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Over the past two years, financial markets have experienced numerous shocks, including heightened geopolitical tension, inflation, a regional banking crisis, and, most critically for private equity markets, higher interest rates. Venture capital (VC) adapted with a general slowdown, as valuations, deployment, fundraising, and exits returned to more moderate levels, in line with historical averages. Looking ahead to 2024, we see positive signals indicating that the downturn may have hit bottom. Just as privates trailed the public market correction in 2022, we believe they will follow its recovery, with a lag. With the Russell 2000 up 15% in 2023 and the S&P 500 returning 24%, we are optimistic that 2024 may favor cycle-tested private managers who have weathered this most recent storm.
Deployment was down in 2023 amid a valuation reset across the VC market (Figure 1). Valuations generally fell to long-term historical averages as founders accepted that there will be no quick return to the lofty levels of 2021. Down rounds reached 11% of financings in 2023 (up from a five-year average of 8%), with 16% of Q3 deals losing value.1 Higher deal flow volumes near the end of the year, however, lead us to believe that deployment may have bottomed out and could rebound in the coming year, driven in part by an improved IPO outlook.
Over the year, we observed increasing pressure on insiders to “step up” and either lead a round or finance a bridge. Some investors decided it was worth continued investment (PitchBook reported that the frequency of insiders leading rounds rose to the highest rate observed in a decade),2 while others found themselves considering the sunk-cost fallacy and weighing whether there was truly potential in these cases. For companies that underperformed previous goals and faced untenable paths to profitability, no one was willing to provide additional capital. The market and a tighter fundraising environment meant that venture capital firms were more willing to “write off” these companies, and we saw a spurt of bankruptcies as a result.
While the valuation reset is painful, particularly for companies that have performed according to plan, it also represents an attractive opportunity for allocators with capital left to deploy. The past couple of years have been like a wildfire that burns broadly but ultimately leads to healthier growth and sustainable balance in an ecosystem. Ultimately, we believe that taking capital at more moderate multiples will benefit companies, as they will face a lower probability of down rounds, and equity holders, who will have higher chances of successful exits.
VC fundraising fell off a cliff in 2023 (Figure 2) for two main reasons. First, distributions from VC funds dropped a staggering 84% in from 2021 to 2023,3 reducing the amount of available capital for reinvestment. Second, many allocators found themselves with a reduced risk appetite and a plethora of safer, higher-yielding investments to choose from. The result was a significant disparity in capital raised versus targeted.
In the near term, we expect the impact of this gap may be most severe for late-stage growth, due to the withdrawal from privates of crossover players.4 Longer term, the broader effects of this fundraising deficit are unlikely to be fully appreciated for the next three to five years, as the gap narrows. Unless the trend reverses, with significant capital raised in 2024 and 2025, deployment should continue to fall, as there is simply less capital to put to work. The 51,000 VC companies tracked by Preqin may find financing harder to come by, and we expect the already soaring demand-supply ratio (2.0x for late stage and 1.8x for early stage5), to continue to rise.
Here again, only the strongest and most innovative companies will be left standing amid the smoldering wildfire, and these are the ones most likely to receive financing. Ultimately, VC portfolios should see an exceptionally strong vintage, as less competition means a higher likelihood of investing in top companies at reasonable valuations. To be sure, managers will need to be discerning with their investments, as risks do remain.
Across the board, exits remained down and IPOs continued to lead the decline in 2023 (Figure 3). Despite a resurgence of activity in Q3, the pricing of several high-profile IPOs was too rich for the market and their post-listing performance failed to create real momentum. During the year, trade sales — not IPOs — accounted for most exits. This is unsurprising, given trade sales’ shorter execution and lower potential risk to sellers. We expect IPO activity levels to improve in 2024, on the back of strong public market performance and better-than-expected US GDP growth in 2023 and the likely conclusion of interest-rate hikes. Historically, the IPO window tends to close (or narrow) for one to three years at a time, on average. With the second year of the most recent period of low issuance behind us, we anticipate a reopening in the latter half of 2024, which will give strong late-stage companies more opportunities to go public. A recent Preqin survey shows cautious optimism from other managers as well, with 40% of VC managers expecting activity to improve over the next 12 months, up from 18% last year, while 30% expect it to worsen, down significantly from 76% in 2023.6
One area that has not slowed is innovation. We remain in a period of extraordinary transformation, with huge improvements in generative artificial intelligence (AI) causing VC investment to almost double in the first three quarters of 2023 (Figure 4). As expected for a highly disruptive technology with few established players, early-stage financers have been the most prolific investors, with growth managers — especially late-stage VC — having fewer opportunities to date. We expect this segment to evolve, as companies continue developing products that enable and support AI and machine-learning applications.
AI aside, innovative companies continue to emerge across many sectors, including biotechnology and climate technology. We also see disruptive new companies in consumer discretionary, with direct-to-consumer models challenging incumbents; health care, with updated approaches to employee benefits and mental health; and financial services, with expense management and cross-border money transfers, to name a few.
While the VC market is dynamic and can change quickly, we are excited about the year ahead. Less competition for capital means that extreme volumes are no longer necessary to execute deals, and we believe 2024 will offer opportunities to invest in great companies at rationalized prices for patient investors. We also think attractive late-stage companies that are ready to go public will be much more likely to do so in 2024.
