I imagine that most venture capitalists (VC) are feeling a tad uncomfortable now. These new masters of the universe were on a roll until recently, with returns buoyed by surging markets, new initial public offerings (IPOs) and intense competition between ‘traditional’ VCs and a newer breed of asset manager-cum-private equity combo such as Tiger Global and Baillie Gifford.

Everything has now changed as markets stagger near to the all-important 20% decline, which marks out a bear market. From its peak on 3 January the S&P 500 fell to 3,933 last week, a decline of just over 18%. A few more bad days and we could be firmly into bear market territory. Already big names like Tiger are reporting huge losses.

If we do slip into a bear market, then it’s probably bad news for venture capitalists. Their traditional favourite route to bumper profits was through an IPO or special purpose acquisition company (Spac). Turbulent markets will shut that IPO pipeline down for a while. But for how long? As we’ll discuss, in the worst scenario this deep freeze could last for a couple of years.

Valuation writedowns

Traditionally public market investors probably wouldn’t care if it was two weeks or two years!

Public markets were for mature, established, profitable businesses whereas venture capital was for institutional investors only. But over the last few years, venture capital and private equity has emerged as an adventurous subcategory within the public markets. I think this a profoundly positive development as it gives private investors access to high growth unquoted businesses. But I’d also be remiss if I didn’t mention the obvious downside – you are exposed to the brutal write-downs that can happen in VC land.

Stockmarkets have become increasingly exposed to venture capital in different ways. Arguably the biggest flow of capital has come from established equity fund managers such as Baillie Gifford (and a few years ago Neil Woodford) pumping money into private businesses from established funds such as Scottish Mortgage (SMT ) as well as specific VC vehicles such as Schiehallion (MNTN ).

That latter vehicle is also at the forefront of a vanguard of listed venture capital funds listed in London such as Chrysalis (CHRY ), Molten Ventures (GROW), Augmentum (AUGM ) and Seraphim Space (SSIT ). These funds mix two different styles of VC investing – some such as fintech specialist Augmentum are much more focused on early-stage businesses while the likes of Chrysalis are more focused on later stage, pre-IPO businesses.

There is also a long list of tax-efficient venture capital trusts or VCTs which mix traditional early-stage venture capital investing in say tech stocks alongside a more traditional private equity approach to backing cash-generative businesses.

We can already begin to see the damage that a near bear market inflicts on listed VC funds in the table below which shows returns – and widening discounts – for the main public market vehicles. Investors in Scottish Mortgage (with most money invested in listed businesses but also a sizeable slug in private businesses) will already be aware of the damage to date with its share price down 42% year to date.

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Growth capital investment companies	Year-to-date price return %	Share price discount to asset value %	Average 52-week discount %
Augmentum (AUGM)	-26.2	-25.2	8.7
Chrysalis (CHRY)	-45.9	-36.9	-3.2
Molten Ventures (GROW)	-45.2	-36.9	5
Schiehallion (MNTN)	-36.4	25	34.2
Seraphim Space (SSIT)	-27.9	-7.9	11.5

Source: Numis Securities

It’s important to say that these losses should not come as a great surprise to investors. Venture capital involves investing in private businesses where liquidity is poor, and valuations volatile. Put simply, if you want above average returns – over 15% to 20% a year in most cases during good times – then you’ll have to accept above average losses.

Red data

The big question then becomes how bad could it get? The huge share price moves for the likes of Chrysalis suggests that the public markets are already taking out a big fat red pen and marking down valuations. That’s an easier exercise for later-stage, more mature private growth businesses, if only because there are so many existing VCs chasing participation in these pre-flotation businesses.

There are even third-party data vendors such as ApeVue who are tracking the valuation of late-stage pre-IPO businesses and their data suggests prices are falling already. Its most recent analysis from April suggests looking at the top 50 pre-IPO businesses pointed to a decline in valuation of 6.37% for the first quarter. My guess is that the next quarter will look even worse, with declines of 10% possible, implying that first half 2022 losses could be close to 15%.

That slightly glum message is also echoed by data provider Pitchbook which has also been tracking late-stage deals. Although its current data on valuations suggests that valuations haven’t been drastically marked down yet, ‘institutional investors are leaning away from the full risk-on mode we experienced in 2021, which makes finding providers of liquidity much more difficult, especially if the downturn persists. For instance, exit opportunities such as IPOs have already seen a serious pullback, and massive crossover VC rounds that could provide secondary liquidity are beginning to decline in volume as asset managers retrench in the face of the current volatility’.

A more useful exercise would be to look at VC valuations over the last few decades but this data is notoriously difficult to obtain (even more so, to verify) but Pitchbook analysis does suggest that there were sharp declines in returns after the global financial crisis in 2008/9, with the biggest eventual losses for early-stage series-A and seed-stage businesses.

Another way of getting a handle on valuations is to look at alternative sources of data which might influence valuations and deal flow. Take IPO deals for instance – this measure tracks the number of initial public offerings on the US market since the early part of the 2000s. Various data websites track these publicly available data sets and show that in the run up to the dot com boom IPOs shot up, hitting a peak of 486 listings in 1999 before crashing to just 88 in 2003. Moving forward in time, IPOs hit 297 in 2007 before crashing back to 57 in 2008. In 2021 there were 951 IPOs plus 248 Spacs in 2020 and 63 Spacs in 2021.

If this historical data is at all useful, it suggests that once the IPO pipeline freezes up, investors should expect at least a year or two of below average listings.

Another useful metric comes via the amount of money raised in aggregate by big US VCs ie. total private equity firepower. For much of the last decade this number has been doubling pretty much every year as money has flooded into the sector but these flows are cyclical. VC funding also boomed in the late 1990s before peaking in 2000. It then spent at least two years falling consistently. The peak in 2008 was much more subdued and within a year funds were increasingly flowing into VCs again. 

This last data set points to an important observation – this time it really might be different. Sure, the IPO pipeline might close but after a sharp decline of say a year, VC fund inflows might pick up again given the deep structural changes in the VC industry: compared to a decade ago, there are now immeasurably more VCs, more deals, more structures and more types of investors in this space.

So, is there more bad news to come? If, and that’s a big if, we are entering a bear market and a possible recession, I’d suggest the answer is yes. Late-stage VC funds such as Chrysalis, dependent as they are on the IPO pipeline, might have a rough next 12 months. This late-stage segment of the market might recover very quickly though whereas the early-stage VCs might suffer fewer losses in the short term, but their valuations might drop sharply towards the end of 2022 and into 2023 and then take longer to recover.

My own rough finger in the air is that if we are in a bear stock market, then a peak-to-trough haircut of 50% to 60% for listed VC share prices might be appropriate which implies possibly more pain for the listed VCs, possibly in the order of a further 20% decline in share prices. A more optimistic scenario is that the current sell-off will subside, in which case current discounts on listed VCs probably represent decent value. 

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