PitchBook News - How likely is a recession?

Our three scenarios for where the market goes from here; Late-stage VC valuations decline in Q1 as pressure mounts; Tech research on infosec, mobility
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May 14, 2022
What are the odds of a recession? Three scenarios of where the market goes next
Markets staged a small bounce back on Friday, but major stock indices still suffered heavy losses on the week. The S&P 500 is 16% below the all-time high it closed at on the first trading day of the year.

This magnitude of loss is certainly not abnormal. Equity markets typically register drawdowns of 10%-20% at least once a year and more than 20% every few years.

Why then does market sentiment feel more like the sky is falling?

Our view is that sentiment is incredibly pessimistic because of influential paradigm shifts within financial markets, the economy, and geopolitics that are all happening at once.

Individually, these shifts present significant downside risks to investment portfolios, but taken together, they could lead to extremely bearish developments. Some of that downside risk has already played out in markets over the last several weeks.

The first big shift is that inflation is running uncomfortably higher than the Fed's stated policy goal of roughly 2%, which fundamentally alters how the central bank is able to conduct monetary policy.

The Fed has already hiked rates by 75 bps since March, and the market is pricing in an additional 200 bps of tightening by year-end. The increase in discount rates has led to a second big shift, which is a major repricing of valuations and a sharp rotation away from stocks with relatively high implied growth rates toward stocks with low growth rates.

This underlying rotation is one of the main reasons the mild drawdown in the S&P 500 has not captured the full extent of the pain, as many of the high-flying tech stocks that have driven market gains for years are down more than 30%.

We believe the pricing dynamics playing out in the public markets are also happening in private markets to varying degrees across asset classes and industries, although it may take several quarters for this to appear in the data.

Venture capital is particularly susceptible to repricing given its high degree of exposure to young companies that will require significant growth to reach profitability—and given the surge in valuations over the past few years.

Meanwhile, the biggest worry related to private equity is not valuations, but rather the impact of rising rates on borrowing costs.

Looking ahead, we see three plausible economic scenarios that will drive how markets perform from here.

The first and most likely scenario is one in which the Fed is able to engineer a soft landing and avoid a recession. Our model indicates that there is still only a 20% chance of a US recession occurring in the next 18 months.

The second most likely scenario is a deflationary recession in which monetary tightening stymies demand and growth and, as a result, prices fall.

The final scenario is an inflationary recession, or stagflation. While this is the least likely of the three, we believe it is a significant tail risk that deserves attention and one that most investors are unprepared for.

For further detail on these economic scenarios and what each might mean for private markets, please download the free research note:

How inflation, monetary tightening and volatility are impacting PE & VC
 
Thanks,

Andrew Akers, CFA
Quantitative Research Analyst
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Late-stage valuations decline in Q1 as pressure mounts on VC deal terms
The recent rout in public equities, which has been especially concentrated and violent within the tech sector, has brought intense scrutiny on the valuation multiples of growth assets that swelled during the post-pandemic recovery.

The valuation climate of 2020 and 2021 implied perfect adherence to long-term growth targets, but then the onset of significant inflation and subsequent increase in interest rates has challenged the feasibility of those future revenues and cash flows, causing the repricing we're seeing now.

Shifting to how this affects VC, we still seem to be in a wait-and-see pattern as of the end of Q1.

Our new US VC Valuations Report has yet to show any significant declines because of the illiquidity the private ownership affords these companies as well as the slight lag in data collection.

Median valuations in Q1 2022 are broadly flat relative to 2021, with the exception of late-stage VC, which has actually started to display a decrease. The average is the easiest space to see this as outlier transactions like unicorn creation and mega-deals have started to slow significantly.
 
Late-stage startups feel the pain of market struggles first.

For startups nearing an exit or facing pressures from early investors and employees, the realities of the valuation environment are even more evident.

The issue here is that institutional investors are leaning away from the full risk-on mode we experienced in 2021, which makes finding providers of liquidity much more difficult, especially if the downturn persists.

For instance, exit opportunities such as IPOs have already seen a serious pullback, and massive crossover VC rounds that could provide secondary liquidity are beginning to decline in volume as asset managers retrench in the face of the current volatility.

These liquidity transactions can also be complicated if the deal is anchored to a price or multiple that is no longer the market rate, but insiders want to avoid a negative revaluation.

Regardless of any of these benefits to the illiquid nature of VC around smoothing the market troughs, the persistence of this valuation repricing will eventually trickle through to VC-backed businesses even at the seed and early stage.

It may not be until next quarter's data or the quarter after, but the reality of public valuation multiples reverting to their current levels cannot be ignored or dodged forever by private investors and startups.

There will not be a lack of funding for startups as the stores of dry powder will continue to support fundraising. However, new conversations around capital raises are undoubtedly being negotiated within the context of this new normal as exit multiple assumptions are necessary even at the earliest investment stages.

We expect startups to get creative on ways to extend runways, perhaps opening previous rounds to raise capital on similar terms and valuations or taking on non-dilutive financing such as venture debt.

We also believe that more protectionist deal terms may emerge if the downturn extends for a few more quarters as investors look to gain back some control that has been ceded during the boom times of the last few years.

There's much more data and analysis in the free research. Download our US VC Valuations Report.
 
Best,

Cameron Stanfill, CFA
Lead Analyst, Venture Capital
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Thematic Research
Private Markets Real Estate Fundamentals

Real estate tends to attract increased attention from private markets investors during periods of inflation.

And for many investors, the current environment is the first major bout of inflation they've experienced in their careers so far.
 
Our research dives into strategies and industry dynamics.

For those entering the space who may be unfamiliar with how private markets real estate investing works, or for people interested in learning more, we've produced a comprehensive primer covering topics like:
  • the capacity of different strategies to hedge against inflation
  • fund types and access points
  • investment strategies' risk-return profile, leverage usage, and holding periods
  • property sectors and subsectors
  • industry dynamics
  • how sustainable investing fits in
download the free research
 
Emerging Tech Research
Mobility tech startups have hit a speed bump, as VC investment has decelerated from 2021's torrid pace.

Weaker public markets have also impacted exit activity, with only three listings in Q1 as acquisitions become the more preferred route.

Our new mobility tech research examines the trends driving the industry amid the continued effects of the pandemic.

The report features a market map of key startups, an isometric map or the broader landscape, and pages upon pages of updated charts and tables, as well as an analysis of emerging opportunities in electric vehicle batteries and autonomous vehicle hardware:
non-clients can access a preview
 
Funding for information security startups slowed in Q1, particularly at the late stage.

We believe a slowdown in early-stage investment may materialize in the coming quarters as market conditions remain depressed.

In addition to analyzing VC trends, our new infosec research features updated market size estimates and market maps, as well as insight into emerging opportunities within cloud-native application protection platforms (CNAPP), security service edge (SSE), and threat intelligence.

Key takeaways:
  • Startups are beginning to scale with integrated platforms for application security orchestration.

  • Network security incumbents are consolidating secure web gateways, cloud access security brokers, and zero-trust network access via M&A.

  • During the geopolitical tension of Russia's invasion of Ukraine, enterprises require customized threat intelligence feeds that orient to their threat models.
non-clients can access a preview
 
Commentary
Senior foodtech analyst Alex Frederick weighs in on the news that grocery delivery giant Instacart has filed confidentially for an IPO:

"This week third-party grocery delivery platform Instacart acknowledged that it had confidentially filed for IPO.

"The move was a surprise given a challenging exit environment characterized by significant market volatility.

"Online grocery sales surged at the onset of the pandemic but have since tapered off due to pandemic fatigue and warming spring weather that had led many consumers back into stores.

"Third-party grocery delivery services enable many small and midsize grocery chains to compete against Amazon, Walmart and other leading online grocery providers.

"However, significant fees challenge profitability in an industry with margins in the low single digits. Food price inflation could likely erode order values or send customers searching for less expensive alternatives.

"Instacart recently launched services offerings such as the Instacart Platform and Carrot Warehouses, which offer a suite of ecommerce management tools and microfulfillment centers enabling ultrafast grocery.

"These tools may help retain or attract new customers as the online grocery landscape evolves."

 
Alex Frederick

Senior Emerging Technology Analyst
Foodtech
In the News
Our insights and data featured in the press:
  • The startup world is due for a reckoning: While valuations for mature startups remain high, they fell in Q1 compared with 2021. [CNN Business]

  • Women-led venture funds have already raised more money than last year. [The Information]

  • The best- and worst-case scenarios for the VC market. [Quartz]

  • "Traditional finance software has been slow to adopt crypto features and services, which has created a gap for startups to develop innovative solutions for companies with crypto strategies." [City A.M.]

  • While VC deals are still closing, the most expensive transactions are the most vulnerable to macroeconomic issues. [Institutional Investor]
If you're a journalist interested in interviewing our analysts or requesting data, contact our PR team.
ICYMI
Highlights from our other recent research:

Market updates Thematic research Emerging Technology Research Coming next week (subject to change)
  • European VC Valuations Report
  • Global League Tables
  • GP Stakes Portfolio Construction
  • More reaction to the new macro environment
Thanks for reading! Feel free to email us any time with feedback, questions, or tips!

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