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Investors should prepare for the private market valuation hit

Venture capital, private equity in the spotlight as rates hit price and growth

The Morningstar-owned private markets publication Pitchbook this week highlighted the growing risks in the economy along with the potential impact of higher interest rates on the popular venture capital and private equity sectors. In a paper titled ‘How inflation, monetary tightening and volatility are impacting PE and VC” the group suggests the threat of market downs on these asset classes as a real and present danger.

“The presence of inflation that is uncomfortably higher than the Fed’s stated policy goal of roughly 2.0% fundamentally alters how the Fed can conduct monetary policy”, meaning they have little choice but to continue to pull the short-term interest rate lever available to them. The initial moves, the first in decades, have led to a “fundamental repricing of valuations” sending the S&P500 down 18 per cent from the all-time high reached on 1 January.

As we all know, the rotation has been clear and simply, with stocks exhibiting relatively high sales and earnings growth rates sold in favour of those with low implied growth rates. Whilst corrections of this nature are extremely common, Pitchbook highlights the unique dynamic that has many investors feeling like the “sky is falling”. Their view is that “sentiment is incredibly pessimistic because there are several influential paradigms shifts within financial markets, the economy, and geopolitics happening at once”.

  • Interest rates have and will remain the most important influence on valuations, but particularly the discount rates used to value future cash flows for everything from unlisted property to venture capital and private equity. Whilst many were surprised by the level of inflation, they highlight that it was inevitable than “when you combine a positive demand shock with a negative supply shock” you get higher prices.

    Thus far private market investments haven’t suffered the 70 per cent valuation falls that some companies on the Nasdaq have, but the paper suggests “pricing dynamics playing out in public markets are also happening in private markets to varying degrees” but may take several quarters to show up. For instance, the group runs a Venture Capital IPO index, the constituents of which have fallen 75 per cent below their 52-week high.

    Such a huge dislocation in valuations between private and public markets is something they believe markets will find hard to ignore for much longer. “Venture capital (VC) is particularly susceptible to repricing given its high degree of exposure to young companies that will require significant growth to reach profitability” they explain, whilst with many private equity deals financed via floating rate senior secured loans, the cost of borrowing is also on the rise.

    Performance of VC-backed companies that have recently gone public suggests there has been a huge dislocation in valuations between private and public markets that we think will be hard to ignore any longer. They put forward three different scenarios for the outlook and the economy, noting that it will be rate movements against the current forecasts rather than absolute changes that drive returns.

    Unfortunately, they do not expect a quick reversal in valuations as rate hikes continue, and recommend that “private market investors should prepare for valuations to be marked down in the coming quarters, especially in VC”.

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