By the following year, the venture capital — which usually has little interest in investing in the next phase of the company’s growth — can make a profit from the private equity money and leave.
Venture capitalists and private equities adhered to the so-called “power law”. They need not get every investment right, just a few of them right, and those few would result in big payoffs.
The system worked — provided money remained cheap, as it allowed private investors to spread the money. Venture capital and private equity could spread the wealth and build company valuations up, with small risks, all the way until a company was listed on the stock market.
Resurgence of inflation
While no one assumed that zero interest rates would last forever, high levels of global debt (360 per cent of global gross domestic product), low levels of investment and the chronic absence of inflation led to the natural conclusion that they would remain low for a very long time.
However, the resurgence of global inflation, resulting from tectonic geopolitical shifts, upended this process. As the cost of money rose, so did the opportunity cost for those funds.
At the same time, their own capital is drying up. Pension funds and other big organisations that could not find a yield in bonds would expand to equities and private equity.
But as the risks rise, and bond yields with them, they are now beginning to trim their exposures. PitchBook, a news outlet for private equity companies, said in February that “private equity returns are a major threat to pension plans’ ability to pay retirees in 2023”.
The calculus now changes. Private equities and venture capital companies can no longer spread their money as much, meaning the probability of severe capital losses mounts. As a result, they are less able to invest in new companies, instead focusing on squeezing value out of their current exposures.
Global deals have sunk to their lowest levels in more than a decade. In April, Blackstone, one of the world’s largest private equity companies, stopped redemptions for some of its funds. Global merger and acquisition volumes have collapsed.
The 10-year average M&A volume stood at $3.8tn at the end of 2022. For 2023 so far (until the end of April), the total value of deals reached was around $700bn. Even if this figure were tripled — which would imply that further rate hikes will have zero impact — the number would still be half of the average annual volume of the past decade.
As time passes, the valuation method changes. It is not just what someone paid for a company a couple of years back, it is the profits this company should be making now.
