The case for US venture capital outperformance

We’ve seen widespread losses in global equity markets this year. After a decade-long bull run, many venture capital funds have found themselves holding overvalued shares of companies whose IPO prospects have been either eliminated or significantly delayed.

The markets have now become skittish, as evidenced by widespread correlation across asset classes. There are certainly structural factors sowing the seeds of pessimism such as severe inflation; a hawkish U.S. Federal Reserve leading a global trend of interest rate hikes; an evolving European energy crisis; the first land war in Europe in 70 years; various supply chain disruptions; an ongoing global pandemic; growing global trade tensions, and, to top-off the sundae, a slowly collapsing Chinese credit bubble.

While public markets have priced in some of these headwinds, their severity and duration remains unclear. With respect to the U.S. technology sector, the Nasdaq composite index is down sharply year-to-date, price-to-earning multiples are at six-year lows and venture funding has slowed significantly. Large-cap public technology company revenue and earnings have generally held up well to date but are expected to falter in the coming quarters as a result of Fed-induced, demand destruction.

Despite all these current and high-profile pressures, it is our view that the technology and innovation supercycle narrative remains unchanged, and many companies are poised for growth. Private technology companies are refocusing on fundamentals, and valuations are returning to reasonable levels.

It is also our view that the current economic conditions create a unique opportunity for venture capital funds holding dry powder to earn significant returns, as was the case for VCs that deployed in the 2010-2014 time period.

Despite the Fed preventing the natural three-year transition period from yield inversion to golden period, we still believe 2023/2024 vintages will indeed achieve golden period status.

A sound investment process analyzes both macro trends and fundamental data to assess the probability of various potential outcomes. We have identified two distinct potential outcomes for the U.S. private technology sector over the next six-12 months.

Scenario 1: Additional pain before recovery

A few weeks ago, Federal Reserve Chair Jerome Powell forecast that the Federal Reserve’s efforts to contain inflation would entail a “sustained period of below-trend growth” that would “bring some pain to households and businesses.”

This implies a period of lower range-bound U.S. equity price stagnation over the next 12-24 months. Such an outcome is probable in the near term if the following negative economic and geopolitical developments were to occur:

Aggressive Federal Reserve

An overly …read more