With the downfall of Silicon Valley Bank, the entire start-up ecosystem is shaking on its foundations. SVB played a huge role in the sector as it served 44 per cent of the VC-backed technology and healthcare companies that went public last year. SVB also pioneered venture debt, a type of loan designed specifically for early-stage, high-growth companies with VC backing.
What else is happening in the Venture Capital world? How is the current landscape and how does that effect the technology sector? In this article we’ll paint the picture.
In the world of venture capital, the term "dry powder" refers to the amount of cash reserves that a VC firm has available to invest in promising startups. The term comes from the idea that this cash is "dry powder" just waiting to be ignited by the right investment opportunity.
Having a healthy amount of dry powder is essential for VC firms to stay competitive in the fast-paced world of startup investing. With new opportunities emerging every day, having cash on hand allows VC firms to move quickly when they see a promising startup with potential for growth and high returns.
However, managing dry powder effectively can be a delicate balancing act. Too much cash sitting idle can be a drag on the firm's overall returns, while investing too aggressively can lead to overvaluation and losses. VC firms must constantly evaluate their dry powder levels and investment strategies to ensure they are making the most of their available resources.
For several months, people have been pointing to the record levels of "dry powder" in venture funds. At the moment, the U.S. Venture Capital Industry is sitting on a $300 billion powder that’s ready to ignite a new wave of tech startups. However, even though there is a very high amount of capital raised, doesn’t mean that all this money is sitting there, ready to be spent.
Limited partners are incentivized to move very slowly. They want to preserve cash to invest it with less risk in high-yield assets.
Additionally, a lot of LPs who had a large percentage of their capital obligations to venture firms outstanding, invested in short-term holdings to earn interest in the meantime. These short-term holdings are now worth a fraction of the expected amount. They may have to sell at a loss and in some cases, they might not have the capital to commit to their capital obligations.
As a result of this mismatched dynamic of LPs that have overly illiquid portfolios, dramatic underperformance, and liquidity demands, a lot of VCs have started to refer to this dynamic as "wet powder."
No matter how fast founders want to move at this point to collect their funds before the capital well dries up, funds seem to be frozen.
What does this mean for the tech industry?
Tech stocks are seeing significant valuation corrections and have been through quite a storm this past year:
The Nasdaq composite index has seen losses of 32%.
Since the start of 2022, Meta, Amazon, Netflix and Google have seen their shares plummet by 63%, 45%, 48% and 34%. For only these four stocks, such a decline has meant a decline of $2.3 trillion in market value, which is 1.4x the cumulative market capitalization of all 40 companies in the TecDAX (Germany’s largest stock market index).
These big declines were driven by a correction in valuation metrics. In 2021, the average enterprise value for listed cloud software companies went up to 20x NTM revenues. After the early 2022 correction, values have normalized and are now at around 5x to 10x NTM revenues. But the downturn also affected private-market start-ups. The average valuation of Series C rounds fell from $500 million in Q4 2021 to $336 million in Q2 2022.
The freeze in funds, in combination with skyrocketing layoffs, inflation and recession fears, caused experts to label the current climate as the “startup apocalypse.” Some LPs describe todays funding environment as “existential crisis”. Both not very positive sounding descriptions.
But despite all this, the tech sector has remained resilient. Changes in the way we work and the emergence of tech like cloud computing and AI have kept the sector alive.
In 2021, the global investment in Proptech startups reached $29.2 billion, up from $23.8 billion in 2020. The US leads the investment with over $11 billion in funding, followed by China, which received over $4 billion. The top-funded subsector of Proptech in 2021 was Construction and Project Management, followed by Smart Buildings, and Data Analytics.
In 2022, it was a different story. Though VC Proptech funding increased by 5.65% during the first half of the year compared to the same period in 2021, investment activity decreased as the year progressed. From the first to the second quarter of 2022, funding dropped 23%.
The VC landscape needs to change to be able to defrost. These are the strategic changes we are expecting to see:
- Portfolio management: Fund managers may focus on optimizing their existing portfolio by divesting underperforming assets, restructuring troubled companies, or increasing efficiency to generate liquidity and free up capital.
- Secondary market transactions: Funds may sell their existing portfolio investments to other investors in the secondary market to generate liquidity and unlock capital.
- Co-investments: Funds may partner with other investors or companies to co-invest in new opportunities, reducing their overall risk and increasing their investment flexibility.
- Traditional investment managers will continue to come into the growth stages, while larger VCs, are going into public markets and PE space, decreasing the differences between large multi-asset investment managers and mega VCs.
- The large amount of new data and algorithms available will be the key aspect in sourcing and selecting startups, replacing highly intensive coaching models.
More data, more transparency and secondary liquidity should bring more efficiency and consistency to the VC sector. Hopefully, a stable VC landscape will bring more opportunity to new startups and allow the tech sector to keep blooming!