Interest Rates Hang Over Tech Sector

Despite Wall Street soaring and the economy remaining relatively healthy, the tech sector is laboring under the pressure of high interest rates and debt service.

By Larry Walsh

Wall Street has recently reclaimed its leading position in the financial world. The past week witnessed the Dow Jones Industrial Average, a pivotal indicator of public-company stock performance, soar and consistently stay above 37,000 points for the first time ever. With the U.S. unemployment rate remaining under 4%, a decrease in core interest rates to 3.1%, and an impressive 5.2% growth in third-quarter GDP, fears of a recession seem to have dissipated.

Despite this, the technology sector, along with others, is rapidly losing jobs. This year, tech companies have eliminated over 250,000 positions, marking a 50% increase from 2022. These companies are reducing budgets and discretionary spending to control expenses, manage cash flow, and sustain profitability.

An even more concerning trend is the rising number of start-up failures. As reported by Carta, a firm monitoring start-up performance, 112 private-equity-backed companies, each with over $10 million in funding, have shut down in 2023. This represents a 238% increase in closures, nearly equaling the total of the last three years combined.

If the economy is thriving, why are tech companies cutting budgets and start-ups folding? The answer lies in interest rates. After the 2008 financial crisis, central banks globally, including the Federal Reserve, slashed borrowing costs, with prime interest rates falling below 2%. This made borrowing highly affordable, encouraging a leverage strategy and inflating U.S. corporate debt, which reached $22.5 trillion this year, a significant rise from $17.7 trillion at the start of 2022.

Worldwide corporate debt stands at nearly $90 trillion, more than double the amount a decade ago. A notable issue is that 90% of these corporate bonds are “callable,” giving lenders the right to demand full repayment at any moment.

Low interest rates also made it easier for investors to secure loans for their ventures. This led to funds and individual investors seeking higher-yield investments compared to low-yield bank accounts. Despite the growth of private-equity funds, they borrowed up to one-third of their capital to invest in start-ups and mid-stage companies, banking on low interest rates and high growth rates to minimize risks.

But the cost of borrowing has surged as high as 8% recently, quadrupling the cost of capital. Concurrently, rising interest rates have escalated business costs, while many tech sectors are experiencing stagnating or declining sales and revenue. Many tech vendors are reporting revenue growth solely due to price increases, necessitating cost reductions and restrained borrowing.

Shock waves rippled through the investment community when OpenView, a Boston-based venture-capital firm, essentially collapsed with the sudden departure of two of its three managing partners. The firm’s latest fund had only invested $80 million of its $570 million balance. While the partners’ exit was due to “personal reasons,” many in the investment community worry that OpenView’s situation is a reflection of the growing debt crisis among companies backed by private-equity and venture-capital firms.

All of this is having a collateral impact on the channel. Vendors cut deep into channel budgets in 2023, and will continue to do so in 2024. Vendors are looking to get more productivity and revenue contributions out of their partners. At the same time, partners are struggling with these inflation and debt issues too. Low investments and confidence, combined with sluggish spending by customers, is putting pressure on the whole channel.

Over the past 18 months, the Federal Reserve has been incrementally raising the prime rate to slow down the economy and bring inflation back to the target range of 2% to 2.5% annually. This approach has so far averted a recession, guiding the U.S. economy toward a “soft landing,” but the Federal Reserve plans to maintain high interest rates until 2024, followed by a series of rate reductions, the extent and pace of which remain uncertain. While the anticipation of rate cuts is currently fueling a stock market rally, it’s unlikely to significantly counteract the ongoing budget and job reductions.

The Channelnomics Perspective
Interest rates are just one challenge facing the tech sector. For years, the tech industry has been a major driver of economic growth in the United States and other developed nations. However, the long-standing expectation among politicians and investors for technology companies to consistently deliver high growth and investment returns was unrealistic. The focus now is shifting toward valuing sustainability and consistent growth, even if modest, versus chasing elusive, high-growth “unicorns.”

The anticipated interest-rate reductions in 2024 will offer some relief to tech companies burdened by debt and borrowing challenges. Lower rates will facilitate refinancing, easing balance-sheet pressures. Nevertheless, this relief might not arrive quickly enough for investors and lenders to inject much-needed capital into struggling start-ups.

The forecast for the first half of 2024 is challenging, but conditions are expected to improve in the latter six months leading into 2025. Gartner already predicts a surge in IT spending growth in 2025, exceeding 8%, driven by fresh investments in artificial intelligence infrastructure and capabilities. Until interest rates decrease and new innovations stimulate investments, the focus for the upcoming year will remain on conservation and optimization.

Larry Walsh is the CEO, chief analyst, and founder of Channelnomics. He’s an expert on the development and execution of channel programs, disruptive sales models, and growth strategies for companies worldwide. Follow him on Twitter at @lmwalsh_CN.