As Venture-Backed Valuations Tumble, Investors Worry About 'Silent Crash'

There is an argument that says tech valuations have fallen too far. But the industry - venture capitalists and entrepreneurs - is filled with preternatural optimists who believe the only way to go is up. 

The real question is to what degree the 2019-2021 was a reflection of real value creation or just a sign of excess capital looking for a likely opportunity. What happens for the rest of this year may determine that outcome. JL 

John Mason reports in Seeking Alpha:

The venture capital sector is just the latest financial area that benefitted from the largesse of the Federal Reserve in recent years but is now facing a painful future. Venture capital and angel finance show signs of excessive investment. The blank check SPACs over-extended and are now retrenching. The bubble connected with crypto-assets busted and regulators are moving in to get this under control. We have private equity firms adjusting their portfolios to reduce their exposure to excessive exuberance in their investment activities. And, there are other sectors of the financial space that are of concern going forward.

Summary

• The venture capital world has hit new highs in the past couple of years, but now is facing a time when the future looks dismal.
• The venture capital sector is just the latest financial area that benefitted from the largesse of the Federal Reserve in recent years but is now facing a painful future ahead.
• Some have said the venture capital world is "in the grip of a silent crash."
• These revelations give further indication that although on the surface the U.S. economy may look like it is doing OK, underneath there are some real problems arising.
• These realities just add to the job that the Federal Reserve is facing in the near future.

I have been writing about retreating sectors in recent months, sectors of the economy that have boomed over the past two years or so due to the largesse of the Federal Reserve, but are now in retreat as the Fed pulls back on financing.

As I have written, I have never seen anything quite like the last couple of years. The Covid-19 pandemic spread throughout the United States and the world, and a small recession hit the United States. Supply chains dried up. Many, many people left the workforce, resulting in the best unemployment numbers in years.

And, yet, because of the Fed's actions the stock market hit more and more historical highs, debt markets boomed, more and more new companies were formed, crypto-assets took off, and I have never seen so much money flow into the venture capital and angel finance worlds.

New, innovative companies came out of the walls.

A chart presented by Richard Waters in the Financial Times captures the scene.

Venture Capital Funding (Financial Times)

Money continued to flow into 2022 until it stopped.

Now things are turning around.

Crash?

Waters write:

"The venture capital world is in the grip of a silent crash."

"In fact, for many of the investors and entrepreneurs who have just lived through a historic boom in venture investing, it is even possible to pretend a crash isn't happening at all. Loose rules that require only sporadic write-downs, the estimated value of private companies, have made it easy for many to turn the other way."

"Only companies with an urgent need for capital have been forced into a full reckoning with reality, as investors putting in new money demand an up-to-date valuation."

At the end of the 1990s, annual investment peaked at around $100 billion in the United States.

In 2021, the amount reached $330 billion.

Connected with this was the flood of IPOs at this time.

Nearly $1.4 trillion was pumped into "promising growth companies," globally, in the past year.

Investors just did not want to "miss out."

With all the money flowing around, the large venture funds grew to enormous size and a lot of money also flowed into "new" investment vehicles.

But, valuations are now tumbling.

Mr. Waters further writes that:

"If predictions...are correct, then investors who put the bulk of their latest funds to work at the peak of the market could be facing the sort of negative returns that have not been seen since the dotcom crash at the turn of the century."

How To Survive

Many funds, as well as many startups and early-stage companies, have cash to work with.

But, the narrative has changed.

The growth that had earlier been expected is no longer being assured.

The game now seems to be for companies to scale back their earlier vision and now adjust what they think can be done back to lower levels.

That is, companies that have achieved some kind of foundation in the market and find some niche where they can move forward because they retain some of the cash earlier advanced to them.

Many others, however, have not created that pathway to continue on or have totally run out of cash options.

Over the next twelve months, there will be quite an adjustment in this area.

Others might be able to sell off assets or ideas.

The bottom line, however, is that the adjustment will be substantial.

The future is highly unknown.

How many of today's investors and startups will still be standing when the market "resets" is unknown?

The Current Picture

And, this is where things are today.

Industrial production is near historical highs. Capacity utilization is near historical highs. Unemployment, at 3.6 percent, is near lows reached only decades ago, although the labor force participation rate has risen in the past year or two.

Many pundits, especially those connected with political interests, are praising how good the economy is.

Below the surface, however, there are many industries in substantial disequilibrium, a disequilibrium that is going to be resolved one of these days, and their resolution is not going to be painless.

This will be especially true if the Federal Reserve does accomplish some of its efforts to reduce the size of its securities portfolio.

So, we have the worlds of venture capital and angel finance showing signs of excessive investment. We have the world of the blank check company, the SPACs, over-extended and now in the process of retrenchment. We have the bubble connected with crypto-assets busted and with regulators moving into the picture to get this world under control. We have private equity firms adjusting their portfolios to reduce their exposure to excessive exuberance in their investment activities. And, there are other sectors of the financial space that are of concern going forward.

Yes, there are a lot of good statistics still being reported on the state of the economy.

But, there are undercurrents that have been created over the past two- to three-year period that are going to adjust in the near future, and these will not produce adjustments of a positive nature.

The major question attached to this narrative is about how the Federal Reserve is going to respond to these financial dislocations.

The Fed has committed itself to combating inflation.

But, the Fed must also deal with the financial dislocations that might arise out of a restructuring of the SPACs, the venture capital firms, the private equity firms, the crypto-asset prices, and other spaces.It is a very complex story we are moving into.