A summer slowdown by VC fund managers was largely responsible for a dramatic decline in US deal activity in the third quarter of 2022, according to a recent analysis of data by EY.
Dealflow for US venture fund managers dropped dramatically in the third quarter of 2022 to $37.4 billion across 2,260 deals from $90 billion across 3,412 deals in the fourth quarter of 2021, the highest quarter on record. Capital raised by start-ups was down 52 percent from the prior-year quarter.
“People actually took time off, put away their laptops, put down their phones and went on vacation and did not do deals and were not nearly as active,” Jeff Grabow, EY’s US venture capital leader, told Venture Capital Journal. “So there’s less pull-through” for deals to be consummated in the final quarter of this year.
The drop in capital deployed to founders stands in stark contrast to record-breaking fundraising by US venture fund managers, who raised $150.9 billion in the first nine months of this year. That already exceeds the full-year record of $147.2 billion set in 2021, according to PitchBook/NVCA’s Q3 2022 Venture Monitor report. That signifies a massive arsenal of dry powder that VC funds in the US are sitting on as they look for more clarity on start-up valuations and the direction of the economy.
“The FOMO [fear of missing out] spell is broken, so we’re not seeing rushes to deploy capital at the paces that we saw” previously, says Grabow.
There was hope that after Labor Day there would be better news and VC deals would pick up, but that hasn’t happened, he says. And that has further fed the pessimistic narrative around VC dealmaking.
The number of mega rounds fell 46 percent to 77 in Q3 from Q2 and was off nearly 68 percent from 238 in the fourth quarter of 2021, Grabow notes.
“It’s never been cheaper to start a company but it’s never been more expensive to scale,” he says. “When you get to that scale stage, that’s when you see those big rounds.”
Because of economic and market headwinds, “you’re seeing a smaller subset of companies that break into that growth stage these past few quarters,” he explains. “And you’re seeing companies that are already there that need to hunker down because the public [markets] are closed effectively. It’s very challenging to take a company [public] right now and there’s no reward for doing a good IPO in a tough market, so people are just waiting.”
With investors taking a much more serious look at everything, deals are taking longer. That’s being compounded by doubts about valuations, which got very frothy over the past couple of years. PitchBook says the median pre-money valuation for an early-stage deal hit a record high of $55 million as of September 30, up from $44 million last year, VCJ previously reported.
VC managers will likely focus on those companies in their portfolios that they believe still have good opportunities for growth. They’re advising entrepreneurs to reserve two year’s worth of cash to ride out market uncertainty. That could be through fundraising, workforce reduction or a careful focus on how they’re spending on their operations.
Energy shines bright
EY noted that one bright spot for Q3 was in energy and utilities, where activity jumped 35 percent to $4.2 billion from $3.1 billion in Q2. Renewable energy start-ups saw the biggest gains, raising $3.7 billion – 93 percent more than what they raised in Q2, but down 13 percent from a year earlier. Utilities raised $219 million – up 61 percent from Q2 and nearly 11 times what they raised a year earlier. Notably, nonrenewable energy companies raised 75 percent less than they did in the prior quarter.
EY defines the energy and utilities sector as including batteries for electric vehicles, EV charging stations and other infrastructure, but not electric vehicles themselves. In the first nine months of this year, start-ups in energy and utilities have raised more money than they did in all of 2021, says Grabow.
In light of heightened concerns around energy security, geopolitical instability and the rise of energy prices, there’s a lot of attention being paid to “finding technological solutions to provide energy, plus figuring out what to do around climate change and a climate crisis,” notes Grabow. “So there’s a lot of opportunity, and a lot of very smart people are looking at how to leverage technology to help solve this problem.”
Among the biggest energy deals in August were TerraPower, a nuclear innovation company launched by Bill Gates in 2006, and Longroad Energy, a Boston-headquartered start-up focused on wind, solar and energy storage. TerraPower raised $750 million in a round co-led by SK Inc, one of South Korea’s largest energy providers, while Longroad raised $500 million from MEAG, a Munich-based asset manager, as reported by Crunchbase.
While investment surged in energy and utilities, the sector is still relatively small, accounting for 11 percent of total US dealflow in Q3, not enough to offset declines in other sectors. IT, business and financial services and healthcare continue to be where the majority of venture dollars are invested.
Grabow expects overall dealflow to be “soft” in Q4, though not necessarily lower than in Q3. Historically, there isn’t much activity in the second half of December, and in light of the Thanksgiving holiday, there’s a very tight window for deals to be done in the final quarter of the year, he says.
He expects total capital deployed to start-ups this year to come in between $200 billion and $210 billion, down 35 percent from $325 billion last year. Still, for the first nine months of 2022, dealflow surpassed all of 2020.
After five years of significant increases in deal activity, a pullback was to be expected, says Grabow. “The art is as an entrepreneur how do you deal with it?”
Historically, many venture-backed companies have been launched during very challenging times.
“If you’re starting now fresh, you don’t have the legacy of [frothy] valuations and deals that were struck in a more heady environment, and you’ve got plenty of capital on sidelines that can be deployed,” he notes.