Venture Capital on a Sugar High: The Interest Rate Effect
How interest rate changes impact venture capital activity.
The last decade of low interest rates is a historic outlier. Both the UK and the US saw interest rates nosedive to almost zero, as political and economic leadership made efforts to encourage more lending, borrowing, and investment to stimulate underperforming economies. This shift had a profound impact on the venture capital industry.
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Low interest rates bring about “cheap money”. But like a child who’s had a sugar-driven burst of energy, setting rates too low and for too long spurred a frenzy of venture capital fundraising and deployment that has since crashed back down to levels of investment inertia not seen since the dot-com crash.
Just how strongly linked are interest rates to the amount of venture funding in an economy?
To answer that, we can turn to the work of researchers Cristiano Bellavitis and Natalia Matanova. Their analysis of 270,000+ VC investments in 20 countries over 35 years found that a 1% rise in interest rates led to a reduction of $650m in funds raised by VCs the following year. This decline is equivalent to 3.2% of the average annual amount of money raised by VCs in a year.
Put another way, these findings show that when interest rates increased by some increment, the amount of money that VCs typically raised in a year dropped by 3.2x the percentage change in interest rates. What drives this negative correlation?
In a high-interest rate environment, the venture asset class becomes relatively less attractive. A pension fund or university endowment may, for example, choose to put less of its capital into venture funds and instead go for more government bonds or treasury bills.
At the time of writing, a 3-month treasury bill yields over 5% and this return is virtually risk-free. For institutional investors this could be a more compelling investment choice when compared to a median venture fund. After all, half of venture capital funds do worse than the stock market, and they don’t provide a meaningful return premium to justify their risk.
The opposite trend happens when rates are low. At the height of the pandemic in 2020 short-term treasury bills were yielding a paltry 0.1%. This drove a period of intense venture capital activity.
In a low-interest environment, investors pursue higher-return assets since they can’t make much money on bonds, and that often involves putting money to work in private equity and venture capital.
It’s worth noting that other factors impact VC fundraising at an industry level. They include the health of the broader economy (and the volume of IPOs), capital gains tax rates, and other regulatory changes. However, interest rates are a helpful indicator to keep an eye on.
Looking ahead, what can we expect?
Even though rates have consistently gone up in the last two years, they will eventually come back down (and there are long-term structural trends that suggest real rates are on a long-run decline). When this happens, expect VC fundraising to pick up again. But remember: while it's tempting to ride the wave of low-interest euphoria, it's wise to pace investments. Nobody likes the crash of a sugar high after all!