U.S. Venture Capital Industry Bracing for Changes: Inflation and Valuation Recalibration
When the COVID-19 pandemic sent the economy into a free fall two years ago, the market unexpectedly witnessed a strong recovery as valuations soared to new heights through 2021. Simultaneously, the tailwinds also benefited the VC industry, which has seen vigorous activity and valuation premiums across deal-making, exits, and fundraising. Nevertheless, 2022 presents potential headwinds given increasing risk exposures to inflation, geopolitical turmoil, and a massive valuation correction.
The structural shifts also offer new opportunities beyond traditional tech hubs as momentum cools. The venture industry must navigate through these shifts and brace for change in 2022. Nevertheless, 2022 presents potential headwinds given increasing risk exposures to inflation, geopolitical turmoil, and a massive valuation correction. The structural shifts also offer new opportunities beyond traditional tech hubs as momentum cools. The venture industry must navigate through these shifts and brace for change in 2022.
US VC Activities In Recent Two Years
Despite the turmoil from the pandemic, venture investment, exit activities, and fundraising activities reached historical highs in 2021, far exceeding long-term expansionary trends.
US VC Activities by Quarter, 1Q20-1Q22
In 2021, the U.S. VC market witnessed more than $340 billion invested across 16,554 deal counts. Given the robust momentum and excessive valuation premiums, total deal value doubled compared to $166 billion in 2020. However, as the market faces increasing geopolitical risk, high inflation, and a significant valuation markdown, this growth is expected to decelerate in 2022.
Notable trends in 2021
The labor market tightened since COVID-19 with quit rates jumping higher than the pre-pandemic level. This trend suggests increasing opportunities for VC as new business formations increase.
First financing activities have increased for seven consecutive quarters since Q2 20, indicating strong VC momentum backing the new pool of entrepreneurs.
2021 registered exceptional volume in VC deal activities outpacing the long-term trend. The robust momentum was partially fueled by i) higher valuation premiums with larger deal sizes and ii) faster increases in the amount raised from round to round.
Geographically, VC investments also moved beyond traditional tech hubs such as the Bay Area, boosted by a shift to remote work. Funding across different states ticked up in 2021, most notably with a 442% and 326% increase in Vermont and Montana, respectively.
With $133 billion VC capital raised in 2021, fundraising also outpaced the long-term trajectory, coinciding with an increase in the supply of capital relative to demand.
Investors opted to settle for fewer deal terms focused on downside protection indicating stronger startup friendliness.
Outlook for 2022
Venture-backed companies raised nearly $71 billion during Q1 22. Despite a gradual slow-down, the figure still exceeded pre-2021 quarterly totals.
With the S&P 500 off 7.45% YTD (as of 4.15.22), VC’s may face fundraising headwinds and a negative impact on step-ups. A flattening yield curve may prompt institutional investors to pull back from alternative investments, but the effect would likely be tempered as inflation remains high.
As the economy contemplates a potential bear market, public markets are likely to be less receptive to sky-high valuations, implying discounts to exit values.