Interest rates rule everything
As interest rates rise, venture capital and startups bear the brunt
Introduction
I’ve been thinking a lot recently about interest rates, and how they affect venture capital and startups. There seems to be a lot of confusion about interest rates, and why they matter to both venture capitalists and startup entrepreneurs. I figured that this is good a place as any to put my thoughts together.
What follows is a synthesis of my thoughts and ChatGPT’s. My prompt to ChatGPT is: How does a rise in interest rates affect institutional investors’ interest in investing in alternative asset classes like venture capital? In turn, how do these changing preferences affect venture capital funds and the startups in which venture capital funds invest. You can see this prompt and ChatGPT’s response here1.
I suppose that any venture capitalist or entrepreneur who reads this post could interpret it as an attack on them and their interests. I don’t see it that way, however: I am interested in understanding how high(er) interest rates affect the work that venture capitalists and entrepreneurs do. I see both venture capitalists and entrepreneurs as vital to human flourishing, and on balance, I think more entrepreneurialism and venture capital is better than less. Nonetheless I also think it’s true that incentives drive outcomes, and high(er) interest rates create different incentives from the ones that have driven the venture capital market for most of the past decade. I am interested in understanding the consequences of these changed incentives.
So here’s a brief outline of what follows:
Higher interest rates mean that bonds generate ‘equity-like’ returns, which in turn means that institutional investors don’t need to chase risky assets in search of yield (return).
Investors’ suddent disinterest in alternative assets, such as venture capital, means that the world of LP capital available to alternative assets is smaller than it was, say, last year. Which in turn means that venture capital funds will raise less capital.
Higher interest rates tend to depress equity valuations, in both the private and public market, because higher interest rates yield lower discounted cash flows. This means that startups’ valuations will decline relative to recent historical norms, and startup employees may start to demand more cash, and less equity, in their compensation, thus increasing a startup’s cash demands at the same time that venture capitalists have less cash to invest.
Finally, I have no idea how long interest rates will remain elevated. On the other hand I don’t think that we’re returning to a zero interest rate environment any time soon. So if you’re looking for a pronouncement along the lines of “this will all be over by 2026 or ‘27,” you’re reading the wrong Substack.
There also isn’t practical advice to be had in this post: I can’t tell you what to do, given that interest rates are elevated. It seems inevitable to me that the second-order effects of sustained higher interest rates will wipe out many startups and venture capital funds.
Effect of Rising Interest Rates on Institutional Investors’ Interest in Alternative Asset Classes like Venture Capital
Increased Cost of Borrowing: Higher interest rates make capital more expensive. Institutional investors may find that their leveraged bets are costing them more money than they anticipated. This may make them more risk-averse.
Reduced Attractiveness of Some Fixed-Income Assets: Bond prices move inversely to yield, meaning that when interest rates drive yields up, bond prices tend to fall. Institutional investors may sell bonds to buy new, high-yielding bonds.
Risk Rebalancing: Higher interest rates make investors more risk-averse. This is because higher interest rates create the conditions that allow bond yields to rise. Bond coupon payments are contractually-obligated payments of cash to creditors. Those contractually-obligated payments of cash are much lower risk than equities and alternative assets like venture capital.
Discount Rate Effect on Valuation Models: Equity valuations, especially for private equity (which includes venture capital), are calculated with a discounted cash flow analysis. Higher interest rates depress these equity valuations. Depressed valuations make equtiy investments less attractive than less risky fixed-income investments.
Hurdle Rates and Required Returns: If bonds offer both higher and safer returns than alternative assets, or even publicly traded stocks, then these assets have much higher hurdle rates, in order for institutional investors to find them appealing.
Impact on Venture Capital Funds
Fundraising Difficulties: Given that higher interest rates change institutional investors’ preferences, venture capital funds will find it harder to raise new funds. This will most significantly affect newer funds with little or no track record, but even the most well-established venture capital funds will find that the universe of LP capital is smaller than it was a year or so ago.
Stricter Due Diligence: Investors will require more due diligence before they commit to a check, simply because they can. If fewer institutional investors are allocating less cash to venture capital overall, then the remaining institutional investors have much more leverage to demand due diligence before they cut a check.
Change in Investment Strategy: Because venture capital funds will find raising capital to be that much harder, the investment strategy they pursue will likely change. No longer will venture capitalists be willing to indefinitely fund money-losing startups with high customer acquisiton costs. Instead, venture capital investors will show a preference for startups which quickly scale revenue, and, more critically, generate free cash flow. The ideal investment will be one where the path to a liquidity event, either via IPO or acquisiton, is clear.
Impact on Startups
Reduced Funding Availability: If venture capitalists have less cash, then fewer startups will be funded. And those startups which are funded will have to make do with smaller funding rounds.
Higher Scrutiny: Just as venture capitalists will be subject to more scrutiny from limited partners, so, too, will startups be subject to more scrutiny from venture capitalists. The days of Tiger Global investing hundreds of millions on an unproven startup, with next to no due diligence done2, are likely over for the foreseeable future.
Valuation Pressure: As interest rates rise, the present value of future cash flows declines, leading to lower equity valuations. This, in turn, will reduce the value of employees’ equity compensation, which may lead employees to start demanding that more of their compensation be paid in cash and less in equity. An obvious consequence of this would be that a startup’s cash needs would increase at the same time that venture capitalists have less cash to invest in startups.
Innovation Slowdown: The more risk-averse investors are, the less potential innovation there is. To some extent, artificial intelligence technology will blunt this impact.
Note that if you review the ChatGPT session, you will see some speculative stuff from it, as well as certain ‘product’ recommendations; these are an artifact of my custom instructions, and I’ve ignored them in this piece, as they’re not relevant.
I realize that Tiger has claimed that it did extensive due diligence on its investments, including by outsourcing diligence to Bain consultants, but the pace at which they invested raises the question of how sufficient that diligence was, especially given their recent troubles.