How VCs Survive and Even Thrive in Recessions – Part 1
May 4, 2020 | Anton Simunovic
In February of 2020, I penned a short note to my colleagues at Alumni Ventures Group that the 11-year bull run had finally ended and the U.S. was headed into a recession. Despite Wuhan being in lockdown, I believed that a single-party system built on misinformation was not going to be able to contain a virus that was more contagious than SARS — and in a world that was far more interconnected than ~20 years ago. China’s problem was soon to be our own.
The realization brought me back to experiences of past downturns. I remember March 13, 2000, like it was yesterday. On that day, it became clear that the NASDAQ frenzy of mass speculation in internet-related companies — the so-called dot-com boom — was a bust. While tech companies took months to break out of their stupor of denial that the party was over, the recessionary effects rippled to other industries.
In 2008, our financial markets wobbled with the bankruptcy of Countrywide, but it was Lehman’s white-knuckle collapse in September that defined the Great Recession. What was initially thought of as a Wall Street problem quickly became a Main Street problem.
Today’s world is even more hyper-connected. Tight linkages in capital markets, supply chains, and commerce mean recession in any major economy tends to affect us all. Which leads me to my second point: When we’re faced with recessions, emotions tend to run high. During these emotional times, separating fact from fear is essential.
Factually, we know a couple of important things. First, the U.S. has experienced three recessions since 1990, and the average peak-to-trough contraction took just over 11 months, with recovery taking many months thereafter. This would suggest we are destined to a downward slope well into 2021. However, the Federal Reserve is behaving in truly unprecedented ways, using all of its firepower to instill confidence and unleash liquidity to stave off bankruptcies and encourage employment. So, what’s going to happen next?
The truth is, no one knows how the economy will perform in the short term. But to the venture investor, the short term is much less meaningful than the medium-to-long term from which investment outcomes are generated. Through this lens, whether the recession has a “V,” “U,” or “L,” recovery matters much less than knowing that there will be a recovery.
And recover we shall. For well over 100 years, it has always been a good investment to bet on the vitality of the US economy. Innovation is its engine room. For half a century, sophisticated venture investing has been a key driver and recipient of the benefits of American innovation. The returns of top-quartile venture firms — with which AVG strives to invest — have outperformed those from all other asset classes.
So, whether the recession is long or short, deep or shallow, playing the long game has and will remain a sound investment choice.
How COVID-19 Is Different
Unlike during past disruptions, the U.S.’s healthcare situation must stabilize before our economy stabilizes.
As of mid-April, some 86 candidate vaccines and experimental compounds are being evaluated or are in clinical trials to fight COVID-19 (many of which are being backed by venture capitalists). It’s hoped that therapeutics will arrive within months and a vaccine in 2021.
As the risk of infection subsides, consumer confidence will rise, and what is likely to start as a slow recovery will accelerate. Until that time, we must identify infections quickly, isolate them, and then trace their source. Simple concept, herculean execution.
Paradoxically, it was government-mandated shelter-in-place policies — appropriately issued to protect the health and safety of millions — that has led to the stratospheric surge of Americans seeking unemployment benefits. Small businesses, including venture-backed companies, account for nearly 50 percent of private-sector employment in America. In these unprecedented times, to keep a company afloat means the near-immediate cutting or furloughing of employees — gut-wrenching but necessary decisions.
Take comfort in knowing that conquering COVID-19 is the world’s collective number-one priority. COVID-19 too shall pass.
What COVID-19 Means for Venture
There is a belief in venture that every 10 years or so business models are forced to refocus on the quest for rational profitability (product-led growth), and the reckless pursuit of customers (dollar-led growth) becomes passé. As Alfred Lin of Sequoia has noted, the “fear of missing out” has given way to the “fear of looking stupid” among investors. We seemed due for a pullback.
Indeed, markets were already adjusting following the WeWork debacle in Q4 2019, where the number of big funding rounds — those over $100 million — had already fallen by a third. The companies that wrote many of these checks allowed undisciplined firms to avoid the scrutiny of the public markets and have since been punished. Speculation, often seen at the tail end of long booms, finally gave way to substance.
Sequoia followed its now-famous “Rest in Peace Good Times” presentation from 2008 with a letter to founders and CEOs calling COVID-19 the Black Swan event of 2020. Sequoia, like so many others, has tightened its investment criteria and is encouraging its portfolio companies to tighten their belts by
- Extending cash runways
- Planning contingencies based upon the market environment
- Conducting only mission-critical projects
- Raising the ROI bar on marketing spend, and
- Doing more with less headcount
— to name a few strategies.
There is no escaping the need to adapt in response to COVID-19’s impact. Every venture capitalist is being forced to triage their portfolios against recessionary vulnerability (impact on cash, capital raising plans, burn rates, revenue projections, budgets, etc.), as well as the specific threat of COVID-19.
Investments that bring people together in the real world — those with business models that support taking trips, eating out, staying in hotels, going to the movies, retail shopping, or generally gathering — are most vulnerable. Tempered, of course, by a bullet-proof balance sheet.
Investments that provide access to remote healthcare (telemedicine, direct-to-consumer), generic consumer staples (food and its delivery, toilet paper!), or services for those stuck at home (entertainment, e-commerce), are well-positioned. In short, across the world, demand is shifting online at an accelerated rate.
Today, VCs are still open for business and doing deals, just more slowly and selectively. They are backing teams with both clarity of purpose and track records of success operating in capital-scarce environments. Investment terms are changing too. What has largely been an environment of management-friendly terms is giving way to reduced valuations, inside-led rounds, smaller rounds, and downside protections for investors. For smart venture investors, that’s an opportunity.
These are my thoughts about the immediate changes, challenges, and opportunities the world and venture capitalists are seeing. In my next blog post, I’ll address the impact of COVID-19 on AVG, what we’re doing in response, and the longer-term investing trends that we anticipate in the post-pandemic world.