I was at a venture investor dinner last month where our host asked each of us to stand up and, as part of our self-introductions, to state where we needed help from the group and where we could help others. One of my fellow investors, a partner at a well-known firm, joked that he was “looking for this thing called liquidity” and asked if anyone knew where to find it. The wave of laughter from the crowd spoke volumes. This also caused me to reflect on the things we’ve learned about liquidity over the last few years. Fortunately, it appears that the decline in interest rates means that many of us will begin to find liquidity in 2025 and beyond.
Lessons from the interest rate hikes
As part of a broader family office, we have seen firsthand how the interest rate increases affected the work of our asset allocation team. The rise in interest rates changed the investment landscape and gave rise to a long-missed category for asset allocators: the ability to put money to work in credit and to earn meaningful rates of return.
To make matters worse for those of us investing in venture, the interest rate increases also impacted venture outcomes negatively by increasing the cost of borrowing for acquisitions by private equity firms. This has helped throttle the M&A market, which is the primary source by dollar value of exits in the venture ecosystem.
This combination of factors, along with the lingering hangovers from a frothy IPO market, has helped curtail exits and thus distributions to limited partners in funds. They have thus cut back on re-investing into new funds over the last two years. In fact, it’s created a set of circumstances that we haven’t seen in roughly twenty years: a time in which venture exits were few and far between and yet the rates of return in shorter-duration, relatively risk-free, liquid assets became meaningful.
How correlated are interest rates to venture outcomes?
To understand the degree to which interest rates and exits in the venture ecosystem are correlated, we looked at the correlation over the last twenty years between (a) 10-Year U.S. Treasury average annual yields, (b), the total deal volume in dollars for mergers and acquisitions of U.S. venture-backed companies, and (c) the deal volume in dollars of IPOs of U.S. venture-backed companies. We looked at 10-Year Treasury yields from the Federal Reserve Bank of St. Louis’ FRED dataset and exit volumes for U.S.-based venture-backed companies from Pitchbook.
To quantify the degree of correlation between 10-Year Treasury annual yields and M&A and IPO values, we inflation-adjusted earlier year exit values to normalize these amounts for our analysis. We found that the 10-Year Treasury rate had a correlation coefficient of -0.577 versus U.S. Tech IPOs, indicating a moderately negative correlation (with an R-squared value of 0.333, implying that as much as a third of the variance in the latter could potentially be explained via movements in the interest rate).
We found that the 10-Year Treasury annual yield had a correlation coefficient of -0.670 with U.S. M&A values, indicating a strong negative correlation (with an R-squared value of 0.433).
The implications are that higher interest rates generally are associated with periods of lower exit volumes, as has become abundantly clear in the search for liquidity among venture investors over the last two years. There are obviously a host of factors that lead to liquidity (or the lack thereof) in a given market, but it’s also interesting to see the extent to which something as macro as the interest rate regime appears to be one of them.
The outlook going forward
We believe that the recent shift to declining interest rates is a harbinger of better times ahead when it comes to exits. Though the analysis above only speaks to correlation and not causation, we see other signs that point to an opening IPO window as well as clear, anecdotal evidence that private equity and corporate M&A is already starting to pick back up. For those companies that have been able to survive and thrive over the last few years, we think we’ll see many more opportunities to exit and that this, in turn, will pave the way towards reinvestments into the venture ecosystem. The dry patch that we’ve experienced should soon be over if the last twenty years is a guide to what we might expect going forward.
