2022-11-04
From the Messy Middle to a New Dawn: A 2023 Outlook for Private Equity and Venture Capital
As fundraising challenges persist in private equity and venture capital this quarter, managers seeking new capital are expected to enter what some perceive as a daunting 2023, as they vie for competitive advantages. However, to predict what 2023 will look like, we need to start by understanding where we are now—what TechCrunch has recently labeled as the “messy middle”—a period of enhanced uncertainty.
As we reflect on the market forces that have created the messy middle in this outlook, mounting evidence highlights that, perhaps, a positive new dawn could soon be upon us, despite all the recent doom-and-gloom forecasting for the New Year.
Today, venture capital and private equity firms are insisting that financial challengers reduce losses and chart a path to profitability. The culling of competition in this tough economic climate may ease pressures on the most successful firms, but to remain successful, those firms are increasingly turning to new technologies to give them an edge.
This article reviews the anticipated transition from the messy middle to what could prove to be a promising New Year, as well as the differentiators that firms should employ to be well-positioned in 2023.
The Outlook for Venture Capital in 2023
Due to geopolitical instability, inflation and market volatility, the macro environment has slowed a bit for venture capital (VC) … at least, for now. Generally, one may say that investor confidence has dropped and growth rounds are limited, with both seed and Series A valuations down by 30%-50%. Naturally, it is increasingly questionable to pump money into a company that doesn’t have the traction to back up its worth. However, one must not judge a book by its cover when observing the broader landscape.
VC funds raised $151 billion in the first three quarters of this year, exceeding any prior full-year fundraising, according to recently released information from PitchBook Data Inc. The money has been concentrated in fewer, larger funds, such as Sequoia Capital’s $2.25 billion and Lightspeed Venture Partners’ $7.1 billion hauls from July. However, even first-time fund managers, who tend to struggle in downturns, have been resilient so far. They expect that their funds will perform much better than if they had started their funds when valuations were higher, and they would have overpaid for startups months ago.
So, why all the (potentially misconceived) doom-and-gloom forecasting in the market today?
First, new entrants or ‘crossover funds’—institutions, hedge funds, and corporates—drawn into late-stage venture in hope of cashing out quickly during the boom have contracted their prior ambitions, given the state of the market. Second, limited partner (LP) investors are pulling back on some commitments as the value of their VC investments appear bloated, relative to a lower valued stock market, known as the denominator effect. With VC valuations still seemingly rather elevated, the denominator effect may force more LPs to continue tweaking their allocations through 2022 and possibly until early 2023.
However, this doesn’t mean that all deals are off. VC firms still have nearly $300 billion in “dry powder,” or money that is still available to spend.
What’s more, many family offices, sovereign-wealth funds, and other well-situated LPs remain steadfast backers of VC firms. Concurrently, the North American retreat by some large asset managers has made even more room for an influx of LPs from Europe, China, the Middle East and Singapore. They remain convinced that seemingly unstoppable tech trends, such as artificial intelligence, platform technology, IoT, and even blockchain will outlast the current economic downturn. Historically, venture capital has offered better returns than other asset classes, even during a recession. And, firms are still stockpiling incredible amounts of money, despite the broader (temporary) decline of tech stocks and persistent inflation.
One must remember that economic forces are cyclical, and in some firms, a buzz is starting to build that we could see a return to significant capital investment in 2023. Although, recently, some firms have been reticent to make bold investments over the past few months, this will change. If firms begin to deploy the massive amount of dry powder in their coffers, we could see a changing tide of investment next year along the lines of what we experienced in 2021 or, perhaps, even greater.
With startup valuations lower than last year, it’s an ideal time for investors to ramp up investment in startups that have demonstrated past and ongoing success, despite the extremely challenging conditions over the past few months.
Of course, VCs will need some of that cash to support their existing portfolio companies. Some have argued that they are squirreling away 30% to 40% of their funds for startups that might have trouble raising money from new investors. However, plenty could be left over to spend on new deals when the price is right.
Indeed, smart fund managers know that they must invest in down cycles as well as up cycles because no one has a crystal ball to determine exactly when the next 10-year bull market is going to start. The wisest of these fund managers further realize that to thrive in 2023 they will have to increasingly harness the power of data, automation, and new technologies to inform all of their most important decisions.
In this environment, in 2023, your firm will be redefined by the technology solutions that you choose to give you a competitive edge. Regardless of its size, your firm needs the ability to manage relationships, transactions, processes, workflows, and compliance matters in a very data-centric, automated, and secure manner. This is why VC leaders are increasingly choosing purpose-built platform technology that’s easily configured to meet their needs during today’s murky economic conditions.
I predict that those firms that do harness the power of cutting edge technology in their tech stacks this year will be best poised to succeed in 2023. Those who do not, including the dominant players, will find their prospects less rosy.
A Look at Private Equity as We Draw Closer to 2023
It doesn’t take an eternal optimist to believe that during the next six to 12 months there could also be a compelling new dawn to make money in private equity (PE).
As the market remains volatile, the Fed continues to hike rates, and the messy middle appears to loom, private equity deals have, indeed, slowed down a bit. Deal value in the first half of 2022 totaled $529 billion, a healthy figure by historical standards, but activity is expected to slow a bit for the rest of the year. While strategic acquisitions dominated exit activity in Q2 and Q3, sponsor-to-sponsor exits slowed and IPOs were rather limited.
It’s important to note that less than ten years ago, a key statistic was that companies were staying private for four to six years and there were fewer than 100 private companies with a billion-dollar valuation or more.
Today, there are more than 1,170 companies that have a billion-dollar valuation and, on average, have been private for 10-13 years. With that in mind, it’s still very much a great time to be active in private equity.
I challenge all the doom-and-gloom pundits casting a cloud over this sector and ask them to reflect on history. In fact, I believe that over the next few quarters, there will be a resurgent boom period to make money in private equity. We will, again, see opportunities similar to those that arose during the COVID-induced market downturn, where increased pressure on costs and earnings estimates caused valuations to be lowered.
While valuations right-size, the current challenge is similar to the pandemic period: there are very few bids in the private market. Some traditional investors who bought a lot in the private markets have left the market as the public bear markets significantly impacted their portfolios. Meanwhile, crossover funds have trickled to a near stop on new investments and some of the largest private investors suffered significant losses in their hedge funds. As the old adage goes, “this, too, shall pass.”
Naturally, to carpe diem, timing is everything, and precisely timing market downturns and rebounds is never an easy endeavor. That said, PE firms have some advantages in the private markets, as they can leverage technological analysis and insights from the public markets, especially when it comes to public company disclosures and information on where stocks and bonds are traded. The valuation moves in the private market tend to lag, which means they have a little bit more time to adjust to the downturn and prepare for the eventual rebound.
While the near-term investment climate is likely to be a test for the current generation of PE firms, as they witnessed their fortunes increase over the last decade with surging exit multiples, 2023 will still offer significant opportunity. With valuations resetting in the public markets as the messy middle dissipates, high growth private issuers may have a lost year or two. Nonetheless, I think it’s a safe assumption to predict that private equity will continue to outperform public markets. I would argue that, while there remains a relatively small number of institutional investors active in the market right now, as many of them are dealing with the challenges posed by public securities, this presents a significant opportunity for eventual secondary market growth.
Further, the private market is one of the fastest growing and most coveted asset classes. As demand for the private market asset class increases, many sell-side institutions have not been equipped to meet their clients demands for access to pre-IPO unicorns. This is an opportunity for tech-savvy, data-driven PE firms that help their clients navigate the complexities of transacting in the private markets by providing the ability to access, invest and trade in later-stage private companies, in particular.
What’s more, just like in the VC sector, PE is ripe for technological disruption, and leveraging much needed platform technology solutions to give your firm an edge will prove essential to thriving in the New Year. Perhaps now more than ever, PE firms must proactively anticipate a new dawn on the horizon and get ahead of it by leveraging advanced technologies that will give them strategic advantages. This will be critical to weathering this turbulent period, so firms can take advantage of the eventual rebound that awaits them in 2023.
Ultimately, both private equity and venture capital seem destined to not only rebound at some point in the New Year, but they’re further poised for significant growth over the next five years, as the messy middle wanes and a new dawn emerges. Once viewed as risky alternatives when compared to other asset classes, private equity and venture capital are increasingly a staple in some investors’ portfolios. Investors remain quite enticed and committed to these industries, and the underlying appeal of these asset classes only looks set to become more pronounced.
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Sources:
TechCrunch.com, “2023 VC predictions: Finding an exit from the ‘messy middle.’” https://techcrunch.com/2022/10/17/2023-vc-predictions-finding-an-exit-from-the-messy-middle/
PitchBook.com, “Private equity fundraising challenges set up a tough 2023.” https://pitchbook.com/news/articles/private-equity-fundraising-2023
Foley.com, “Venture Capital Firms Sitting on Billions in Dry Powder: Will This Lead to a Wave of Investment?” https://www.foley.com/en/insights/publications/2022/10/venture-capital-firms-billions-wave-investment
Fortune.com, “From the return of IPOs to stocks that can survive a recession, here’s what to expect in 2023.” https://fortune.com/2022/10/13/from-the-return-of-ipos-to-stocks-that-can-survive-a-recession-heres-what-to-expect-in-2023/
Crunchbase.com, “Global VC Pullback Is Dramatic In Q3 2022.” https://news.crunchbase.com/venture/global-vc-funding-pullback-q3-2022-monthly-recap/
Nasdaq.com, “Opportunities in Private Equity.” https://www.nasdaq.com/articles/opportunities-in-private-equity
WSJ.com, “Investors Pour Into Venture Capital Funds Even as Markets Cool.” https://www.wsj.com/articles/venture-capital-stays-hot-with-investors-even-as-markets-cool-11667357577