There’s a massive arbitrage opportunity in VC

We made the case just a month ago that clickbait stories warning of a crippling recession that would hammer the public markets, were seriously overheated.

There have been even more dire warnings about the private markets, with some predicting a Startup Mass Extinction.

And VC has indeed gotten crushed.  Down rounds increased four-fold increase in Q1 2023, capital raised dropped by 80%, and round velocity dropped across all stages.  Industry giants like Tiger Global and Softbank took 30% writedowns on their private market holdings – and are rumored to have run failed processes to do block secondary sales.

The single biggest driver of a nasty VC climate?  A dismal IPO market, which dropped more than 80% YoY in 2022.

But a funny thing happened on the way to the recession. The financial media is now doing a 180 from “recession is coming, and that right soon,” to declaring that The Bull Market is Just Getting Started.  After all, the Nasdaq is up 29% in 2023 and off to its best start since 1983, and ten of the 11 sectors in the S&P 500 rose in June.  Not everyone shares this view.  And the public markets wobbled when the new employment data came out showing a hot job market.  But the data are there.

Could recession still throw sand in the gears of the public market rally?  Of course.  And recession will obviously come at some point – though we note that the 22.3 P/E Ratio of the S&P 500 is still 45% below the pandemic peak.

What’s striking is the arbitrage opportunity the public market rally is creating in the private markets.

The IPO market now appears to be opening up, with a roster of high quality issuers rumored to be queued up for multibillion dollar offerings, including Stripe, Klayvio, Instacart and Reddit.

Most compelling may be that nearly every measure of investor greed is flashing green.  Whether it’s put to call ratio, the CBOE Volatility Index, or junk bond demand, they all show investor sentiment that appears primed for a roaring return of the IPO market.  If there are more frequent successful offerings like Kenvue’s $41 billion IPO, the increasing flow of IPOs could become into a gusher.

If it does, expect a rebounding IPO market to drive a major turnaround in venture capital.  Yes, as consumers spend the last of the Covid stimulus funds that have kept them cash-rich, the economy and the broader market could suffer.  Potentially, a lot.  But in the meantime, our wager is that venture funding volume and private market valuations will rebound as the IPO market recovers.  Maybe that’s why Calpers just increased its VC allocation by six fold.

That’s our bet.


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