How Does the US Government Issuing $1 Trillion in Debt Affect Startups?

What does the US Federal Government issuing $1 trillion of debt mean for the startup financing environment?

The Republicans and the Democrats have agreed with each other and the debt ceiling has been raised. The Treasury has been holding off on issuing a lot of debt, so now $1 trillion is coming to market. By the time you are reading this, it probably will have already arrived.

Public Investment vs. Private Investment

You wouldn’t think that they’re connected, but this is the classic case of public investment crowding out private investment. What that means is, the money to buy that debt has had to come from somewhere and so they have to incentivize the public to buy Treasury securities to make it work. That includes all of the mutual funds, the pension funds, the endowments, and everyone else across the world that invests in US government bonds. As a result of that, interest rates on Treasury securities will most likely go up or at least stay the same to draw in more investors.

It’s a matter of supply and demand, and there’s a lot of supply in the market. So investors will need to be compensated in the form of higher yields on Treasuries to create more demand.

What this will cause, however, is less money in the aggregate for venture capital funds. For the first time in 10-12 years, venture capitalists are competing with the bond market for capital. The last time this happened, before interest rates started going up, interest rates were at zero or 1%. This meant all of the traditional venture capital investors and the limited partners were putting money into VC. They weren’t really tempted by the high yields in the bond market.

Interest Rates Are Going Up

However, interest rates have risen dramatically. All of a sudden the low-risk government bond (that is roughly five and a half percent for a six-month maturity) looks pretty darn safe and attractive. Banks are increasing the interest rates for their savings, money market, and cash management products, which increases the range of options for investors. And bank accounts are insured through the FDIC, which makes them much less risky than VC investments.

Subsequently, less money is going to go into venture capital.

What this means for startups is, unfortunately, commitments to VC funds are going to go down, and that is something we are already seeing.

Stocks May Go Down

The other thing that usually happens, as interest rates go up, is the stock market will most likely take a haircut.

Currently, this isn’t too extreme and, recently, the stock market has been fighting back and climbing. Nevertheless, the general idea is that the discounted cash flows of all of those companies in the stock market, all those earnings they’re going to make in the future, are worth less at today’s discounted, present value because interest rates have gone up. Therefore, the stock market will generally go down a little bit more. That then exacerbates the numerator-denominator problem for venture capital funds. This is because most big VC investors can only put 5, 10, or 15% of their total portfolios into venture capital and 20 to 25% will usually go into alternatives.

There are some other strategies where 40% of a portfolio is alternatives, but venture capital is a slice of that, meaning the portfolio becomes over-allocated when the stock market goes down. In this case, the percent of venture capital relative to the rest of the portfolio, which is the denominator, becomes unbalanced. Ultimately, this means that the people who make those commitments can’t make any more commitments until things are rebalanced.

It’s a Tough Environment for Venture Capital

So this huge debt offering will have some far-reaching ramifications for the venture capital community. Don’t expect to see a direct correlation immediately, but we have seen it happen before. It’s hard to raise a VC fund in this kind of market, since bonds are so attractive and low-risk. That’s not the case for venture capital.

On an optimistic note, hopefully interest rates will start coming down as inflation comes down, and, hopefully, venture capital will get this group back. However, until then, a lot of startups are putting their cash into low-risk investments, and it’s a good time to do so!

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