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US capital markets slow down with higher interest rates
As 2023 opens, volatility and uncertainty have increased in US capital markets — leading to deal flow slowing, valuations falling and investors seeking refuge in less risky assets. The economy will likely slow in the coming quarters, and stock prices may fall further in the short term. But we believe the markets are establishing a solid, fundamentals-driven platform for future growth.
The transition to a new environment has already begun. After a period of sustained economic growth — coupled with low interest rates and government stimulus — inflation surged to 9%. The Federal Reserve (Fed) responded in 2022 by aggressively raising rates by 425 basis points to wrangle inflation down to around 2%.
Stock market returns generally have a negative correlation with inflation — with obvious exceptions like commodities — because higher costs can’t always be passed on to customers. Inflation is just one of many contributors to the S&P’s loss of 19% in 2022 though. Some of the major drivers of capital markets volatility include the likelihood of a recession over a soft landing, geopolitical instability, human capital issues and emerging ESG considerations.
Still, we see some encouraging trends:
- The Fed’s monetary tightening policy has made progress with inflation declining from 9.1% in June to 7.1% in November — marking five consecutive months of deceleration.
- More than 70% of companies beat EPS estimates, and most companies have left guidance for Q4 unchanged.
Economic outlook: Uncertainty, inflation and a potential recession
Third-quarter real GDP grew at a 2.6% seasonally adjusted annual rate, supported by consumer spending, government spending and a narrowing trade deficit. US growth is expected to remain positive in Q4. Consumer spending has slowed but remains in good shape — fueled by a tight labor market and strong household balance sheets even after accounting for recent asset price declines. The US economy still might lapse into a mild recession next year due to factors including high inflation, aggressive Fed tightening, a strengthened dollar hurting exports and slowing global demand. Our baseline scenario includes a mild 0.2% drop in real GDP growth for 2023 following an estimated 1.8% rise in 2022.
Traditional IPO market slowest in over 20 years
- The IPO market was virtually closed in 2022 due to higher volatility and falling valuation multiples, especially in the high-growth, high-multiple tech sector. Those factors made it less attractive for prospective companies to price.
- There were only 27 traditional IPOs in 2022. These were led by the pharma-life sciences, tech and financial services sectors. Excluding one outlier with a very large return, traditional IPO returns were basically flat in 2022. However growth prospects helped drive IPO returns to outperform the S&P loss of 19%.
- Only 85 SPACs were able to complete their IPOs, which was an 86% drop in volume from 2021. SPAC IPOs that completed mergers have generally underperformed traditional IPOs, with the 101 deSPACs being completed in 2022 showing an average loss of 59% at year end. There are still nearly 400 SPACs with over $80 billion of dry powder looking to merge with a potential target.
- In a recent development, the SEC approved proposals from the Nasdaq and the NYSE to amend several rules around direct listings, including the elimination of the price range restrictions. The changes also include adding a requirement for issuers to have an underwriter on the transaction, which is likely to provide another effective avenue for companies looking to provide liquidity to investors.
- The health of the 2023 market for IPOs and direct listings will be largely dependent on the Fed’s ability to reduce inflation. Even in the event of a mild recession, we are optimistic that the IPO market will be receptive to high-quality, profitable companies — likely backed by proven financial sponsors such as venture capital and private equity.
- A flight to quality will likely continue in 2023. IPO investors are placing a heavy emphasis on financial fundamentals and intrinsic valuation, as opposed to market valuations emphasizing high-growth stories. There is a heightened focus on return via margins, operating leverage and cash flow. Companies that are likely to be positively placed for IPO success in 2023 will be those that can demonstrate profitability or at least a clear path to profitability.
VCs see drop in valuations
- Venture capital invested $238 billion in 2022, a $107 billion decrease from 2021's staggering total.
- There are more than 650 unicorns, of which one is valued over $100 billion and 35 are valued over $10 billion. More than 170 were minted in 2022 and we expect the creation of unicorns to moderate significantly as the market returns to fundamentals.
- Despite recent media attention surrounding various crypto companies, VC investment in the sector was relatively flat in 2022 with $15 billion as compared to 2021’s total of $17 billion. We’re expecting a pause in VC investments in other high-profile technologies like artificial intelligence and machine learning.
- Looking forward, investors will be more prudent in assigning valuations. We saw the median late-stage valuation drop to about $70 million by Q4 2022 from $100 million in 2021.
- With the IPO markets focused on intrinsic value, many VC-backed companies with high-growth prospects and a shortening cash runway are considering alternative forms of equity and private debt.
The cost of doing business soars
- Debt markets slowed, particularly in the second half of 2022, in the wake of rising rates, inflationary pressures and general risk aversion following two consecutive record-setting years for issuance.
- High-yield interest rates are roughly double what they were in 2021. US debt capital markets raised $1.7 trillion in 2022 — down from $2.6 trillion in 2021.
- The leveraged finance markets were particularly challenged in 2022. The year saw a number of leveraged buyout (LBO) transactions in which the banks were unable to sell debt to investors, leading to a 47% decline in high-yield bond and leveraged loan proceeds supporting PE-backed LBOs.
- The market saw an emergence of creative financing solutions including private credit, seller’s notes and bank debt. Some credit investment firms have even started to raise funds to buy loans stuck on bank balance sheets.
- In the near term, we expect conditions to remain difficult — particularly for lower-rated issuers — as the Fed continues to raise interest rates. As inflation begins to moderate, and pending any unforeseen economic issues, conditions in the market should improve. That will open the window for more opportunistic issuance moving forward.
Note: IPOs with deal values of less than $25 million, best efforts offerings, oil and gas royalty trusts, business development companies, pricing on OTC Bulletin Board and OTC Pink Sheets are excluded from this narrative. Later-stage median valuation is as of 12/13/22. Data from SEC filings and third-party databases are as of 12/30/22.
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