Private markets have experienced a downturn in the last two years, as inflationary pressures globally led to tightened monetary policies resulting in a higher interest rate regime. This has been particularly problematic in the United States, which experienced inflation of up to 9% in June 2022, far above its target rate of 2%, and had to keep its benchmark rates between 5.25% to 5.50%, the highest it has been in the last 22 years.
The impact of these high interest rates has been rather adverse for the private market. S&P Global’s PE/VC deal tracker reveals that global deal volume has dropped by 55% between its peak in Q2 2021 till Q3 2023 (the current quarter). This significant drop in deal volume has opened up questions about PE/VC investing behavior, as there is more to the picture here than what meets the eye. Investment trends in the private market vary from participant to participant depending on factors such as investing style, investment objectives, risk tolerance, liquidity needs and time horizon of investment. All of these factors are of course also complemented by behavioral factors.
The VC approach to start-up investing is more hands-on and collaborative with startups, in order to support their growth. Their interests are not purely financial as of those of a hedge fund or other large financial institutions. This difference of approach also shows why venture capital deal values are more concentrated towards the early stages. A Carta report revealed that early stage valuations are on the rise, with Series A valuations on the rise, and deal volume in APAC has been rising. Not to mention, while overall deal volumes have dropped, investments in certain segments such as Gen AI have seen tremendous growth this year. This goes to show that VC investments are far more long term, as opposed to other institutional investors.
From a behavioral perspective, private markets often exhibit a degree of herd mentality. For example, the VC rush into the shared economy bubble was a product of crowding into a trendy sector that led to oversaturation and then inevitable failure, given the variety of regulatory, competitive and operational challenges faced by these startups. One can argue that we are seeing the same thing with Gen AI, and previously saw with Blockchain and Web3.
We also see loss aversion bias playing out when it comes to VC funds, where funds are not handing out down-rounds where they are deserved or even growing their investment into failing companies in a bid to keep their stakes at a decent valuation. This behavior is not commonly observed among other participants in the private market, who are quick to exit losing positions, as seen in the case of hedge funds.
Over the last 2 years, hedge fund activity in the venture capital space is dwindling after having made a huge push in 2021. Hedge funds generally invest in VC funds either through traditional 10 year vehicles or commingled vehicles. Commingled vehicles allow hedge funds to make quick exits from their positions in venture capital funds through secondary sales. Unlike VC funds, hedge funds are ruthless and nimble when it comes to their investment strategies, as their agenda is to earn alpha at any cost. While they followed the herd initially, they did not hold their positions once a down-market was on the horizon.
While the examples listed above are not exhaustive and cannot be used to conclude that behavioral trends are behind VC performance, they raise enough issues to warrant a further investigation into the topic. Every private market participant is likely to react differently to a change in macroeconomic conditions, and we believe that understanding and classifying behavioral trends can add another dimension to our understanding of private markets.