Given the unprecedented monetary expansion, the fiscal response by governments to the pandemic, and several other factors such as historically low interest rates and major supply-chain constraints, we are in a period of growing inflation. There is a lot of debate about how long it will last, and how markets will be affected, particularly venture capital and private markets. TLDR: it depends.
While private equity and venture capital could be affected similarly to their public counterparts, the private asset class is a laggard in reacting to economic fluctuations, taking one to two quarters to realize effects seen in the public markets.
In periods of inflation, investors must focus on absolute returns by concentrating on companies that can produce returns at a rate higher than inflation. This is done by investing in and across companies that can build inflation into their models fluidly and also realize sustained levels of growth.
Here’s what to consider when evaluating alternative investments during periods of high inflation, and how strategic investments in venture capital can provide a potential shield against current market turbulence.
Flexible Business Models
Importantly, inflation requires stricter focus on flexible business models and pricing structures within differentiated and high-demand companies.
Private companies that have strong IP and product demand can pass inflationary pricing along to customers in order to preserve margins and real revenues. Tech and healthcare companies fall into this category as they can vary pricing based on inflationary forces and don’t have the margin pressures from their cost of goods. Whereas companies with long-term fixed income streams with multi-year fixed price contracts or companies that would suffer from higher input prices, may see margins and real revenues eroded in a highly inflationary environment.
Focus on Real Returns Driven by Growth
During inflationary periods, investors are challenged to make real returns above inflation. What may have been a 10% annualized return in normal times, drops to 4% annualized real return when inflation is at 6%. This challenges investors to find sectors that can drive more meaningful returns, while absorbing inflationary pressures.
Specific to venture capital investments in inflationary environment, there are several advantages:
- private valuations are marked to market, so as the dollar value declines and public market valuations go up, so too do their private market counterparts,
- venture capital equities typically have longer hold periods allowing market fluctuations to stabilize prior to realizations,
- venture capital-funded companies have historically shown the best ability for hyper-growth than other sectors which is an imperative factor during inflation.
With this in mind, the core business of venture studios and internal formation funds is to create new equity that can grow and scale from inception. In doing so, they are able to benefit from periods of hyper-growth in the company’s life cycle.
Given the equity creation process that venture studios and internal formation funds employ, they are well positioned to shield against periods of high inflation and market turbulence. Venture-backed companies historically utilize flexible, scalable business models that can adapt easily during inflationary periods. Additionally, products and services are rigorously tested in order to ensure market fit and market demand. The focus on high ownership and scalability in early stage formation can drive returns at higher rates than inflation, and in many cases higher than traditional venture returns.