Investment is a core pillar of economic growth. Fluid and easy access to investment capital allows firms to grow their businesses, develop new technologies, advance into new sectors, and hire more workers. Private and public capital markets serve an important and critical function in efficiently allocating capital.
Capital, broadly speaking, includes all the productive assets of a firm. Such productive assets could fixed or physical assets such as machinery, factories, or land, or financial assets used for investing or purchasing productive physical assets.
Financial capital is essential for the growth of a business. Businesses require such capital to buy new technology, machinery and hire employees. Often, companies must raise the financial capital necessary to grow their businesses, especially in the critical early periods where profits are speculative and costs are high.
What Does it Mean to be Raising Capital?
Companies can raise necessary financial capital through three main instrumentalities – they can retain earnings, reinvesting profits back into the business; financing capital raising through taking on debt, whether through borrowing money from traditional lenders, such as a bank, or through issuing debt instruments such as corporate bonds; and finally, through equity funding, offering ownership in the company and rights to future profits in exchange for financial capital.
What is Equity Financing?
When a company raises money through equity financing, it offers ownership to other actors in exchange for capital. Such ownership can be sold through private means – through stock agreements and other private contracts – or directly to the public through initial public offerings.
Raising capital through equity financing can be attractive to companies because it provides much-needed capital without adding liabilities to their balance sheets. The company does not, for example, owe interest payments on the capital, which could disrupt cashflows, or owe back the principal at a later date.
On the other hand, the equity financing presents its own drawbacks. The more a company relies on equity financing, the more control it gives over to actors other than the founders and principals. Multiple stakeholders in a company could change its direction or force a sale. For public companies, corporations have fiduciary duties to stockholders, which could constrain their freedom of action.
What is Debt Financing?
Companies can also raise much-needed capital by issuing debt or taking on loans. Like other forms of private debt, such issuances and loans can be short, medium, or long-term.
Larger companies can sell bonds, which, like government bonds, exchange a security – the bond itself – for liquidity. The company can use the bond sale proceeds to reinvest in the business, buy machinery and new technology, order inventory, and anything else it might need to grow and meet its obligations. However, the bond is a liability on the company's balance sheets, and the company will continue to pay interest on the bond and the principal.
Companies can also raise capital through bank loans or from other lenders. Like all loans, the interest payments on the debt must be considered when projecting future cash flows, eating away at the company's future growth. Such constraints on future growth are a serious consideration. However, such risks are often worth it because the capital raised can increase growth potential, attracting newer investors and raising future profits.
Capital Markets and the Current Economic Landscape
When raising capital through either traditional means – equity or debt financing – companies often turn to public capital markets.
Capital markets are coordination institutions where corporations and other companies needing investment can receive capital from investors. Those with the capital to invest are usually large institutions such as banks and investment funds. Corporations, governments, and individuals can seek investors' money through capital markets.
Who is an Institutional Investor?
Institutional investors can include businesses, banks, and government agencies with excess cash and savings. For example, insurance companies and public pension funds will often be the source of large investments, along with investment banks.
The bond market is a capital market in debt. As described above, governments and companies needing capital will sell bonds – a promise to repay – in exchange for liquidity. On the other hand, the stock market is a market for equity financing – the selling of shares or ownership in a company in exchange for capital.
Venture Capital and Private Capital Markets
Much capital-raising is conducted through public capital markets, in which anyone, from retail investors to large institutions, can act as suppliers of capital, either as creditors or investors.
Public markets, however, are very tightly regulated – and many companies, particularly start-ups, lack the financial stability to raise the capital they need on public markets. Because public markets are – as the name suggests – open to the public, expansive regulatory systems protect investors through strict disclosure requirements. Only companies with sufficient financial stability and considerable assets can meet the standards necessary to participate in public debt and equity markets.
What are Private Equity Firms?
Private equity firms provide a form of equity financing that does not require participation in the public stock market. As a result, private capital markets are an integral source of capital raising, with high returns compensating for the comparatively higher-risk companies that seek private equity funding.
Private markets represent a significant share of global investment – in 2022, the total number of assets under management (AUM) increased to $11.7 trillion. In that same year – considered a “down” year in private equity – fundraising by private equity, the new capital raised totaled over $655 billion.
Venture capital is a subset of private equity and performs an important role in the private capital markets. While private equity firms typically invest in larger, well-established companies, venture capital takes on higher risk premiums and chases greater growth.
As a result of this quest for growth, venture capital is disproportionately invested in industries that have seen the highest returns. Information technology represented 42% of total venture capital investment in Q1 of 2023, while sectors that offer lower growth multipliers, like industrials and consumer goods, represented less than 5% combined.
This has also led to the geographic concentration of venture capital investment. In Q1 of 2023, $25.7 billion in venture capital funds were invested in the San Francisco Bay Area – New York, the next largest region for VC investment, represented only $3.8 billion in the amount invested.
The Macroeconomic Picture and its Affect on the Growth of Private Markets
In the decade following the financial crisis, venture capital, along with other forms of private equity financing, grew at a rapid pace. Such growth was provoked by historically low interest rates, with investors chasing higher returns than traditional lending and investing and using easy leverage and low borrowing costs to fund riskier investments.
The peak of private equity and venture capital growth came in 2021, following a pandemic-induced depression of deal activity and capital raising. That year, private equity fundraising increased 20 percent from 2020, reaching almost $1.2 trillion.
But the macroeconomic trends quickly let the air out of the exuberance – the return of high inflation, the raising of interest rates worldwide, and the shrinking of certain high-growth sectors, depressed venture capital investing especially, with partners looking for less-risky investments.
The Collapse of Silicon Valley Bank
Also important is the collapse of multiple banks, like Silicon Valley Bank, which affected venture capital firms and their portfolio companies. Those collapses could not be separated from the larger macroeconomic trends – the sudden increase in interest rates had made insecure previously safe assets, leading to massive losses on banks' balance sheets.
While private markets still outperformed public markets, 2022 saw a dramatic decrease in private market and venture capital activity. While there were 3.9 thousand venture capital equity financing deals in Q4 of 2021, valued at over $92 billion, in Q4 of 2022, there were fewer than three thousand, valued at almost $33 billion – a decline of nearly 66 percent year-over-year.
Venture Capital Trends in 2023
In 2023, venture capital has fared a little better, declining from the already-depressed deal numbers and valuations in 2022. In Q2 of 2022, there were over 3 thousand equity financing venture capital deals, valued at over $61 billion; in Q2 of this year, that number was 2 thousand deals, with a valuation of less than $30 billion.
At the highest end of venture capital funding, the decline is even starker – mega-round financing, deals that involve investments over $100 million, dropped 18 percent from Q4 2022 to Q1 2023. The total number of deals in 2023 Q1 declined 75% year-over-year from 2022 Q1. Such rapid declines from the heady days of 2021 and 2022 place in stark relief the changing attitudes of investors in the current macroeconomic environment.
2023 Q4 and Beyond
As the US – indeed, the world – enters into an extended period of high-interest rates, venture capital, with its emphasis on chasing growth at the expense of risk, may continue to see marked declines in a macroeconomic environment where borrowing costs are high and liquidity is harder to come by. Safer investments, with predictable yields and risks, may be more attractive options. Inflation remains stubbornly above the Federal Reserve’s target rate of 2%, and geopolitical instability, like the war in Ukraine, has its own destabilizing effects.
However, there are some green shoots of hope – though inflation remains high, it has come down considerably; investments in domestic energy production may also have a downward pressure on prices; and secular trends in the global economy may return us to a world of low-interest rates and easy capital. Whatever happens, venture firms will no doubt be watching closely.
Are you looking to raise capital in 2023 or 2024? Contact our experienced lawyers today for a free consultation and information on the best fundraising route for you and your business.