Interest rates are the Federal Reserve's go-to treatment for an ailing, lethargic economy.
But the Fed's meds have a curious side effect – they're a shot of adrenaline for the venture market.
Low interest rates jolt the heart rate of venture capital, driving a manic frenzy of transactions and funding for startups.
On the other hand, high interest rates kill the vibe, causing deals to dwindle and prices to plummet.
You don't need a PhD to understand that. What's less obvious is exactly how large of an effect we're talking about here.
Turns out – it's huge. For a 25 basis point or 0.25% change in the one-year Treasury yield:
These effects are persistent, meaning we're always dealing with the aftermath of past interest rate shocks. It's the (highly oxygenated) air we breathe.
It's Jay Powell's world. We're just living in it.
Thoughtful analysis of the business and economics of tech
The Federal Reserve's zero interest rate policy (ZIRP) has come to an end:
It's no secret interest rates affect tech valuations:
During the last few years low interest rates and money printing led to a funding bubble in private technology – Elad Gil, Startup Decoupling & Reckoning
So the corporate finance logic goes, companies are worth the present value of their cash flows, and the "discount rate" one applies to those cash flows is the key input – lower rates mean higher valuations, and vice versa.
As much as investors like to ignore it, there's an obvious connection between valuations and interest rates:
Source: Redpoint Ventures
Source: Bessemer Venture Partners
These charts reference publicly traded companies. However, I've never seen anyone quantify the sensitivity of private tech valuations. In other words, "if interest rates fall by X percentage points, venture valuations rise by Y%," and vice versa:
Meanwhile, interest rates could affect more than just valuations. Recall a few essays ago I introduced the following framework for thinking about the individual "components" of a dollar of venture capital funding – deals, valuation, and dilution:
Interest rates could affect all these variables, and we should want to know how:
So I set out to find some answers.
A quick note before we proceed. It turns out, the Federal Reserve is mostly predictable, so most of its moves are already "priced in" by the market. I instead focus on unexpected and unanticipated shifts in interest rates that market actors haven't yet reacted to. To account for these expectations, I control for other macro variables like U.S. GDP, inflation, and the Nasdaq index.
For example, if the one-year Treasury rate declines by 0.5%, the market may have only expected a 0.25% decline based on current economic conditions, leaving 0.25% unexpected:
OK – that's the most complicated concept you need to understand. With that out of the way, let's jump to the results.
The following charts trace the effect of a 0.25 percentage point or 25 basis point (bps) cut in the one year U.S. Treasury yield on various measures of venture activity, up to twelve quarters / three years out:
The effects are quite strong, especially on deal flow and valuations:
Critically, interest rates affect deal flow, not just valuations:
This has pros and cons:
Let's drive that point home by visualizing the same analysis but for an increase in interest rates rather than a decrease:
Rising rates squeeze the life out of venture capital. Per the logic I outlined in my last essay, we know this reflects reduced investor demand, since quantities and prices drift together:
Demand can shift… which causes prices and quantities to move in the same direction (up when demand increases, down when demand decreases – We Don't Have Nearly Enough Startups
The (multiplicative) aggregation of these individual sub-effects yields the overall effect on venture funding:
With rising rates, funding falls just over 20%:
Perhaps it's obvious, but these are extremely large effects!
Thankfully, interest rates don't move up or down enough to regularly generate these sorts of reactions. A 10 bps / 0.1% surprise is much more common than a 25 bps / 0.25% one.
Notably, the effects aren't permanent; As interest rates reset, so does the venture market.
The current "era" of venture capital has been deeply influenced by this strange interest rate regime, having evolved entirely within it.
With our previous estimates, we can run a backwards-looking "attribution analysis", explaining the ups and downs of venture in terms of interest rates. In other words, we can break down the recent history of venture activity into the portions influenced by interest rates vs. other factors.
First up: deal activity. In red I plot an index of the overall growth in venture deal activity since early 2014, averaged across funding stages, and in blue I plot the portion attributable to unexpected interest rate shocks:
Of all the charts, this is the one I probably spent the most time staring at and double-checking the numbers, as it's just so striking.
Let's do the same for valuations (notice the bigger scale here):
This is important: that interest rates explain nearly all deal flow but only part of the rise in valuations implies that demand for startups has outstripped supply of startups. With nowhere else to go, that excess demand spills over into prices. You can't invest in startups that don't yet exist, so you compete for the few that do, bidding up prices. This is the same conclusion I reached in a prior essay:
… the valuation inflation we've seen "comes from" the incredible growth in demand and lack of supply of startup equity – It's Valuations (Almost) All the Way Down
Putting it all together, here's what our little attribution methodology has to say about the effect of interest rates on overall VC funding:
Monetary actions affect economic conditions only after a lag that is both long and variable – Milton Friedman
Before concluding, I should mention some caveats to this analysis:
Caveats aside, Friedman's proclamation appears to hold for venture capital – it takes multiple years for interest rate effects to fully play out.
Even in the private markets, we're all Fed watchers now: these interest rate effects are too large to ignore. In fact, interest rates are so impactful that they explain most of the mass hysteria of the last few years, both on the upside and the down.
Importantly, interest rates cannot forever move in one direction. Over the years, they mean revert, making their impact temporary at best. Don't get too accustomed to any particular regime – the new normal will always eventually look like the "old normal."
Don't discount interest rates.
Thoughtful analysis of the business and economics of tech