By Octavio Sandoval, Director of Investments at Illumen Capital
Many professionals in alternative investments are relieved that 2023 is behind us. Despite the challenging year, there are potential significant 2024 tailwinds that make investing in Private Equity (PE) and more specifically Venture Capital (VC) attractive again.
For instance, the U.S. VC fundraising environment is expected to rebound because the 2023 exit market was pretty much closed. In 2023, the rate at which capital has been distributed back to limited partners is at the lowest level since 2003. Lack of liquidity contributes to how much capital can be invested into new VC funds. Predicting the full reopening of the U.S. IPO market is very subjective but there are encouraging indicators.
Throughout 2023, the U.S. economy has been performing better than expected. Most recently, GDP increased 5.2% in Q3, which temporarily calms expectations that the economy will fall into a recession. With the Fed’s recent announcements hinting that they may decrease interest rates in 2024, it is expected that the central bank has concluded its current cycle of rate hikes. VIX, a gauge on volatility, is at a number significantly lower than the long-term median of 18. Lower expected volatility tends to reduce the expected risks with filing IPOs. With more expected liquidity events in 2024, fundraising for VCs should be better than it was in 2023.
Another popular saying in the industry is that investors can’t eat MOICs (Multiple on Invested Capital). The recent valuation reset has temporarily impacted LP interest in VC funds. Many of these VC funds quickly deployed capital in recent years. Consequently, their interim fund performance is suffering from markdowns driven by the private valuation correction. The initial lack of distributions to LPs has discouraged them from committing to new venture funds. Therefore, funds in a raise cycle must show DPI or distributions to attract new limited partners. We have been seeing distributions throughout 2023, which is very encouraging as we head into 2024.
Even though 2024 is expected to be a better year for VCs than 2023, there are still risks. For example, valuations across the U.S. VC ecosystem have corrected or reset from 2021 highs. We’re seeing a trend in participation in co-investments including extensions and even down rounds as well as unicorns having their valuations cut significantly. As more unicorns deplete cash runways and struggle to turn profitable, returning to raise in an uncertain 2024 environment could potentially force them to compromise their valuations to stay afloat.
Additionally, companies are selling off IP or even shutting down altogether to return at least some capital to investors. But, we remain optimistic that VCs will continue to focus on unit economics and consequently have their portfolio companies on a better path to profitability, which should command the highest valuations.
There will be attractive deal flow for VCs in 2024. The number of U.S. VC insider-led deals should increase in 2024 because VCs will be able to capitalize on their asymmetrical information. The hurdle for startups to secure venture financing has risen significantly. Amid a challenging equity financing environment, VCs have been stepping in, providing needed capital to support most promising portfolio companies to reach the next milestone and attract external funding for the subsequent round. This allows VCs to take more ownership in their portfolio companies. When the exit market opens again, VCs are in a stronger position to have outsized returns and can provide their limited partners with distributions.
Regarding the expected deal flow in the private equity industry, private equity secondaries could rise to a record high in 2024. Private equity secondaries in particular to limited partners typically can be purchased at a discount to fair market value, creating a gain on day one of the investment. As context, in 2021, private equity secondaries peaked at a high of over $130 billion. Although 2022 and 2023 did not reach new highs, there could be one in 2024. With substantial amount of dry powder, an expected narrowing of the bid-ask spread in secondaries, and most importantly the continuing need for liquidity among LPs, there are significant tailwinds for private equity secondaries.
In summary, 2024 is expected to be a rebound year for alternative investments. Noteworthy, given the recent setback in DEI initiatives especially in the big tech sector, there are even more opportunities to invest in diversity. The momentum of the George Floyd racial justice reckoning in which many major banks, corporations, and more importantly investment firms pledged to make diversity a top priority. Black founders and Black-led startups saw historic gains in securing venture capital funding in 2021.
However, as market conditions deteriorated, a lot of those gains were lost by the end of 2022 and the market is reverting back to an old habit. As competitive as the investment world is, investors need to change their mindsets to see diversity as a fruitful investment opportunity. There is hope that VCs and more broadly investors continue to invest in diverse teams.
Opinions expressed are those of the writer and do not reflect the official position of Illumen Capital.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.