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Venture capitalists face all the challenges

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It is tough out there for venture capitalists as persistently high interest rates dog a sector reliant on long-term leverage, and this difficult environment looks set to last.

In his Venture Capital Quarterly Update for Q3 2023, Preqin’s Michael Patterson CFA, says higher rates for longer may be a net negative for venture capital (VC). 

“Higher capital costs increase the discount on the expected cash flows of firms and VC is especially susceptible due to its long duration.”

He also questions whether inflation will become more embedded as shifting global supply chains keep inflation above the Federal Reserve’s target rate.

There is already clear evidence that investors are taking what Patterson calls “smaller bites” of the VC pie, reducing the size of planned commitments to VC funds over the next 12 months.

The Preqin research shows that 75 per cent of investors are committing less than USD50 million in the third quarter of 2023, up by 13 percentage points from the same quarter last year.

The smaller commitments are reflected in the lowest levels of fundraising since 2025, which Patterson describes as a “sore point”.

“In the third quarter, 178 funds closed raising USD16.5 billion. This marks the sixth consecutive quarter in which aggregate capital raised has fallen.”

Patterson explains that since GPs have not been returning capital in investors in the tougher exit environment. In turn investors have been unable to put money to work through commitments to firms, which creates a vicious fundraising circle.

Where deals are capturing investor attention, Patterson points to artificial intelligence (AI) where aggregate deal value reached USD75.1 billion in Q3 up from USD67.5 billion in Q2.

Patterson says: “Deals are still taking place but there are fewer happening and the average size is bigger. This may be because firms are preferring to reup into existing companies in their portfolio rather than deploying capital into new start-ups.”

AI has also caught GPs’ attention with aggregate AI deal value as a proportion of total aggregate VC deal increasing from 5.9 per cent in the first quarter of 2023 to 10.7 per cent in Q3.

Patterson says: “Investors have limited choices on how to gain exposure to this vertical in public markets which may be a selling point to LPs who are looking to refresh their VC portfolios.”

Despite this less that rosy picture for the VC world, there is demonstrable appetite for these kinds of investment at least among UK local authority pension funds.

At the end of October, Northern Gritstone, the investment business focused on university spinouts and IP-rich businesses in the North of England, announced a final close of GBP312 million, anchored by investments from local authority pension funds.

More than GBP150 million of the funding commitments have been provided by South Yorkshire Pension Fund, West Yorkshire Pension Fund, Greater Manchester Pension Fund, Merseyside Pension Fund and East Riding Pension Fund.

These have been boosted by additional investments from the metro mayors for Greater Manchester, West Yorkshire and South Yorkshire.

Northern Gritstone CEO, Duncan Johnson, says:“Our deals have already generated nearly GBP100 million of investment in the North, providing support to some of the country’s most promising businesses. Our investors’ backing will allow us to explore further opportunities across the wider northern venture ecosystem and stimulate growth and job creation in the region.”

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