkits, the end goal of tangible operational support remains the same. After years of smooth macroeconomic sailing, we are currently placing a premium on a manager’s ability to help steer the boat. Managers can also support companies through cash infusions. Every direct VC investor will technically do so in at least one round via their initial check. However, we view proper management of reserves as essential for supporting star holdings and, in some cases, bridging others which might become high growth holdings. It is also worth noting that certain funds can invest throughout the startup lifecycle, thereby providing increased assurance of future funding availability. We currently believe both value-additive activities and proper reserve management support successful navigation of changes within the venture capital market.
The bottom line
In sum, we believe now is the time for investors to prepare themselves for continued shifts in the venture capital market. We believe there is the potential for decreased prices at enhanced terms on companies of potentially increased soundness in the not-too-distant future. However, we additionally believe the opportunity set is complicated by such considerations as deployment periods, the time elapsed between today and the early 2000s, and uncertainty surrounding the post-execution market environment.
While the future is unpredictable, we can say that VC provides an attractive avenue for long-term exposure to the continued march of technological progress. However, success therein remains predicated on proper manager selection. Knowing what to look for and remaining abreast of the opportunity set remains essential in order to take advantage of opportunities and avoid challenges related to continued shifts within the venture landscape.