Venture Capital’s Leading Indicator
A surprisingly large amount of ink and conversation in the startup world is devoted to updates on the current availability of venture capital for investment, market clearing prices at which it can be had, and predictions and analyses of why it is getting harder/easier to raise money for your startup. Let me just start with what I believe is the most important, and rarely made, observation:
The pricing of equity — public or private — is primarily driven by public sentiment. That sentiment is reflected first in the public markets, and is inherently difficult to predict.
I see/hear otherwise bright people getting lost in their arguments and analyses, and becoming confused about the underlying causality. I would argue that the opinions of venture capitalists, investors into venture funds, and those who write about the venture industry, are at best a lagging indicator. The place where public sentiment is reflected first is in the prices of public equities. Indeed, there are convincing arguments that the public markets create the means by which public sentiment is discovered.
My personal favorite single barometer of public sentiment is the Shiller Price to Earnings Ratio (based on the S&P 500). The Shiller PE is graphed below for the same quarters as in the chart above.
As we compare the quarterly capital flows into, and from, venture firms, with the value of of the Shiller PE, there are a few things worth noting:
- Wow, those plots are striking in the degree to which they line up! More on the actual correlations below.
- Capital flows in the venture ecosystem reflect a sub-optimal “buy high, sell low” procyclicality that is true across most asset classes. I examine this in more detail in a previous post.
- Each data point in the first graph reflects information not knowable until the end of a quarter. While each data point in the second graph is a snapshot of a value that is knowable in real-time (during market hours). Put another way, if the S&P 500 shoots up 20% on the first few days of the quarter, it’s a good bet that venture capital flows will go up markedly before the end of the quarter.
- The best predictor of where public market prices will be in the future (after correcting for inflation and GDP growth) is where they are today. Anyone who actually has a better prediction capability — if for example, surveying the opinions of venture capitalists could predict the public markets — would be a billionaire trading their own account. They certainly wouldn’t be wasting their time sharing their predictions with you or me.
We could easily get absorbed in looking for a better proxy than the Shiller PE Ratio. There are indices that are more tech-centric; there are indices that are more small-cap centric; there are indices that are higher-growth centric. Yes, yes, and yes. But, let’s not lose sight of the key fact that the public indices are real-time indicators of market sentiment, and all venture capital opinion pieces and compendiums of private prices reflect averages that are weeks or months old. Indeed, when we check correlations between quarterly changes in the Shiller PE Ratio and quarterly VC Investing and quarterly VC Fundraising, we find a few very interesting things.
- Consistent with a visual comparison between the first and second graphs above, we see noticeable positive correlation between Shiller PE change and change in in-quarter capital flows for both VC Investing and VC Fundraising. Correlations of this size across such a large number of quarters are strong and statistically significant results.
- When we look at the correlation between Shiller PE changes and changes in next-quarter capital flows for VC Investing, we see that the correlation remains strong, suggesting that venture capitalists may take a few months to respond to changes in market sentiment.
- But, the story is very different when we look at the correlation between Shiller PE change and changes in next-quarter capital flows for VC Fundraising. Here we see the correlation essentially goes away, suggesting the LPs who invest in venture firms react fairly quickly to changes in the public market.
Of course, current venture round pricing information is sometimes useful. If you are a startup founder raising a round of financing, it is certainly worth collecting up some data to have a quantified view. But, please bear in mind that you’re collecting up old data, and that the best way to adjust it to current time is by looking at the changes in the public markets. And, changes to the value of your startup are a magnified version of the changes to the public markets. Not only does your startup’s equity have higher beta in the standard financial sense (as we might partially address by picking a high-tech, high-growth, small-cap index), but changes in the value of your startup are also magnified to a greater extent than can be observed in the public markets due to:
- Capital formation ability. If the public markets go down, it’s going to be harder for all startups to raise additional money, and vice versa if the market goes up.
- Willingness to buy from the little guy. The same positive sentiment that buoys the public markets gives people the confidence to buy from a little startup. But, when the markets fall, there is generally a flight to quality, and people don’t want to take a risk on buying from a startup.