Interest rates and tech startups
The higher interest rates go, the lower investors' risk appetite becomes
I wrote a tweet recently which did numbers:
At least, it did numbers relative to my usual tweet views. I figured I’d expand upon it in this Substack post.
The simplest way I can explain this is: capital flows between asset classes are a manifestation of investor preferences. When cash flows from stocks to bonds, or from bonds to commodities, or, yes, from startups and VCs to bonds, investors are expressing a preference. And those preferences are driven, in large part, by interest rates. As interest rates decline, investors are more interested in riskier assets, which includes technology startups, LP interests in venture capital funds, and growth stocks.
If you’re going to play the VC or tech company game, it behooves you to understand how interest rates affect flows of cash between the capital market’s various sectors. You may want to read Howard Marks’ December 2022 memo. I will quote from it at length, because he highlights certain issues which I think are vitally important for tech company employees and venture capitalists to understand about our present macro environment:
The period between the end of the Global Financial Crisis in late 2009 and the onset of the pandemic in early 2020 was marked by ultra-low interest rates, and the macroeconomic environment—and its effects—were highly unusual.
An all-time low in interest rates was reached when the Fed cut the fed funds rate to approximately zero in late 2008 in an effort to pull the economy out of the GFC. The low rates were accompanies by quantitative easing: purchasing of bonds undertaken by the Fed to inject liquidity into the economy (and perhaps to keep investors from panicking). The effects were dramatic:
The low rates and vast amounts of liquidity stimulated the economy and triggered explosive gains in the markets.
Strong economic growth and lower interest costs added to corporate profits.
Valuation parameters rose, as described above, lifting asset prices. Stocks increased non-stop for more than ten years, except for a handful of downdrafts that each lasted a few months. From a low of 667 in March 2009, the S&P 500 reached a high of 3,386 in February 2020, for a compound return of 16% per year.
The markets’ strength encouraged investors to drop their crisis-inspired risk aversion and return to risk taking much sooner than expected. It also made FOMO—the fear of missing out—the prevalent emotion among investors. Buyers were eager to buy, and holders weren’t motivated to sell.
Investors’ revived desire to buy caused the capital markets to reopen, making it cheap and easy for companies to obtain financing. Lenders’ eagerness to put money to work enabled borrowers to pay low interest rates under less-restrictive documentation that reduced lender protections.
The paltry yields on safe investments drove investors to buy riskier assets.
Thanks to economic growth and plentiful liquidity, there were few defaults and bankruptcies.
The main exogenous influences were increasing globalization and the limited extent of armed conflict around the world. Both influences were clearly salutary.
As you can see, interest rates drive a lot of behavior. As they rise, they drive massive flows of money from riskier assets to less risky assets. These flows of money are larger, by a few orders of magnitude, than the entirety of the venture capital industry. Venture capitalists, their LPs, and the startups in which venture capitalists invest are just tiny boats buffeted by the oceans of cash flowing from one set of assets to another in accordance with investors’ preferences. And those preferences are, of course, driven by interest rates.
So, if you want to understand why venture capitalists are saying the things they have been saying as of late, make sure you understand the relationship between interest rates, appetite for risk, and how cash moves among various asset classes given those risk appetites. The simple rule is: as interest rates rise, investors’ interest in risky assets declines. Investors prefer the safety of higher-yielding treasuries and investment-grade corporate bonds. When interest rates fall to near zero, as they did for much of the past decade, investors hunt for yield. When investors hunt for yield, cash pours into risky assets, and valuations rise.
If you’re going to be in the tech game, you need to understand the inextricable link between interest rates and appetite for risk. If you don’t, you may well be the one left holding the bag.