Estimated reading time: 9 minutes

In the third quarter of last year, we released an update on the U.S. VC market, discussing the ongoing pullback in the Venture Capital (VC) market, which some deemed the “VC winter.” The chilly headwinds continued through to the end of the year. However, with the robust performance of public equities to start 2024, a stronger-than-expected economy, and largely favorable macroeconomic conditions, the question becomes: Is spring around the corner, or did the groundhog see his shadow?

Reflections on Last Year

Understanding the current state of the VC market requires looking back at the last year.

In 2023, VC valuations saw an overall decline. Late-stage pre-money valuations dropped 16%, while the threshold to be in the top 10% of deals was $359 million, continuing a pattern of decline for the top decile that began in 2021, where the threshold value topped out at $750 million. Meanwhile, venture growth pre-money valuations declined nearly 50% YoY to $142 million, the largest compression of all VC segments. Seed and pre-seed valuations remained relatively flat, though transaction volumes in these segments were at 2020 levels, implying a higher bar to raise rather than an exception to the downward valuation trend (i.e., in cases where investors may have funded at a lower value in the past, now investors are staying away altogether).

At 14% of overall deal volumes, down-rounds in the VC space were at their highest level since 2017. This number is understated as it does not include structured rounds, which are technically akin to down-rounds and insider-led rounds. The number of structured new rounds—which include dilutive downside protection, cumulative dividends, and liquidation preferences at multiples of original issue price—are increasing. Rounds with cumulative dividends in 2023 were the highest since 2013, and insider-led deals are at a decade high of about 20%. The venture growth space saw roughly 44% of deals either flat or down.

Over the course of the year, as market liquidity dried up and macro issues began to impact VC company fundamentals negatively, VC Investors preached to the management of their investment companies to focus less on top-line growth and extending cash runway by focusing more on cost controls and liquidity, while maintaining a conservative balance sheet. As a result, investor interest waned, as evidenced by declining fundraising trends. In 2023, fundraising was down about 20% overall in the private capital markets, and the U.S. saw the lowest total amount raised since 2018. Non-traditional investor (NTI) activity in the VC space, primarily from private equity and hedge funds, also fell to 2018 levels. While these deals typically price higher than others, pricing was down roughly 20% over the past two years. Pitchbook estimates an approximate 40% decline in NTI investors in the VC space since 2021.

Recovery in NTI interest likely depends upon the IPO market coming back, and the outlook for that is challenging. At year-end, the Pitchbook VC-backed IPO Index and the DeSPAC Index were down about 40% and 70%, respectively, since the start of 2022. Main exit paths from the prior two years are closed, and there were only 128 US IPOs in 2023 compared to almost four times that amount in 2021 (excluding SPACs).

Venture Capital Funds Fundraising

By the nature of their stage in development, many VC companies depend on funding to grow. Because many funds were held off on fundraising last year, there will likely be an oversized demand in 2024. Prospective investors will scrutinize existing general partners based on their handling of 2021 and 2022 to determine if they should receive new capital. General partners that overspent during the peak valuations seen in 2021 and 2022 will likely see less interest from investors versus more prudent GPs who did not over-engage during such frothy times or those whose investments held up in value. Given the closed IPO market and anemic M&A activity, the lack of exit paths from the prior two years has limited LPs’ liquidity and ability to reinvest. Specifically, Pitchbook shows that the annual average distribution as a portion of net asset value of ~5% is at a 14-year low. Fundraising will also be constrained by increased investor due diligence, given generally poor VC fund and portfolio company performance since 2021. And finally, improved returns in less risky asset classes will add to the competition for fresh capital.

There is still a lot of dry powder, with more than $300 million of deployable capital in the US VC Fund space. However, because crossover funds and NTIs are staying out of VC, later-stage VC funds will likely have less competition. This year could see a cleanse of the overly saturated space as managers with poor performance or without a strong strategy or competitive edge are weeded out, as there were many new VC funds formed due to near zero rates, historically high returns from ballooning valuations, and fear of missing out on high returns over the past few years. Such an environment also favors established managers over new entrants. In fact, Pitchbook reports that the fundraising gap between freshman and sophomore VC funds is near a record high at 2.6 years.

VC Debt a Bright Spot

VC lending has been an exception to the general VC malaise. Venture debt deal value and deal count were down nearly 30% and 24%, respectively, year-over-year, primarily due to the loss of Silicon Valley Bank and the pullback in NTIs. Still, this reduction in supply has been a boon for VC business development companies (BDCs), which are now operating with less competition within the space.

BDCs are seeing record returns as yields increased from the low teens to the 16-17% range due to much higher base rates against only modest compression of credit spreads on their floating rate loan products. Also, VC lenders historically had to settle for higher-risk borrowers to drive higher returns. However, as base rates are up, lenders can get higher returns from higher-quality credits, with higher base rates making up for tighter spreads on quality credits.

As demand for funds in the VC space outweighs investors’ willingness to supply equity capital, and companies are hesitant to dilute their equity positions at lower valuations further, the valuation proposition of VC debt becomes increasingly appealing, particularly for later-stage companies. Based on deal count, 2023 was the second most active year in the late-stage venture debt market. While higher yields drive higher returns for VC lenders, it comes with a catch—it increases stress on portfolio companies due to higher debt servicing fees, thus increasing default and restructuring activity.

There have been increased levels of amend and extend (A&E) transactions and amendments pushing out interest-only periods and amending covenant thresholds to prevent (or, perhaps more accurately, in many cases, delay) defaults. In the broad credit markets, there was $175.9 billion of A&E in 2023, exceeding the previous record of $110.1 billion set in 2021. Corporate defaults are defying the expectations of many market observers, but January/February 2024 still saw 29, the most in the first two months of a year since 2009. While VC debt funds are well positioned for new underwriting (later stage, stronger credits at higher all-in yields), there is still cause for concern surrounding many earlier issuances that may be approaching maturity or have been patched over by A&E activity and have no clear path to another financing round or to an exit.

 Valuations YTD 2024

So how does the above translate into movements in valuations in 2024 year-to-date and current fundraising?

Generally, VC pre-money valuations saw a slight uptick in the first quarter. However, there is a major caveat due to a few factors. Pre-money valuations do not account for structure, which is present in an increasingly high number of new deals. This is particularly true for cumulative dividends, which were more prevalent in 2023 than in any year in the prior decade. The second factor is that dealmaking remains relatively slow. Deal value was relatively on par with 2023 levels at $26.6 billion, but deal count was well below 2021 and 2022. Insider-led rounds are at decade highs, hovering around 20%, and first-time financings are at multiyear lows. A large number of companies that raised in 2021 and 2022 have pushed off raises—which would likely be flat or down rounds—through layoffs and less growth investment. Thus, the rounds are now biased towards the “winners”, and there is increased survivorship bias compared to recent years.

The growth between rounds is at or near decade lows, with early-stage VC step-ups at 36.2% and late-stage at 11.2%. Furthermore, the number of down/flat rounds increased to 27.4% in 1Q24, the highest in a decade.

VC fund managers are focused on supporting exiting investments and companies with solid fundamentals, and they have less desire to target riskier, more aggressive investments. They are guiding companies to focus on liquidity and profitability, which takes away from growth spend and lowers top-line forecasts. Typically, this results in lower multiples, as previously aggressive LTM/NFY revenue multiples were often justified by more reasonable later-year multiples. However, as forecasts are revised downward, this no longer remains the case. Unsurprisingly, the exception has been AI-related enterprises, which have seen robust demand and command premium pricing on new deals. Overall, it is an investor-friendly market.

Exit Opportunities

 US VC exits followed 2023 trends and remained historically low in the first quarter of 2024. Last year, exit values in public debuts declined just over 50% (~$117.0 million decline) to $110.6 million. At the start of 2024, there were only 223 exits and $18.4 billion in value. Exit value figures were largely carried by IPOs of Astera Labs and Reddit (over 70% of 1Q24 exit value).

The VC-backed IPO Index price-to-sales multiple is at a decade low of about 5x. From 2020 to 2021, this multiple had a median of 12.3x and peaked in the low 20s. Granted, this was partially due to premature IPOs of earlier stage (i.e., lower revenue / higher expected growth) companies; today’s IPOs are mostly later-stage VC companies with higher revenue bases and relatively lower growth expectations. When considering many of the companies planning to IPO likely last raised funds in 2020/2021, the sizable decline in exit multiples likely results in losses on investment, even factoring in two to three years of top-line growth, thus influencing companies and investors to try and wait out better conditions (i.e., potential return of higher multiples).

From the end of 2021 through the end of April 2024, the Pitchbook VC-Backed IPO Index was down 38%, and the Pitchbook DeSPAC Index was down 76%. Year-to-date, the Pitchbook VC-Backed IPO index is up 6%, in line with the S&P 500, so there may be some light at the end of the long tunnel.

As of the writing of this article, other signs of optimism are that recent headline IPOs, Astera Labs and Reddit, have been trading close to their IPO prices. Some 2023 headline IPOs, such as Cava, Instacart, Birkenstock, NEXTracker, and Arm, are trading above their IPO prices (although Klaviyo and Kenvue are trading at sizable discounts). Nevertheless, many recent IPOs required later-round private investors to experience a lower valuation relative to the last investment round. Or, at the very least, they are not seeing the initial returns they hoped for at investment.

The M&A market has been weak for over a year due to increased borrowing costs and a gap in price expectations between buyers and sellers. Expectations are that the second half of 2024 will see a strong recovery in M&A as investors look to find alternative exit opportunities in a weak IPO market. The first quarter saw deal counts on par with 2019 levels. However, many of the deals did not disclose price, which often indicates lower deal values. In lieu of bigger platform acquisitions, we are seeing more smaller strategic acquisitions.

The last major area of exit opportunities for investors is secondary sales of VC investments by GPs. Per Zanbato, the median and average discount of secondary sales to the previous round were 37% and 28% in 1Q24, respectively. This is a slight rebound QoQ, but it shows the sizable decline in value for many VC companies that do not necessarily show up in other market data tied to new rounds and traditional exits. As GPs and LPs require additional liquidity due to the weak exit markets, the expectation is that secondaries will continue to grow as a source of liquidity for investors.

Looking Ahead

Overall, it appears that the groundhog has seen his shadow, and the VC winter is not over quite yet. Significant near-term hurdles remain that need to be overcome before spring arrives.

Several short-term obstacles need to be cleared before VC deals pick up again:

• Geopolitical wars and tensions
• Stubborn inflation
• Interest rates remaining higher for longer
• The potential for a recession

Long-term factors that will impact the VC market, mostly for the better, include:

• Innovative technologies, like AI, are receiving a lot of focus and capital.
• Historically large amounts of dry powder will drive/fuel future M&A activity.
• The possibility of lower rates in the future (based on downward-sloping yield curves, which indicate lower market rate expectations) will alleviate the high interest burdens of existing VC portco companies and help facilitate new M&A deal activity.
• Improved VC company profitability and liquidity as managers focus on profitability over growth.
• YTD strong performance in public markets, if sustained, could help drive a reopening of the IPO market in late 2024 or 2025. Through April, the S&P 500 is up 5.6%.
• Supply chain bottlenecks have been or are being resolved, as exhibited by the Global Supply Chain Pressure Index released by the Federal Reserve Bank of New York.
• And, despite high interest rates and lower growth expectations, default/loss levels have been historically modest, and the economy has generally held up, increasing expectations for a soft landing.

Thus, despite the lingering chill, there are clear signs of optimism over the longer term that can pull the segment forward.