The venture capital (VC) industry is undergoing a significant transformation marked by the emergence of “zombie VCs,” which refers to funds that continue to operate primarily by collecting management fees while their startup portfolios dwindle in value and ultimately fail. This decline has been particularly pronounced in the wake of the Federal Reserve’s shift from a period of low interest rates—characterized as a “free-money era”—to a tightening monetary policy. Since the Fed began increasing interest rates, VC funds have experienced substantial write-downs in their portfolios. This stagnation has led to a drastic reduction in successful exits, affecting the entire VC ecosystem which thrives on the ability to sell portfolio companies at substantial profits. The hot air that characterized previous fundraising efforts has dissipated, except in sectors driven by artificial intelligence and machine learning.
The metrics surrounding VC exits paint a dire picture. According to the Venture Capital Monitor for Q3, exits in dollar terms plummeted to $10 billion, tumble down from the heights of 2021 during the free-money era. Compared to the last year, the declines have been staggering: a 95% drop in exits via IPOs or SPACs and a 91% decrease through private equity buyouts. The sharp contraction in opportunities to cash out has left many portfolio companies unable to find buyers or raise necessary follow-on funding. The decline of the SPAC market has been especially notable, as its destructive impact on investors has caused a 96% decrease in merger activity in 2023. This blockage in the exit pipeline is creating systemic issues for VC funds and startups alike.
The inability of VC firms to generate profitable exits has led to an increase in the lifespan of their portfolio companies, which are remaining private for extended periods while awaiting a favorable market to do so. Many of these companies are now raising funds at lower valuations—a situation commonly referred to as down-rounds—while others face the prospect of bankruptcy when unable to secure additional funding. The inventory of US private companies has ballooned, reaching a record high of 57,674 startups. This has left investors in a precarious position where they find it increasingly difficult to convert their portfolio values into realized cash distributions, further complicating the fundraising landscape for startups.
As a direct result of these dynamics, cash distributions to limited partners (LPs) have sharply declined, signaling a significant reduction in the overall health of the VC ecosystem. Data shows that cash flows to LPs have mirrored the low levels experienced during the global financial crisis, with rates consistently in the single digits over the past two years. This stagnation is in stark contrast to the average distribution rate of 16.8% over the past decade, showing just how deeply this environment has affected payouts. The likelihood of continued low distribution rates indicates that VC funds will struggle to reinvest, thereby slowing the entire cycle of venture capital investment and innovation.
In light of these challenges, the rise of the “zombie VC” phenomenon has become evident. The number of active venture investors has decreased significantly, resulting in approximately 45% of funds failing to make any investments in 2024 thus far. These zombie funds, unable to raise new capital or invest in new startups, survive by maintaining their existing portfolios and collecting fees without generating any meaningful outputs. Predictions from industry observers suggest that the number of these inactive funds could reach up to 50% of the total VC market in the coming years, representing a substantial shift in the investment landscape.
In seeking to revitalize the venture capital market, many investors are urging the Federal Reserve to continue cutting interest rates to stimulate growth and investment opportunities. However, these rate cuts may bring their own complications, with longer-term Treasury yields on the rise and inflation fears creeping back into the bond market. The push for lower rates aims to reinvigorate the VC landscape by making alternative investments more appealing; nevertheless, the tightening of monetary policy has put additional pressure on both present and potential fundraising efforts. The interplay of these forces will significantly shape the future path of venture capital and the broader innovation economy as it seeks to recover from a period of unprecedented disruption.
