A new macroeconomic regime — what does it mean for venture?
The cause, not the symptoms.
The term ‘unprecedented’ has been common parlance for the last two years of everyone’s lives, and the last few weeks have only served to reinforce that we are a long way from a return to normal, stable times. The invasion of Ukraine and the ongoing humanitarian crisis continues to be the most pressing priority on both personal and professional levels for many. However, there is an additional facet of global (financial) conditions which we’ve been thinking through as a fund. Even prior to the current crisis, there had long been a ubiquitous sea of red across global tech stocks as markets grappled with the changing nature of monetary policy.
While there’s been a lot of talk in VC and founder circles about whether we will see the degradation of public market multiples flowing through to private markets…it’s been tumbleweeds in terms of discussion around why markets are moving this way. Perhaps more importantly, there’s also been a complete chasm in discussion as to whether these root causes mean that we can expect this volatility to continue. With the second Federal Reserve meeting of the year commencing tomorrow, we wanted to share some thoughts to help better understand these root causes. The OMERS economics team have kindly collaborated with us for this post, and we owe a special thanks to Sandra Ramirez and Summer Qu.
It’s the economy, stupid.
Frothy valuations have become embedded in our psyches and expectations, with little thought given to the huge fiscal and monetary stimulus which the global economy has been enjoying for the last decade or so. While you’ll always find an economist who is willing to take the contrarian view, the general school of thought is that this unprecedented level of support has had a few consequences. One being elevated asset levels, and two a substantial rise in inflation.
There’s been vigorous debate as to the drivers of inflation seen so far. For most of 2021, central bankers were of the view that the bout of inflation was largely “transitory”, a reflection of pandemic-related global supply chain constraints putting temporary pressure on prices for goods and commodities. Indeed, this was the case for most of the year with the transportation and commodity industry exhibiting the most severe inflation:
Central banks expected that these pressures would largely dissipate as companies ramped up production, and as demand normalized away from goods back toward services. While some of these supply-chain constraints are beginning to subside, particularly in the transportation industry, commodity prices continue to rise, and inflation is broadening across other sectors (e.g., housing). Russia’s invasion of Ukraine and the subsequent global sanctions on Russia, one of the world’s largest commodity producers, is yet another supply shock putting upwards pressure on energy and food inflation.
So now the music does seem to be stopping. The Federal Reserve have signalled that we’re entering a new macroeconomic regime. The Fed is now clearly concerned that it is behind the curve and needs to reaffirm credibility with the market. More importantly for Venture, the Fed has signalled that it won’t be beholden to the levels and stability of equity markets, and it is squarely its mandate of price stability which is in play now.
The return of volatility
This has unsettled the market for a few reasons, as the era of forward guidance from a predictably dovish* chair has ended. The move away from forward guidance to data dependency is a significant one, as the Fed is seeking to retain as much optionality as possible to respond to forthcoming data. Market anxiety and volatility is further magnified by the fact that this data is increasingly difficult to forecast. The difficulty with forecasting in a post covid era is evident from the dispersion of US professional forecasting of inflation 1 year ahead:
Going into the recent Ukraine crisis, uncertainty about the outlook for inflation was already very elevated. The recent spike in energy prices and the impact that it will have on both global growth and inflation only further complicates central bank policy making. Central banks typically look through spikes in energy prices, but the impact that commodity price passthrough could have on already rising core (ex-energy) inflation is uncertain. While the immediate impact is clearly inflationary, over time it eventually weighs on growth and inflation as commodity price spikes are essentially a tax on the consumer.
The other elephant in the room is what the Fed will do with its substantial balance sheet (which is currently in excess of $8trn). Given the US dollar’s dominance in trade and financial markets, the Fed as the central bank for the world, could be expected to be even more careful now in reducing the balance sheet. What we do know is that around $1trn of that is in US treasuries which are maturing over the next year, so if that all rolls off, that equates to ~11% YoY contraction.
What next for public markets?
One big question for market participants remains: how will valuations be impacted as central banks around the world begin tightening monetary policy? While tightening policy is not the only driver of valuations, it’s worth examining how PE ratios performed in previous tightening cycles:
Generally, PEs tend to run-up months before the Fed starts hiking and then fall subsequently. The extent of PE drawdowns, on average, depends on whether the Fed decides to hike policy rates quickly or slowly. In faster hiking cycles, PEs fall, on average, 30% a year after the first policy rate increase. In slow hiking cycles, PEs fall, on average, 10% a year after the first policy rate increase.
This time around, the forward PE ratio for the S&P500 has fallen by ~20%, bucking the trend seen in previous cycles of PEs rising into a hiking cycle. There are a few reasons to think this cycle is different. For instance, one anomaly this time around is that earnings have recovered much faster than prior cycles.
Where does this leave private markets?
Unsurprisingly, the 2020–2021 euphoria for tech/growth stocks in public market filtered down into early stage fundraising. While there is no perfect data set for private valuations (and we’d absolutely love to meet anyone who is solving for this), the most recent data from Pitchbook shows the rapid pace of valuation inflation over the last few years:
While an increase in valuations won’t come as a surprise to many, the point which generates less discussion is the slowing pace of revenue growth, which this data from Kruze Consulting illustrates quite succinctly.
While we’re not disputing that there are certain sectors where it still seems that people will be able to grow into their valuations (e.g. growth in cloud software continues to accelerate if Q4 earnings are a guide), it is unlikely this will be the case across the board.
In addition to the large number of risk factors which have already been discussed which are guiding wider market sentiment, there are also some tech specific growth queries which we’ve been discussing with founders. First, the speed with which 1 time covid beneficiaries have given back their gains in public markets (e.g. Zoom, Shopify, Peloton, Asana…et al) has been a surprise to many. It has thrown into question the durability of TAM creation from Covid. There is an awareness that churn is unpredictable in many verticals right now, and this should be a focus point for founders. In a similar manner, even where TAM creation is more sustainable, this does not a priori mean that growth rates can be sustained.
What does this mean for founders?
- Dry powder is still in abundance BUT crossover funds will be behaving differently — there are already numerous market rumours around the changing behaviours at later stages. Last week’s performance data only reinforces our view that crossover funds will now 1) be disproportionately exposed to private investments given the scale of their public mark downs and 2) will likely be far more price sensitive.
2. Founders will need to raise longer runways — while we are the first to highlight how much committed capital there is still to deploy and that funds are incentivised to deploy that capital, in such a difficult economic climate, most founders would be well advised to do what they can to extend runway. Now more than ever, you need plenty of ‘cushion’ when assessing your cash runway.
3. Founders might need to take more dilution — the past few years have seen founders at Series A — C able to hold a fairly hard line on dilution in financing discussions, we expect that this will become a growing point of negotiation, especially given the growing fund return hurdles which most GPs face. Read this from Finn at Frontline to get the seed perspective.
4. Investor behaviour might not always be the best — this will truly be a time to test the often repeated mantra of ‘founder friendly’. Now more than ever, founders need an active and engaged board, rather than passive investors who are no longer particularly invested in the success of the business.
For those still with us — thanks for making it to the end! As always, we welcome all thoughts and questions and you can find us at lshaw@omersventures.com and hgladwyn@omersventures.com.
Footnotes:
*Economists share the VC passion for jargon and acronyms. Broadly speaking, the term hawkish refers to policy makers who favour higher rates, while doves are policy members advocating for lower rates.
