Risk Capital Delta: What Does It Tell Investors?
Looking For Clues In The Data
The availability and accessibility of risk capital fluctuates over time, and that data reveals a great deal for the investor.
I will employ three indicators in this analysis and, although each has its limitations, when considered collectively, they offer a comprehensive assessment of the fluctuations in risk capital.
The first proxy involves assessing funds invested by venture capitalists, categorized by various stages ranging from pre-seed and seed financing for very young companies, progressing to capital infusion for more established businesses, culminating in exit events like acquisitions or initial public offerings (IPOs).
The second indicator centers on observing the trend in IPOs, encompassing both the number of IPOs and the value of capital raised through them. A robust IPO market often signifies a favorable climate for risk capital.
Lastly, but by no means least, the third marker entails analyzing original bond issuances by companies with higher risk profiles, often rated below investment grade or as high yield. Such issuances are typically better received during periods of abundant risk capital, as opposed to periods of scarcity.
Beginning with venture capital, which has historically been the primary funding source for startups and young companies, particularly in the United States, this sector experienced notable shifts over the years. The dot-com boom of the 1990s witnessed a surge in venture capital funding, peaking at over $100 billion in 2000 before plummeting due to the bubble bursting. The 2008 financial crisis led to a nearly 50% decrease in 2009, with the market requiring almost five years to regain pre-crisis levels. In the past decade, from 2011 to 2020, venture capital funding and investment experienced substantial growth, nearly doubling once again in 2021 compared to 2020. In fact, 2021 set a record with venture capital raising $131 billion, surpassing even the heights of the dot-com era, albeit in nominal terms. Moreover, successful exits through IPOs or mergers and acquisitions (M&A) have become more lucrative, with 43 exits exceeding a billion dollars (achieving unicorn status) in 2021.
The frequency of IPOs offers a valuable insight into risk capital trends. IPOs undergo periods of high activity, during which issuances surge, and periods of low activity, characterized by fewer listings. Over the past decade, hot periods have dominated, with the 2000/2001 and 2008/2009 periods experiencing minimal offerings. While 2021's IPO count remains below the dot-com peak, the proceeds from these IPOs reached an all-time high.
Similarly, the proportion of high-yield bond issuances aligns with the availability of risk capital. Major downturns occurred in 2000-2001 and 2008-2009 due to market corrections and crises, while the past decade saw easier access to risk capital. The percentage of corporate bond issuances hit a historic high in 2021, accounting for more than a quarter of all bond issuances.
In summary, these three indicators consistently reveal parallel patterns in risk capital trends over time, displaying simultaneous ebbs and surges. Notably, 2021 emerged as a year of significant expansion.
The looming question for the years ahead centers on whether the current pullback in risk capital is transient, akin to 2020, or more enduring, resembling the aftermath of the dot-com crash in 2000 and the 2008 market crisis. Should it be the latter scenario, markets could stabilize, but high-risk assets might endure prolonged price declines.
It seems plausible that the latter scenario could prevail. Unlike the Covid19 crisis with quick fixes in terms of vaccinations, inflation lacks swift remedies. Furthermore, with inflation enduring, central banks and governments are not only constrained in providing the kind of stimulus seen in 2020, but quite the opposite are now tightening monetary policy which will inevitably exacerbate rather than alleviate risk capital challenges.
While it may sound unsympathetic, a return of fear and a longer term pullback in risk capital could ultimately benefit markets and the economy. The prolonged era of easy returns may have caused risk capital providers to become complacent and imprecise in their pricing and trading choices, leading to skewed capital allocation. In this evolving landscape, investment strategies that thrived in the last decade may falter, prompting a revisiting of seemingly outdated lessons.