Venture capital for start-ups: Turnaround in interest rates spoils the mood of financiers

In view of the high inflation, central banks around the world have initiated a turnaround in interest rates. At the end of July, the European Central Bank (ECB) raised interest rates for the first time in eleven years – the monetary authorities surprised the markets by half a percentage point. The US Federal Reserve (Fed) even increased interest rates by 0.75 percentage points in June and July. In the USA, the key interest rate is already in the corridor of 2.25 to 2.5 percent.

According to the investor barometer, the interest rate hikes increased the pressure towards lower valuations further. Because the reaction of the central banks was particularly another damper on the stock market prices of technology stocks.

Their development is not reflected one-to-one in the VC portfolio valuations. The experts are convinced that the falling prices would gradually have an impact on the valuations of new rounds of financing.

The climate for IPOs (initial public offerings) also deteriorated significantly, according to the investor barometer from KfW and BVK. According to the experts, the IPO window has never closed as quickly as in the first half of 2022. Compared to the second quarter of 2021, the number of IPOs in the USA fell from 119 to 30, according to the consulting firm EY, and there was a slump in Europe 166 to 43 IPOs.

According to Fritzi Köhler-Geib, chief economist at KfW, the VC business climate continued to weaken from April to the end of June. Ulrike Hinrichs, Executive Board Member of the BVK, says: “The continued cooling of sentiment was not unexpected in view of the economic and political conditions.” According to Köhler-Geib, however, the consistency and strength with which the US Federal Reserve announced its interest rate turnaround caused a surprise now accomplished.

KfW: More difficult start for new funds

And investment bankers see further challenges for the industry: According to Clif Marriott, co-head of the technology, media and telecommunications sector in Europe at Goldman Sachs, 2021 was a year with exaggerations in many areas. The ratings would now be adjusted to the new realities. “Strong upgrades have become rare.”

According to an analysis by KfW and BVK, rising interest rates will also make it more difficult to set up new funds because institutional investors are now turning to lower-risk asset classes such as corporate or government bonds.

The more difficult raising of new funds recently had an impact on the willingness of VC investors to make new investments, and the corresponding indicator collapsed.

“Extended summer holidays” for investors?

In view of the foreseeable difficulties in raising new funds, according to KfW experts, investors may be trying to spread their existing capital over a longer period of time or to use it to stabilize the existing portfolio. Some investors were apparently reluctant to continue investing during this period of uncertainty.

The investor barometer from KfW and BVK also refers to anecdotal reports from market participants in which they say investors are taking “extended summer holidays”. Thus, the probability has increased that the cooled market climate in the third quarter will be reflected in a noticeable weakening of investment activity.

However, Lyle Schwartz, co-head of Goldman Sachs’ European private placement business, points out that start-ups raised record amounts last year. Investors are generally willing to accompany young companies through difficult phases. Many investors therefore took advantage of the changed valuations. The manager observes that they have sufficient capital that they want to invest.

Financing volume decreased only slightly

Looking at Germany, Austria and Switzerland, the financing volume in the first half of 2022 fell only slightly compared to the same period last year, from EUR 8.1 billion to EUR 7.9 billion. At the same time, however, the number of deals has increased significantly, from 296 deals in the first half of 2021 to 368 deals between January and June 2022, according to Clipperton, an M&A consultancy specializing in tech companies.

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However, it is important to note that there is a time lag in the data: many financing rounds are not entered into the databases until several weeks after they are signed, so only the data from May and June actually reflect the developments since the outbreak of war in Ukraine reflect.

In addition, some deals are likely to be transactions that have been brought forward, in which companies that only wanted to cover themselves with capital again in the second half of the year took care of further financing earlier in anticipation of a difficult market environment.

Clipperton partner Nikolas Westphal points to the major shifts in investment focus that can already be identified. “There has been a very strong shift towards software,” says Westphal, “50 percent of all rounds in the first half of 2022 were in the software area and only 14 percent in e-commerce and marketplaces.”

He justifies this development with a changed risk appetite: “Last year the focus was only on growth, now the focus is on models that also show strong growth dynamics but are also economically robust.” These included business models in which the capital can be used very efficiently, and those that work with recurring revenues, such as software subscriptions.

Westphal von Clipperton thinks two scenarios are conceivable for the second half of the year: The dry powder, i.e. the available capital, is still at historic highs: “The question will be whether the existing capital can simply be transferred to other business areas if the activity remains relatively constant focused,” he says – “or whether investors are actually taking a break because there are too many fears of a recession.”

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