The Venture Capital market has experienced a massive growth in the last two decades. Startups prefer to get venture capital funding instead of raising debt. However, when it comes to economic growth, interest rates and Venture Capital (VC) go hand in hand. VC boost entrepreneurial activities and interest rates are helpful when it comes to risk-taking activities for the wellbeing of the economy.

If the interest rate is low, it serves as a fuel for VC investment, but at the same time, it discourages venture capitalists to put their money in riskier startups that are young, in other countries and in less popular industries.

Typically, VC firms invest their money after comparing the profits they achieve with profits that are available to the investors somewhere else. However, the relationship between interest rate and risk-taking can change based on which investor’s point of view is considered.

 

Effect of Interest Rate on non-traditional Capital

When we talk about short to medium term variations in the interest rate, it usually affects non-traditional capital source, including hedge funds and mutual funds. Unlike conventional Venture Capital investors, who keep their money invested for 10 years or so, unconventional investors can put their cash in different baskets and spread it across different assets classes. They can quickly decide where they should put their money in order to reduce the impact of interest rate variation.

 

Changing Effect of Interest Rate on VC Investments

Over the last three decades, federal rates have changed from as high as 16% in the early 80s to as low as 0.09%. However, VC has evolved from a small industry into a $100 billion per year asset class. Venture capitalists are investing a massive amount of money every year. Therefore, it is important to understand the changing effect of interest rate on VC investments.

Between the year 2000 and 2009, the federal fund rates and VC investments were parallel to each other. When the technology bubble was burst, the Federal Reserve adopted the strategy of decreasing interest rates so as to promote the economic growth. For venture capitalists, the environment was not as attractive as it was before and limited partners invested less in venture capital. The VC decreased with the decline in interest rates.

After the introduction of quantitative easing, this relationship between VC and interest rates ceased to exist and they became inversely proportional to each other.

 

Moreover, after the credit crunch, near-zero interest rate policy enabled financial institutions and brokerages to renew their balance sheets, settle their toxic assets, and revitalize their financial health. It also allowed the U.S. economy to recover from the after-effects of the crisis and enabled businesses to borrow capital at reasonable rates. During this phase of cheap money, technology sector, VC firms, and startups took advantage of the friendly valuation environment.

 

Federal Reserve’s Decision to Raise Interest Rates

By the end of this year, Fed plans to raise the interest rates. If the plan materializes, it will be  the first time in the past nine years that the U.S. will experience the increase in rates, which will bring the era of zero interest rate to an end.

Chairman of the Federal Reserve, Janet Yellen, indicated that the increase in interest rates will not be rapid.

It will be a gradual increase, which will not change the valuation environment of a startup and technology sector instantly. However, it will change along with a valuation environment of the stock market. The reason is simple; valuation multiples are indirectly correlated to interest rates, where in, the multiples decrease with the increase in rates.

 

It is important to observe the next move of the Fed and market reaction to changing interest rates, because it may affect the Venture Capital market.