How do Rising Interest Rates Affect Venture Capital?

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How do Rising Interest Rates Affect Venture Capital?

Inflation has been a hot topic for 2022, which we covered in our article Investing during inflation to help maintain the purchasing power of your money. In an effort to curb rising inflation, the US Federal Reserve recently announced its highest interest rate increase in the past 28 years, which could have important implications for investors. Below are some of my thoughts on how rising interest rates can affect Venture Capital (VC) investing.

TL;DR: Interest rate increases are likely throughout 2022 and 2023. I believe that public markets are unlikely to bottom out until interest rates stop rising. In the meantime, private markets are also unsettled as major pension funds seem to be holding back investment commitments. In this environment of uncertainty, the silver lining is a reduction in valuations for some deals. This could potentially be an opportunity for savvy investors to pick out and invest in promising deals at lower valuations.

What is the Federal Reserve and the Federal Interest Rate?

The Federal Reserve System (often just called the Fed) is the US central bank, which via the Federal Reserve Act of 1913 is responsible for setting US monetary policy, comprising the three tools of open market operations, the discount rate, and reserve requirements. These monetary policy tools are used by the Fed to influence the “Federal Funds Rate”, which is the interest rate for overnight borrowing paid by banks for the funds held in Federal Reserve accounts (the Federal Funds Rate is sometimes referred to as the federal interest rate).

Open market operations (the sale or purchase of securities on the open market by a central bank) are the responsibility of the Federal Open Market Committee (FOMC). The FOMC has twelve members, including the Fed’s Board of Governors and a selection of Reserve Bank presidents. The FOMC sets a target for the Federal Funds Rate, which has flow-on effects to interest rates in other parts of the financial system such as business lending rates, home mortgage rates, treasury bonds, foreign exchange rates, credit card rates, and more. In turn, this can impact other areas of the economy including credit availability, employment, production, inflation, investment, growth, and more.

Recent History of US Interest Rates

Based on data from the Federal Reserve, the highest ever US federal interest rate was 19.1% per annum in early 1980 and the lowest ever rate was 0.05% per annum in early 2020. In the FOMC Statement of June 15, 2022, the Federal Reserve announced a federal funds rate target range of 1.5% to 1.75% , representing an increase of 0.75% over the previous target range. This was the highest increase in the federal interest rate since November 1994.

Recent history of US federal interest rates is summarized in the following chart, which shows the Federal Funds Effective Rate over the past 20 years, since January 2002, as sourced from the Federal Reserve Data Download Program.

Interest Rate Indications from the FOMC

The FOMC meets eight times per year and publishes a Summary of Economic Projections four times per year. Meeting outcomes and projections are reported in press releases and reports, the wording of which indicates the current and potential future direction of the Fed’s monetary policy objectives.

The FOMC June 2022 Statement noted the following:

“…the Committee decided to raise the target range for the federal funds rate to 1‑1/2 to 1-3/4 percent and anticipates that ongoing increases in the target range will be appropriate.”

The economic projections in the FOMC June 2022 Summary of Economic Projections show a median projection for the Federal Funds Rate of 3.4% in 2022 and 3.8% in 2023.

The wording and data provided above indicates that the FOMC considers further interest rate increases are likely to be implemented throughout 2022 and 2023.

How Do Interest Rates Affect Investments in the Public Market?

Investment returns are affected by a range of factors, including interest rates, which can impact different investments to varying degrees. While it’s not possible to be definitive about how interest rates might affect investments in the future, historical trends indicate that interest rates have generally affected public markets as follows:

– Rising interest rates increase the cost of borrowing for companies and individuals, which can have negative impacts on consumer spending and corporate financial performance. In turn, these can negatively affect company profits, shareholder dividends, and capital growth. Such outcomes can affect share prices, thus impacting the overall performance of the stock market.

– Rising interest rates generally cause bond prices to fall. This is because new bonds paying higher interest rates become available in the market, which reduces the value of an existing bond that is paying a lower rate.

Historically, public markets generally have not bottomed out until the Fed gives a signal that it does not plan to continue increasing interest rates. Since this has not happened as of the date of this article, further corrections in the public market may occur until the Fed indicates an easing of interest rate increases.

How Do Rising Interest Rates Affect Venture Capital?

Following on from the above discussion around how rising interest rates affect the public market raises the question of how rising interest rates affect venture capital?

Some large pension funds are significant investors in the private market, which can include venture capital investments. Rising interest rates have the potential to impact returns from public market investments, which can have flow-on effects on pension fund investments in private markets. Anecdotally, we hear that institutional commitments towards venture capital are being held back. This sentiment is supported by survey data reported by industry analyst PitchBook in their recent article VCs hit with ‘fundraising pain’ as LPs deal with venture overexposure, in which they note that pension funds and endowments are limiting their VC exposure and that one of the reasons for this is to comply with asset-allocation targets that are being impacted by lower public asset valuations.

But there is a potential silver lining for investors in the current environment; falling valuations. Since VCs have become more cautious, startup valuations in Angel rounds are adjusting downwards, as can be seen from the chart below (data sourced from the Q2 2022 PitchBook-NVCA Venture Monitor). This could be an opportunity for savvy investors to invest in high potential startups at lower valuations.

Downturns can be a time of opportunity for investors and entrepreneurs. For example, a number of  highly successful startups were launched during or just after the Global Financial  Crisis and Great Recession of 2008-2010. Some examples are shown in the following table:

* All current values stated in the above table refer to the approximate market capitalization of the company on the relevant public stock exchange such as the New York Stock Exchange or NASDAQ, as at July 21, 2022.

In Closing

Indications are that VC investors have funds to invest but may be delaying committing those funds as they wait to see what happens with the economy, interest rates, and valuations. While the public and private markets are not necessarily directly correlated, uncertainty in the public market can impact the private market.

In the current unsettled public market environment, the impact on private markets has been to reduce valuations. This could be a good thing for investors, as this may be an opportunity to invest at lower valuations.

If you are interested in building your portfolio by adding investments in startups, you can find more information here on how to start angel investing and how to find opportunities for angel investing on the Propel(x) platform.

This article is for informational purposes only. We do not provide legal, financial, or tax advice and investors should consult their advisors prior to making any investment. As with any investment, past performance is no guarantee of future performance, and any investment decision must balance the risk against the potential return. Private investments are highly illiquid and risky and are not suitable for all investors. There is no guarantee that a liquidity event will ever take place.

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