Venture capital activity slumps in rising rate environment

Amid a surge in market volatility and rising interest rates, venture capital (VC) investment activity in Canada pulled back sharply in 2022, according to a new report from BDC Capital.

The total value of VC investment dropped 34% last year, amid a 12% decline in the number of deals, it reported.

This drop in venture activity came as central banks began sharply raising interest rates in response to high inflation, which touched off a drop in market valuations. Global VC investment was down 35% too, the report noted.

“The shift to monetary tightening in 2022 led to a higher cost of capital, similar to the dot-com era,” the report said. “In this higher-interest rate environment, prior valuations were no longer sustainable, which led to the recent correction.”

Median exit values from Canadian VC deals plunged by more than 50% in 2022, dropping to $39.5 million from $89.4 million the previous year, the report said.

“With the increased cost of capital for investors and acquirers, company valuations fell as future cash flows were discounted at higher rates,” the report noted.

Against this backdrop, initial public offering activity dried up, following a record-setting 2021.

The report said the formation of special purpose acquisition companies (SPACs) as investment vehicles also fell by over 60% from the prior year.

“By the end of 2022, only 22% of Canadian SPACs raised since 2020 had completed a successful merger,” it said. “Many SPACs that are still looking for a merger can be expected to dissolve, thus returning capital to shareholders.”

Looking ahead, the report said total capital deployment is expected to decline further this year, but the industry should stabilize once interest rates ease again.

It forecast that the Bank of Canada will start cutting rates by the end of 2023 or early in 2024.

“As a result, we believe that beyond 2023, VC activity will return to sustainable levels of growth with corrected and defensible valuations,” the report said.

Additionally, it said Canadian-based venture investors are sitting on an estimated $13.2 billion in “dry powder” that has yet to be deployed, and the revival of the federal Venture Capital Catalyst Initiative “is expected to accelerate approximately $2.2 billion in new capital into the Canadian VC ecosystem.”

James Langton

James is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on regulation, securities law, industry news and more since 1994.