An uncharted path to the new normal for venture capital firms

August 2020 | EXPERT BRIEFING | PRIVATE EQUITY

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The global pandemic caused by COVID-19 has thrown economies and entire financial systems into disarray. Q1 2020 gross domestic product (GDP) data for the US and Europe released at the end of April confirmed the hard truth none of us want to admit: a global recession, and maybe even a global depression, is now upon us. As we look toward the new normal, we are reminded by history that deals struck in times of crises bring historically outsized returns. These lessons of history should inspire optimism, positivity and creativity for venture capital firms and entrepreneurs as we chart a path to recovery.

While the current crisis was triggered by a forced shutdown of global movement of people and commerce in order to contain COVID-19, other post-World War II era recessions were triggered by market, fiscal and monetary imbalances. Despite not yet having exited the first wave of the pandemic, COVID-19 has already prompted the most extensive financial stimulus plan the world has ever seen, with more fiscal stimulus on the table at the time of writing. For China, the US, Europe, Japan and the UK, aggregate fiscal deficits will exceed one and a half times the levels seen following the great recession of 2008-2009. In fact, the US Federal Reserve’s balance sheet as of 6 May was a record $6.72 trillion, or approximately 33 percent of projected US 2020 GDP of $20.14 trillion. This increase to the balance sheet overshadows the 20 percentage-point expansion seen during the Fed’s three stages of quantitative easing after 2008.

According to leading venture capitalists, the first proof points will come in Q2 2020. While 2019 showed strongly positive returns for the venture capital asset class as a whole, the sector had already expanded beyond the world of startups, with increasingly larger funds writing heftier cheques to chase bigger ‘unicorns’. These ‘unicorns’, or private companies with valuations above $1bn, were valued by venture capitalists using comparable emerging growth company transactions and multiples of financial results hidden in the dark pools of the private markets. These results were bid-up by other venture capital firms, sovereign wealth, hedge and mutual funds dipping into these markets for alpha. These valuation methods were used instead of the more efficient metrics of valuation implied by public market trading comparables that had been used historically. Those methods were informed by publicly available and audited financial statements scrutinised by securities regulators and the plaintiffs’ bar. As public markets have shown unprecedented volatility and retreated into bearish territory, most VCs have pumped the brakes on investing in new deals. Meanwhile, founders are setting the bar for private capital deals even higher for those seeking to access venture capital funds.

According to Morgan Stanley, Q1 demonstrated weak results for US venture capital as an asset class. But the full impact of the COVID-19 pandemic will likely intensify in Q2, reflecting a near total shutdown of the global economy during the months comprising the period. Q1 2020 venture data contained deals that were largely struck in the latter days of 2019. Q2 2020 data, by contrast, will be composed primarily of 2020 deals and will include a reporting period where many later Q1 deals would have been completed.

Morgan Stanley estimates global economic contraction will cap off at 7.5 percent in Q2 of 2020. Currently, the number of high-frequency indicators tracked suggests that the global economy is in the process of bottoming. Consumers’ future expectations have improved, and consumer spending is contracting more slowly than at the onset of the outbreak as new signs of reopening sprout across the US, Asia and Europe. As economies reopen and more people return to work, production levels should improve. US economics and biotechnology teams estimate that 54 percent of the economy was in a reopening phase as of mid-May.

So, what will the remainder of 2020 look like? Which industry verticals and categories will VCs target?

“We’ll see more action in the public market and the land of unicorns: Airbnb’s IPO is hotly anticipated yet unpredictable now,” Alex Niehenke, partner at Scale Venture Partners, told Forbes. “But more interestingly, we may see another couple ‘surprises’ from business software-focused companies as we did in 2019 with Zoom and Datadog. That is, super cash efficient, hyper-growth companies operating at a significant scale that garner significant public market premiums.”

“Next year, we will see an explosion of SaaS B2B startups leveraging AI to help businesses get a competitive edge in the new data economy,” Tae Hea, the co-founding managing director of Storm Ventures, told Forbes. “Amazon and Google’s biggest revenue stream is their web service offerings, which is because they have years of data about their customers, whether through search habits, the posts they share, the products they buy, or the music they listen to.”

As the slow and steady economic reopening continues around the world, Morgan Stanley has monitored developments in China to see how sectors of the economy are normalising and how China’s experiences might inform the rest of the world. In China’s case, the manufacturing, infrastructure and construction sectors recovered quickly. Data suggests that manufacturing is back in expansionary territory, while property sales and demand for steel and cement were growing 10 weeks after the peak in new COVID-19 cases. Supply-side disruptions improved quickly.

However, since consumption powers the US and European economies, investors are keeping a close eye on Chinese consumer activity, which is already improving. In fact, China’s online retail sales, which account for 30 percent of total sales, are back in positive territory year-over-year, and traffic to shopping malls is now 70 percent of normal levels. Also, China’s consumer goods companies expect normalisation to have occurred by the end of June. Meanwhile, restaurants have 50-80 percent of their customer base back, but nightlife venues are still closed in Beijing, Shanghai, Guangzhou and Shenzhen, and cinemas remained closed until early June. These channels are expected to have fully reopened by the end of June or beginning of July, and traffic is projected to normalise in the third quarter of 2020.

As we approach the second half of 2020, we expect that stimulus will have worked its way through the economy, the economy will have largely reopened and venture capital firms will begin again to deploy the vast amounts of dry powder at their disposal on buyer-friendly terms which should reinvigorate the innovation economy. Such a renewal should reinvigorate the innovation economy. While a second wave of the pandemic is expected, and more choppy waters lie ahead of us, there are reasons for optimism and positivity amid the creative responses to the crisis.

Louis Lehot is the founder of L2 Counsel. He can be contacted on +1 (650) 796 7280 or by email: louis.lehot@l2counsel.com.

Louis Lehot

L2 Counsel