BFV — Research Dive #8 — Have Rising Rates Affected Early-Stage Retail VC?
Big things happening in Northwest DC of late. And I’m not referring to Georgetown hiring Hoya legend Patrick Ewing as its men’s basketball coach. Though that is indeed very big. No, I’m talking #monetarypolicy and its impact on VC. Federal Reserve Chairwoman Janet Yellen has announced three 25 basis point increases in the Federal Funds target rate since December 2015, with further increases likely over the coming months. The current range of 0.75% to 1.00% is the highest since 4Q 2008, the depths of the Global Financial Crisis.
What is clear is that the Fed believes the U.S. economy a) is strong enough and b) has approached its target annual inflation of +2% to the point where higher short-term rates are appropriate. From the perspective of Brand Foundry Ventures, what is cloudier is how (if at all) increasing borrowing costs have affected its areas of investment expertise: early-stage consumer brands companies. In this post, we will look at some of the commentary, research, and data available to investors and founders.
VC Investment vs. FF Rate. The first thing to establish here is that the connection between venture capital dollars invested and ST rates seems to have weakened in the post-GFC period. Tomasz Tunguz at Redpoint Ventures captured this in the following blog post nearly two years ago: http://tomtunguz.com/interest-rates-and-startups/. The late 2008 through early 2015 period may indicate that historically low rates spurred increasing VC investment; however, between the Tech Bubble and GFC, VC investment tracked closely with the Fed Funds rate (and by extension the Fed’s perceived strength of the economy) per Exhibit 1:
You often hear that VC itself is a no-growth industry due to the limited number of venture capitalists: there were only 898 venture capital firms and 1,562 active funds managing $333bn in the U.S. in 2016, per the National Venture Capital Association. The irony is that investors are searching high and low for companies that demonstrate the potential for significant growth. We think the latter half of the data in Exhibit 1 — which conveniently ends around when a) quantitative easing in the U.S. wrapped up, b) the Fed’s intention to increase ST target rates became more of a reality, and c) I left the working world for two years of the case method at UVa’s Darden School of Business… okay fine, that was less important — can be accounted for in many other respects beyond low rate-spurred investment. Post-GFC, the emergence of corporate venture capital (CVC) arms has been prolific. Likewise, the well-told trend of companies delaying IPOs has also played an effect: the proliferation of Series E, F, and G rounds by larger asset managers who are searching for differentiated returns like BlackRock, Fidelity, and T. Rowe Price factored into the cumulative increase in VC investment from the early 2009 GFC trough through 2015.
Early-Stage Venture Capital Invested in Retail. But what’s going on with seed and Series A investment in retail/consumer today? And have changes in interest rates over the past 15+ months affected much in the way of cumulative investment or deals closed? Well, it’s worth setting the scene. Per PitchBook, quarterly cumulative capital invested for seed and Series A deals in the retail space going back to 1Q 2000, as defined in the Exhibit 2 footnote, is as follows:
A couple of observations from Exhibit 2. Moving chronologically, it is interesting that cumulative capital invested into early-stage retail deals was essentially unaffected by the GFC. Eyeballing the quarterly dollars invested in 2006 vs. 2009 pretty much tells that story. Ten years ago, investors in early-stage consumer may have been unperturbed by the shakiness of the economy. The precipitous drop in the FF target rate from 5.25% in 2Q 2007 to 0.00% to 0.25% in 4Q 2008 did little to move the needle. This starkly contrasts the fall-off in total VC investment shown in Exhibit 1. A second observation is that early-stage retail has increased in prominence very dramatically since 2000. Putting aside the early portion of the 2000s (multiple generations ago from a VC perspective, as far as we are concerned), let’s look at the last decade alone. In 1Q 2007, basically the height of the mid-2000s market optimism and pre-credit crunch reality setting in, $173mn was invested in early-stage retail. This compares to $500mn in 1Q 2017 (a number I would expected to increase marginally to allow PitchBook to capture unaccounted for deals that closed at the tail end of the quarter). That’s a 2.9x increase over ten years. Not bad for an entire industry. A third observation is that the (mostly) consistent upward trend in investment dollars and deals has started to waiver a bit since the Fed made its first FF rate change in seven years in December 2015. Exhibit 3 offers a zoomed-in look at the period beginning at the March 2009 GFC trough:
The blue bars and labels on the right side of Exhibit 3 represent the six quarters since Yellen’s initial FF rate increase announcement. The average quarterly number of early-stage retail deals in that period was 189, -33% off the peak of 283 in 1Q15. Likewise, the average quarterly cumulative capital invested in that period was $720mn, -28% off the peak of $994mn in 1Q16.
The bottom line is that early-stage retail VC investing has gotten choppier in the past six quarters. Still, there has been no dramatic drop-off, as clearly indicated in both Exhibit 2 and Exhibit 3. It is also critical to note that many factors are at work here, i.e., ST interest rates are not necessarily the best predictor of dollars invested or deal count. Admittedly, they might not even be a good one at all. For example, a sophisticated regression with many variables (unemployment? inflation? fundraising metrics? prior vintage year fund IRRs or multiples? pension fund performance across alternative asset classes?) would offer a more meaningful determination of when and how much VC money in the retail space is invested. In addition, we would emphasize that rates on longer duration fixed income remain near historic lows.
Impact on Convertible Notes. One thing that hopefully goes without saying is that longer-term fixed income interest rates do not move in lockstep with movements in the FF rate. Sure, we think ST rates are a good indicator of how the central bank views the relative health of the U.S. economy, and the data shown above might be meaningful for investors to see as they evaluate companies in the retail space. On another level, founders themselves would be smart to think about the impacts of rates continuing to move upward. We believe that convertible notes will remain a prominent source of funding at the seed stage. For investors, the benefit of a higher rate on a covert is the higher equity stake that he or she will get at conversion in the next round of funding; this of course must be considered when a founder reviews his or her respective funding options. Of note, BFV general partner Andrew Mitchell believes interest rates on convertible notes today can be as low as 4% to as high as 10%; they really are company-specific, and any movement in that range looking ahead does not necessarily have anything to do with the FF rate. Also, given a) what is often a quick turnaround from the time a company is founded to when it seeks seed funding and b) the six-month, one-year, 18-month, etc. periods and/or near-term trigger events typically associated with convertible notes, anything longer than a medium-term view of rates might not be important for most startup founders.
Sure, banks and other financial services companies are beneficiaries of increasing interest rates, whereas capital intensive businesses like utilities and telecommunications might find difficulties over the coming years. Within early-stage retail, particularly mobile, e-commerce, consumer devices, and consumer brands, the effect is a bit murkier. By and large, we believe the effect of higher rates over the next several years will play only a minor role in fundraising, investing, and deal terms in the early-stage consumer space.
Previous BFV posts:
Other interesting articles on rising rates and retail:
Fresh track of the day:
Mac covering EC!