What 2022 meant for VC – a necessary readjustment triggered by global events

In this op-ed piece by OpenOcean's Director of Investor Relations Naureen Zahid, she puts 2022 under the microscope and distills what happened and what it means for the venture capital community.
What 2022 meant for VC – a necessary readjustment triggered by global events

Over the last year, the Venture Capital (VC) space has experienced enormous tumult. 2022 saw a sharp decline in start-up valuations and VC investment, especially within the growth stages; waves of layoffs; and the collapse of numerous businesses, including those that had previously seemed strong. 

But looking at the symptoms is not enough. We cannot fully understand what caused this upheaval without looking at wider macroeconomic factors. These have had an enormous impact on the public markets, which in turn, have had a ripple effect on the private markets, in which VC investment takes place.

Neither start-ups nor VCs operate in a vacuum, and the interdependencies between both groups are crucial drivers in many modern economies. It is important to reflect on the events of 2022 to understand how this will affect the industry going forwards. 

A perfect storm: which factors led to market volatility in 2022

To summarise what happened in the markets during 2022, we need to use a macroeconomic lens. Whilst individual actions can have a large impact on markets, what we saw last year was the convergence of many broader factors. 

The first domino to fall was surging inflation, causing central banks to enact quantitative tightening (QT) programmes and increase interest rates. The US Federal Reserve (“Fed”) led the way in increasing interest rates at one of the fastest and steepest levels on record, with other central banks following suit to bring down the sustained and elevated levels of inflation. 

It is difficult to pinpoint exactly what was most responsible for the inflation crisis. A number of factors, including the decision taken by governments to “lockdown” whilst depositing stimulus cheques and furlough payments directly into the bank accounts of citizens during the COVID-19 pandemic, the subsequent fragility in international supply chains caused by the pandemic lockdowns, and geopolitical turmoil following Russia’s invasion of Ukraine, all combined to constrain the supply of goods and services at a time when demand remained high.

The initial policy of the Fed and other similar national institutions (including the Bank of England and European Central Bank) treated these rising inflation numbers as “transitory”, and so chose not to adopt serious deflationary fiscal measures. Once it became clear that this was a misjudgment, aggressive QT and interest rate hikes came into play. 

To understand the effect that this had, it can be useful to look at the performance of the kinds of portfolios that institutional investors have traditionally adopted. The typical weighting is 60% equity to 40% fixed income, aiming to provide uncorrelated returns with exposure to “risk-free” and income-yielding assets such as treasury bonds.

These “60/40” portfolios saw the greatest drawdowns seen in 85 years – for context, we have to go back to the Great Depression to find an analogous moment. The measures used to fight inflation have had a drastic effect on investors' portfolios as liquidity has been squeezed whilst credit-, duration-, and inflation- risks have become a real concern. Investors have been forced to rebalance their portfolios, find sustainable liquidity, and readjust their risk/return approach to both public and private markets. 

Inflation is proving to be more sticky than anticipated, despite the steep rise of interest rates, but the Fed, and other central banks, are holding firm in their battle to control and bring inflation levels back down to target. The result? We will continue to feel the effects of 2022 until the inflation issue has been resolved, either by central bank policy or tighter fiscal conditions within the financial system.

Taking stock: what this means for VC

These macro and geopolitical moves and their effects on monetary and fiscal policy have already had important implications for all involved in the VC space. For start-ups, it has meant that high valuations and multi-million funding rounds are harder to come by than they were in 2021 – though there is sufficient dry powder available for allocation to strong contenders. The main objective for most start-ups this year has been to focus on ensuring they have adequate runway to operate during this turbulent time and shift their strategy from growth to profitability to ensure their survival. 

Efficient capital deployment by start-ups has risen to the top of founders’ minds for two main reasons. To preserve their own resources and to drive lean models which increase their market share for continued growth. 

This fiscal discipline, along with finding innovative ways to drive lean growth, will ensure healthy balance sheets, whilst showing General and Limited Partners (GPs and LPs) that these start-ups can weather the current storm, and maybe even flourish.

Many start-ups that do require additional capital to continue operations and growth will be considering alternative, debt-based funding models more seriously, with raising equity becoming increasingly difficult. Profitability is the one metric everyone will be focusing on, and founders should take some time to think about whether more capital is absolutely necessary right now. With debt funding, it will be tantamount to model debt servicing costs against profit margins.

For VC firms themselves, caution is the name of the game. Compared to 2021, many VCs are prioritising a thorough selection process: conducting far more extensive and deeper due diligence to ensure this happens. VCs will scrutinise companies very closely, using tightened sensitivity analyses, growth and exit scenario modelling, and very conservatively assessing TAM, to name a few. 

Companies that have demonstrated reasonable and justified valuations, which operate in verticals where demand remains strong, and which pair an excellent product-market fit with strong growth potential are the ones that will secure funding.  

Whilst headlines have focused on the dramatic markdowns, it is worth noting that not all areas of VC investment and valuations have seen an equal drop – markdowns have been less severe for early-stage funding rounds when compared to later stages. Deal activity at this stage continues to be robust, with capital inflows into early-stage VC remaining strong throughout 2022.

The Limited Partners (LPs) that provide the capital that VCs invest will be similarly cautious and diligent in their search for alpha. Previously, there has been a trend of LPs looking to place their money under generalist managers with a broad base of knowledge and exposure to investments across many different areas and technology types. Due to increased risk aversion, this will likely change, and LPs may prefer specialist managers with a narrower but deeper field of expertise who can mitigate some idiosyncratic risks. 

LPs will want to capitalise on the vertical areas which show continued demand — meaning they are more likely to deliver strong returns — and focus their resources on these areas in a disciplined and shrewd manner.

The most sought-after managers in the coming months will be those with a long-standing, repeated, and proven track record of continuing to deliver strong returns despite turbulent market environments. 

A long-awaited correction: what this period represents for VCs

VC’s recent market instability should not be seen as entirely negative. These adjusted valuations are simply a reversion to fundamentals, having become unjustifiably frothy in the excitement of the last few years. In 2021, the rampant over-valuation gave a way for many businesses to drum up hype and raise far more than they might in today’s market.

A diligent and cautious approach to investing is simply a return to best practices to ensure capital preservation and growth. With a higher bar for investment comes the pressure for start-ups to sharpen their focus on solving the most pressing problems for enterprises, governments, and consumers. They must dig deep into their customers’ concerns to build sticky solutions that provide added value to the end user.

We should recognise that, by most standards, 2021 was an outlier. Even with the dramatic markdowns of valuations and decrease in investment activity, 2022 remains the second-strongest year ever, by quite a wide margin. 

According to Pitchbook, 2022 saw 10,000 more VC deals than 2020 (the third-strongest year) and the raising of almost $200 billion more than in 2020. As mentioned earlier, deal activity has continued at a good pace within the early stages. Many investors have chosen to take advantage of today’s lower valuations, aiming to drive even higher return multiples on exit.

The current market environment has meant that VCs are putting more resources and focus into identifying the most fruitful areas for investment, which can only be a healthy and positive development. These areas, which will be representative of growth for the tech sector, include those which will enable better scaling of AI, more efficient data infrastructures, and the next generation of intelligent automation and software development. These fields will be well-positioned to raise the growth capital needed to scale and reach maturity.

The macroeconomic and geopolitical trends that triggered the events of 2022 served, in some ways, to highlight underlying issues in the VC industry that urgently needed to be addressed. VC now seems to have made the appropriate adjustments and generally acknowledged the mistakes that were made in 2021, which will be less likely to reoccur in the near future.

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