The Case for US Venture Capital’s Outperformance • TechCrunch
We have seen widespread losses in global equity markets this year. After a decade on the rise, many venture capital funds have found themselves holding overvalued stocks of companies whose IPO prospects have either been eliminated or significantly delayed.
Markets have now become capricious, as evidenced by the widespread correlation between asset classes. There are certainly structural factors sowing the seeds of pessimism such as high inflation; a hawkish US Federal Reserve leading a global trend of higher interest rates; an evolving European energy crisis; the first land war in Europe in 70 years; various supply chain disruptions; an ongoing global pandemic; rising global trade tensions and, to top it off, a slowly collapsing Chinese credit bubble.
Although public markets have priced in some of these headwinds, their severity and duration remain uncertain. Turning to the US tech sector, the Nasdaq Composite Index is down sharply year-to-date, price-earnings ratios are at six-year lows, and venture capital funding has slowed significantly. Large-cap public tech revenues and earnings have generally held up well so far, but are expected to weaken in the coming quarters due to Fed-induced demand destruction.
Despite all of these current and high-profile pressures, we believe the narrative of the technology and innovation supercycle remains unchanged and many companies are primed for growth. Private tech companies are refocusing on fundamentals and valuations are returning to reasonable levels.
We also believe that current economic conditions create a unique opportunity for venture capital funds holding dry powder to achieve significant returns, as was the case for VCs that deployed during the period 2010-2014.
Although the Fed prevented the natural three-year transition period between the reversal in yields and the golden period, we still believe that the 2023/2024 vintages will indeed achieve golden period status.
A sound investment process analyzes both macroeconomic trends and fundamental data to assess the likelihood of various potential outcomes. We have identified two distinct potential outcomes for the US private tech sector over the next 6-12 months.
Scenario 1: additional pain before recovery
A few weeks ago, Federal Reserve Chairman Jerome Powell predicted that the Federal Reserve’s efforts to contain inflation would lead to a “prolonged period of below-trend growth” that “would cause suffering for households and businesses”.
This implies a period of stagnation in US stock prices in a lower range over the next 12 to 24 months. Such an outcome is likely in the short 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 economic conditions in the United States could trigger stock market stagnation and potentially lead to another 20-25% decline in public stock prices. Such circumstances would continue to suppress price/earnings multiples and negatively impact sales performance.
While parts of the economy remain strong, it now seems clear that Fed Chairman Powell is having a Paul Volker moment: a resolute aim to break the back of inflation, whatever the consequences. Orchestrating a “soft” landing was a “hopeful” strategy that is proving increasingly elusive.
Assuming we see further interest rate hikes in the short to medium term, the prospect of long-term profitability for the US tech sector, perhaps counterintuitively, remains strong. A suppressed market would likely lead to above-average returns for the tech sector (particularly SaaS and cloud-enabled businesses) due to its ability to scale quickly without the additional infrastructure and blockchain ramp-ups. supply that will be required by the traditional brick. and mortar companies.
Rising geopolitical tensions around Ukraine
It has been more than six months since Russia invaded Ukraine, and the economic impact of rising commodity prices is beginning to be felt across Europe. While it is too early to predict the military outcome of the conflict, it is clear that Europe and the United States are morally and financially invested in preventing Russia from successfully annexing parts of Ukraine.
Current circumstances suggest a stalemate as the best-case scenario. The conflict in Ukraine resembles the Soviet-Afghan War of the 1980s, a protracted war of attrition in which the West funds, trains and arms local fighters in an effort to stress the Russian economy and thus force a withdrawal of the region. A threatened and cornered Russia could resort to ultimate tantrums, either by including nuclear threats or by restricting/eliminating Europe’s access to its energy and raw material resources.