How far will high-flying tech investors fall?

Free money is gone. Yesterday’s valuation was fictitious. The market has sold the future company.

This is an assessment made by many tech investors amid an uncoordinated information campaign that includes deck, video call and blog post For portfolio companies. Fewer games are their sober outlook on their bottom line.

Venture capital funds have performed well in recent years. According to the data, the asset class has an internal rate of return of 30.5% over the past three years The latest data.

Many of these gains are only on paper, a fact that will become apparent as company valuations come back down. Fund returns in the first quarter are slowly starting to flow in, and they’re ugly.

The VC firm has pushed up valuations based on euphoric public markets, and some explanation may be needed.

“We haven’t seen such aggressive portfolio markups since the dot-com reset,” said PitchBook analyst Zane Carmean. “There’s a shift in mindset that gives VCs the confidence to give ultra-optimistic numbers. “

This article appeared as part of The Weekend Pitch newsletter. Subscribe to the newsletter here.

The inflated fund size in recent years has created a lot of money, which has spurred higher check sizes and prices. These mega-funds are still popular: Most of this year’s venture capital funding came in at more than $1 billion, the highest in a decade relative to previous funds.

Ultimately, though, tech fund managers are bracing themselves for LPs who may wonder where those markups go. Short-lived gains are justified when real interest rates are negative and public markets are hungry for growth companies.

no longer. Our index shows that VC-backed IPOs have fallen 54% this year, underperforming the Nasdaq and even lagging companies that have merged with SPACs.

what must be marked down

About half of VC firms’ reported results in 2021 did not materialize. The price cuts are happening, and the handful of funds reporting in the first quarter are proving how quickly earnings can be destroyed.

Things will get worse before they get better, because no one knows how low valuations will fall from their recent highs. Our data shows that the proportion of downward financing has declined in recent months – companies are avoiding new rounds altogether in the face of the prospect of falling valuations.

The ability of public markets to depreciate quickly is a blessing in some ways. Private markets have had to endure the pain of falling prices for months.

What sell-offs have in common is devaluing future cash flows. That means any company that spends more than it earns should get a haircut. Unlike previous crises, there will be no help at the top because fiscal stimulus is unthinkable until inflation is under control.

A relentless stock market means late-stage tech companies will need funding from a crossover of investors backing public and private companies. But given the relatively cheap public markets, those investors may be harder to attract. Travel investors’ investments in VCs will face their first true test of loyalty in more than a decade.

Mergers and acquisitions could also be a tough sell as depressed stock prices reduce their purchasing power.That leaves buyout companies with their own portfolio pain to deal with and the interest rate outlook makes Debt-fueled deals are riskier.

Partner Restrictions

The relationship between LP and GP will soon be put to the test.

Since 2018, more money has flowed into private funds than has flowed out.This leaves LPs overwhelmed with the promise of alternative assets, and special adventure.

Preliminary figures show that VCs accounted for nearly a third of all capital closed in the first quarter. When issuance surged last year, it seemed reasonable for LPs to chase VC returns.

LPs attempt to allocate a target percentage of their portfolio to various asset classes. The stock market correction triggers a so-called denominator effect, causing the value of privately held shares to take up more of their fair share in portfolios.

GPs will face a tougher fundraising environment and difficult questions about the value they bring and the logic of performance metrics.

To save face, VCs have an incentive to delay price cuts for as long as possible. But ultimately companies have to raise capital and can no longer deny their lowered valuations.

Fundraising will be the hardest for underperforming companies and emerging managers with little track record. The closing time gap between those who can raise funds quickly and those who can’t has grown.

The venture capital ecosystem as a whole has $500 billion in dry powder This will help it get through the tough times. it will need it.

Featured image by Drew Sanders/PitchBook News