2023 Mid-year Alternative Investment Outlook

The state of venture capital markets

Michael Carmen, CFA, Co-Head, Private Investments
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The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

This is an excerpt from our 2023 Mid-year Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the second half of the year. This is a chapter in the Mid-year Alternative Investment Outlook section.

Venture capital has not been immune to broader market volatility, as a variety of factors (both macro and sector specific) have impacted financial markets over the past few years. While some, such as stubborn inflation rates and recent regional bank failures, are clearly challenges to the industry, others point to 2023 as a potentially strong vintage year for venture capital firms that can navigate volatility. 

After years of elevated deal activity (and prices) primarily driven by the low cost of capital, valuations, deal volume, term sheet structure, and the competitive landscape are adjusting to a new normal. While these impacts are wide-ranging across the venture landscape, they are reflected with varying nuance and magnitude by stage and sector. In our view, one conclusion seems clear: The initiative has shifted from companies raising capital to the investors with money left to deploy. 

Figure 1

Venture capital deal activity

Across stages, venture capital deal activity has fallen for five consecutive quarters. Driven by a number of factors, the greatest pullback to date has been in late-stage growth. The sector’s proximity to the public market often means that these companies react more quickly and sharply to downturns in the public market. Adding to this, earlier-stage companies are more reliant on venture capital for survival as many of them are pre-revenue. While some late-stage companies may have low cash burn or even be profitable, earlier-stage companies need to raise money to continue operations and do not have the same levers to pull to postpone funding. 

To quantify this drop in deal activity, aggregate deal value has fallen almost 65% from US$188.2 billion in Q421 to US$67.4 billion in Q123.1 In terms of deal volume, the venture market has fallen to its lowest point in nearly a decade. While this appears to be a largely global trend, with all major geographies showing substantial slowdowns, North America has dropped the most significantly. 

Figure 2

Despite the continued depression in deal value and volume, we have seen opportunities in the market grow significantly over the past nine months. This apparent contradiction is the result of the evolution in demand for funding. At the beginning of the market volatility in early 2022, deal activity was low because companies put off fundraising. They did not want to take capital at reduced valuations and instead were betting that they would recover to peak 2021 levels. While there are holdouts, expectations have rationalized significantly across management teams and boards over the past year. 

Notably, despite this adjustment, the trend of low deal activity has continued because venture capital investors are still hesitant to deploy capital in an uncertain environment. The capital demand-supply ratio in the early-stage venture capital market has risen to a record high of 1.6x, meaning there is just US$1 of funding for every US$1.60 demanded, compared to 0.6x in 2021. This disparity skyrockets in late-stage venture, where it grows to 3.2x for every dollar compared to 2021 levels of 0.9x.2 We believe that this is largely driven by the pullback from nontraditional sources of venture funding like hedge funds. These investors fueled record-high levels of deal activity in 2021, but many have been forced to withdraw from private markets to focus on their larger public-market interests. 

Exits and the IPO market

While new deal activity has been scarce, exits in venture have been impacted even more substantially. Measuring from the end of 2021 to the latest available data in Q123, aggregate exit value has dropped by 84%.3 The closed IPO market is a clear driver of these depressed figures, which disproportionately impacts late-stage growth companies that were seeking to go public. As of Q123, a total of 219 companies are estimated to be in the IPO backlog.4 The short-term impact of this loss of liquidity has been painful for investors and large companies, but the scale also suggests that when the IPO market reopens it will likely be with a high volume of companies that have been waiting and compounding their growth. It is impossible to predict with any certainty when that will be, but the past 42 years of IPO activity suggest that levels tend to be down for one to three years before returning to normal (Figure 3)

Figure 3

Despite less exposure to the IPO market and longer hold times in general, earlier-stage companies are seeing their typical exit routes closed as well. Trade sales dropped by more than 30% during the past five quarters while sales to other GPs were 54% lower.5 We expect that this will reverse in the short-term as some venture capital firms become more willing to provide LPs with liquidity and resort to secondary markets.

Bottom line on the venture capital market outlook

Heightened volatility, reduced deal flow, and shifting valuations bring both risks and opportunities to the venture capital market. In our view, investors with dry powder may be well positioned to capitalize on their growing bargaining power in the back half of 2023 and beyond.

1Source: Preqin Q1 2023 Venture Capital Update. Data as of 31 March 2023. | 2Source: Pitchbook Q1 2023 NVCA Venture Monitor. Data as of 31 March 2023. | 3Source: Preqin Q1 2023 Venture Capital Update. Data as of 31 March 2023. | 4Source: Pitchbook Q1 2023 NVCA Venture Monitor. Data as of 31 March 2023. | 5Source: Preqin Q1 2023 Venture Capital Update. Data as of 31 March 2023.


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