Dry powder now exceeds $500 billion but VC funds are more likely to be cautious and counter-cyclical in the current market…
Global start-up funding is slowing but still exceeds pre-pandemic levels, both by deal number and total deal value. Q2 saw the largest quarterly drop in investment in nearly a decade (by 23%), according to data from CB Insights. The $108.5 billion total marked a six-quarter low but was still the sixth largest quarter for investment on record.
The scale of the venture boom during 2021 has overshadowed the dot com bubble at the end of the 1990s. After almost a decade of easy money, the party appears over and the hangover is currently worst for late-stage start-ups and fintech, which captured one in every five VC dollars last year but as a sector is seeing redundancies build up this year.
“We’re seeing a pullback in fintech [funding], which has been disproportionately hit from a public markets valuation standpoint,” says Stephanie Choo at Portage, “and we’re seeing a reversion to valuing these companies more like financial services companies, and less like tech companies, in terms of recurring revenue.”
More broadly, investment rounds are being extended and have shifted in favour of fund managers with capital to deploy, instead of previously bullish start-up founders. But according to sources in the market it is still too early to predict the winners and losers.
“I think we’re in the early innings of this reset fully playing out,” says Dan Aylott at Cambridge Associates. “We’ll see VCs being much more cautious in terms of their deployment until valuations settle [as] they will have more issues in their portfolios to deal with.”
A more rigorous approach to due diligence has returned among VCs with some sectors facing more challenges than others. New and more pertinent questions are being asked by VCs than a year ago: ‘do you have enough cash to last 24 months?’ is more relevant in the current market than jaw-dropping revenue growth, say sources. Generally, attention has moved away from late-stage funding and growth equity, towards seed and early-stage companies with a longer path to IPO and less inflated valuations [see Chapter 4].
In a July op-ed published in Fortune magazine, the co-founder and CEO of Canada-based Portage Ventures wrote: “Some may find that making a quick buck from investing in the cutest CryptoKittie is more fun than pouring over spreadsheets or A/B testing, but that part of the cycle has passed… venture capital isn’t easy for investors or founders, nor is it supposed to be. We must understand and adapt to the shifts of a new cycle”.
Waiting for offense
For example, grocery delivery app start-ups now look vulnerable, say sources, with retail tech funding down 43% quarter-on-quarter to hit $13.2 billion, marking a 7-quarter low for the sector, according to data from CB Insights.
“VCs are being much more thoughtful and robust about which companies in their portfolios they’re going to continue to support and doubling down on what they believe to be long term winners,” says Aylott. “There will be pockets of opportunity and I think the savvy GPs will be waiting to play offensive in some of those areas.”
Dry powder in the asset class has increased by $100 billion in 2022 already, and now stands at $539 billion, according to Preqin. But given VC strategies can differ, opinions vary on where this doubling down is taking place. All agree that technology – whether this be Web3, deep-tech or blockchain – will continue to drive growth.
A Private Equity Wire survey during July shows the majority of respondents (57%) believe technology still offers the most attractive investment opportunities across VC. This compares to only 7% for consumer/retail investments, and 13% for life sciences.
“AI has been a hot sector for a while and there has been a lot of excitement about the potential of Web 3.0 and cryptocurrency,” says Nic Brisbourne, CEO and managing partner at Forward Partners. “It may seem like there has been a lot of hype, but the reality is many of these technology businesses are building the future of digital applications and tech infrastructure – that underlines basically everything we do. For years, many sectors – law, or medical science, for instance – have been desperate for a way to reduce costs and increase pace. Now we have the start-ups and tech to deliver this, and we’ve seen that AI, in one shape or another, has been widely adopted by businesses across the world. Of course, market conditions have an impact and investors need to be more discerning than ever, but if a start-up is genuinely providing a solution to a big problem facing businesses, that is where the growth will be, and investors will follow.”
Counter-cyclical
In a recent note to investors, JP Morgan pointed out the recent record levels of VC investment into cryptocurrency and blockchain-based start-ups, despite the crypto crash earlier this year. VC firms here are sitting on record levels of dry powder: in Q2, VC giant Andreessen Horowitz said it had raised $4.5 billion for its fourth and largest crypto fund, giving it a total of more than $7.6 billion to invest in the space.
Predictably, there is greater focus on start-ups less exposed to a cyclical downturn and a stronger line is being drawn between B2B and B2C start-ups in the crypto and blockchain world in particular.
“We are deliberately focusing on companies that we believe to be operating in fundamentally defensive or sectors that are more recession-proof and inflation protected,” says Natalie Hwang, founding managing partner of Apeira Capital Advisors, a VC investment and advisory firm.
In fintech, debt collection or debt resolution and PropTech companies are considered counter-cyclical, says Choo at Portage, but it can be difficult to find public market valuation comparables here.
“People are also spending a lot of time on cyber-insurance and anything at the intersection of climate and fintech,” she adds.
Climate-tech and VC start-ups based on the energy transition are indeed showing signs of growth, despite a broader market slowdown. In Q1 this year, five climate-tech investments made it into CB Insight’s top 10 lists covering seed and venture capital rounds, growing to eight by Q2. Since 2017, the sector has tripled in size, according to PitchBook data, but the path to revenue can often be longer than for other tech start-ups.
In the Private Equity Wire survey, 22% of respondents believed ‘energy’ to be the most attractive area for VC investment, second after ‘technology’.
But clues to predict some of more vulnerable VC sectors may be found in the boom. According to analytics firm BryceTech, the amount of money invested in commercial space start-ups – known as space-tech – doubled last year to more than $15 billion. Elon Musk’s private space company, SpaceX, was valued at $125 billion in its latest funding round and at the time of writing was the highest valued start-up in the world, outside China.
Can VC investment in an area such as space-tech continue to grow in a down market? According to Michael Mealling, at space-tech VC Starbridge, ‘good deals’ in the sector are still over-subscribed but risks exist on the upstream, through unstable supply chains, and on the downstream, by misreading your customer base. On a website which tracks the progress of space-tech start-ups, he notes a high watermark of 176 companies in the rocket launch market alone – “far more than the market can support”.
“As you find any technology space, you have a lot of entrepreneurs looking for somebody to give them money so they can go away and play with the technology. And [despite the market slowdown] we still have that.” 
