How Rising Interest Rates Impact Venture Capital

s you’ve likely seen in the news, the Federal Reserve is now likely to raise its benchmark overnight lending rate, also known as the federal funds rate, at the Fed’s next meeting in March.

This raise would be the first since the coronavirus pandemic hit the economy in March of 2020, and the Fed is now expected to raise the federal funds rate multiple times before all is said and done in 2022.

With the Fed adopting a completely different monetary outlook than it had six months ago, investors might be asking themselves how a rising-rate environment would impact the booming venture capital industry.

Well, to put things simply, rising rates tend to be a drag on venture capital.

That’s because when rates are low, safer assets like U.S. Treasury bills - which are guaranteed by the government - yield less, so investors are willing to take more risk. Additionally, higher interest rates tend to make the cost of running a business more expensive and hurt the future earnings potential of high-growth companies.

It’s hard to believe, but the pandemic in away actually created the perfect storm for VCs and startups.

The Fed abruptly dropped rates to zero and began pumping money into the economy through quantitative easing, which helped bring down longer-term interest rates as well. Additionally, real estate and stocks at the beginning of the pandemic got hit hard, so VC firms presented an attractive place for investment.

Furthermore, because the pandemic sent people into their homes and prevented lots of physical interaction, the pandemic accelerated the timeline for digitization and automation in many industries.

 As we all know, innovation is where startups shine, so the acceleration of consumers and businesses resorting toward digital payments, services, and communication essentially created a breeding ground for new company creation, and for those early-stage companies in those sectors.

The results can be seen in some of the numbers from 2021. Last year, VCs collectively raised roughly $669 billion globally, compared to $347 billion in 2020, which at the time was a record of its own.

But now with rising interest rates on our doorstep, the economic environment has changed drastically. If you want to get an idea of how rising rates can hurt tech stocks, then just look at the carnage in the public markets. During the second half of 2021, investors began to realize that rate hikes would not happen at the end of 2022, in 2023, or 2024, but much sooner than anticipated.

The Fed began to slow the billions of monthly bond purchases it had begun to make when the pandemic started, and tech and growth stocks got hammered. Since early November, the Nasdaq Composite is down about 9% but had recently been in correction territory, while Kathy Wood’s ArkInnovation ETF has dropped nearly 42%.

The aggressive drop in tech stocks has led some to wonder if tech valuations might get revised in the private markets.

Greg Becker, the CEO of Silicon Valley Bank, which caters heavily to the VC and startup sectors, did not rule out a minor correction to startup valuations. But he also told analysts not to forget about all of the money VCs just raised. Here was what Becker had to say on Silicon Valley’s most recent earnings conference call earlier this year.

There's so much dry powder, and they need to put it to work. And so, could there be some valuation corrections in a later stage? Yes, there could be as companies look to raise money.

But if they do, they're still at healthy valuations. And so, I think companies need to raise money. There's ample money out there for them to raise money. Could they hold out and wait for a high valuation? Possibly. But again, we're just not seeing it yet. And I think I have to wait at least a quarter or two to really see if there's… anything that starts and then a trend beyond that.

Ultimately, VCs are sitting here today in an interesting situation. They have plenty of money to invest, but markets and the economy are trending in what would normally be an unfavorable situation for the industry. Where valuations will end up is tough to say right now.

It will be interesting to see how many rate hikes the Fed does this year, if the agency will also shrink its balance sheet and effectively remove liquidity from the markets, and if these factors will be able to derail the war chest that VCs have built up. 

This is definitely a situation all investors will want to monitor in the coming months!

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