Action plan for the storm ahead:
The Fed’s open market operations activities, such as successive quantitative easing (QE) programs designed to counterattack the economic fallouts from the global financial crisis and COVID-19 Pandemic, resulted in its balance sheet assets growing from $0.87 trillion in September 2007 to $8.96 trillion as of end of March 2022.
This aggressive QE program, coupled with the most prolonged low-interest rate environment in US history, has led to a wave of fast capital, which among other impacts has driven a period of innovations, growth and consumer spending, and meaningful private and public investment across sectors. It has also left the monetary infrastructure susceptible to volatile pricing shocks, as demonstrated by the recent aggressive increase in price in the basket of goods and inflation.
The Fed’s primary mandate is to control inflation. Two main methods the Fed uses to combat inflation: a) raise the cost of borrowing through hiking the federal funds rate (FFR), and b) limit currency in circulation via selling bonds, otherwise known as quantitative tightening (QT) programs.
Recently, on May 5, the Fed increased the target FFR by 0.50% to a range between 0.75-1.00%; the sharpest single rate increase since 2000. Market interest rates can trade freely (ie: mortgages), but the risk-free rate of interbank borrowing defined by the London interbank offered rate (LIBOR - soon to be the secured overnight financing rate (SOFR)), typically trades off a managed spread over government treasury rates. As a direct impact, as the Fed continues to increase the target FFR, LIBOR and SOFR will jump in kind. The next two Federal Open Market Committee (FOMC) meetings will be held on June 14-15 and July 26-27, 2022.
Unlike previous QE programs designed to stimulate economic growth, notably, post the “great financial crisis” and during the beginning of and ongoing COVID-19 Pandemic, the Fed will start the second wave of QT on June 1, 2022, by selling $30 billion of Treasury securities and $17.5 billion of agency debt and mortgage-backed securities. The quantum of these monthly sales will increase over the course of three months to a cap of $95 billion per month (split between $60 billion per month in treasuries and $35 billion per month in agency debt and mortgage-backed securities) and is estimated to continue monthly thereafter for three years. While higher interest rates and QT are designed to counter the effects of inflation, the expected impact from such a move is a loss in global wealth and generally more conservative institutional investment preference.
Inflation is everywhere today: you simply cannot open a newsfeed without encountering the daily impact of inflation on individuals and businesses alike. To summarize the below: expenditures continue to increase and are heavily driven by services.
The immediate effect of heightened inflation is a decrease in economic output (gross domestic product - GDP) and real wages. Personal savings continues to decline, discretionary consumption has essentially gone flat overnight all the while consumer credit card usage has spiked.
An April 28, 2022 release by the Bureau of Economic Analysis found that real GDP growth dropped from +6.9% in Q4 2021 to contracting (-)1.4% in Q1 2022. This marks the first economic output contraction since the onset of the COVID-19 Pandemic.
A March reading of the consumer credit report released by the Fed found that total consumer credit had expanded $52.4 billion - double the expected amount and the highest on record, driven by $31.4 billion of revolving consumer credit (credit cards), more than twice the month prior and also the highest on record. These movements have run perpendicular to the US personal savings rate, which continues to decrease sharply since spikes during the onset of the ongoing COVID-19 Pandemic.
Increased consumer and declining personal savings predicts an immediate impact on business models seeking to sell consumers discretionary goods and even greater impact on business models extending credit to consumers as a method of supporting gross revenues.
VC and debt investors are typically backed by limited partners that view their investments in terms of risk and return. When both rates and inflation are high, safer investments (i.e. treasuries and other traditional assets) become more attractive in comparison to investments with limited track record. Earlier stage can still appeal to these investors, but will need to meet the investor’s increased required rate of return, which they achieve by issuing higher costs of debt and/or making equity investments at lower valuation multiples. Even for companies exhibiting strong and attractive unit economics, market conditions may only present highly dilutive equity investment opportunities.
Of late, a shift has begun in which VC dollars seek to invest in companies generating positive operating and net margins. This has led to an immediate impact in down valuation for crossover companies and a slowdown in investment volume for earlier (Series A, B) companies, which had previously achieved high valuation multiples by investing in hyper-growth. Companies that are cash rich and generate positive free cash flow may attract more favorable rounds as VCs choose to deploy dry powder in follow-on rounds. However, even these companies will be subject to lengthier and deeper diligence exercises as the idea of FOMO (fear of missing out) VC money continues to evaporate.
Investors are, if anything, predictable in down markets and environments of tightened credit. VCs operate in one of the more cyclical investment environments given the relatively long-dated and illiquid nature of their investments. When new opportunities don’t match their new risk-return analysis, VCs have historically shifted focus to supporting current portfolio companies through follow-on investment rounds. For later stage companies, this may mean pushing companies towards a liquidity event.
Numerous proxies for this type of behavior exist. Perhaps the most relevant to today’s economic environment comes in the form of the VC boom in the 1980s meeting the impact of the historic interest rate- and inflation- combative period under former Fed Chairman Paul Volcker. In this particularly stressed example, a flood of VC investments preceded an immediate and voluminous IPO (initial public offering) season as investors seized opportunity to liquidate risk via the public markets.
It’s safe to say that we’re too early in the cycle to witness a move to liquidity, or a “reset”, but perhaps the beginning of this shift has begun to form for some. To play devil’s advocate: this should also open an opportunity to work with investors still active in finding new opportunities and especially new alternative capital solution platforms analyzing a more granular set of metrics beyond growth and profitability.
Investors may have the luxury of changing their required investment mandate on the fly, but companies who’ve fundraised, hired and built business models don’t have the luxury of an immediate pivot.
In summary, a company that has achieved growth has found a fit and demand in the markets. While traditional markets may stiffen and dry – today’s environment presents a new opportunity for other progressive partners who are hungry to continue alignment with the mission.