What’s next for private markets
What’s next for start-ups, scale-ups and their investors? We analyse developments and provide a roadmap for navigating what’s to come.
While the human and economic costs of COVID-19 are foremost on our minds, private market deployment, round dynamics and success factors are in flux. What next for start-ups, scale-ups and the investors who support them?
We analysed thousands of datapoints from prior recessions, spoke with dozens of leading investors and distilled market dynamics we see — to explain developments and deliver a roadmap for navigating what’s to come.
- COVID-19 will result in fewer investments into new companies and a mix shift to follow-ons as investors’ portfolios demand attention and capital. Appetite for new investment is diverging according to firms’ risk tolerance, fund cycle and ‘dry powder’.
- Among investors, selectivity is displacing shock. Investors are evaluating which companies’ fundamentals are aligned for post-crisis advantage. Structural growth opportunities with weakened incumbents and robust unit economics can remain attractive despite air pockets in short-term demand. Greater selectivity will widen the gulf between industry leaders and challengers.
- Markets are refocusing on fundamentals. Validating customer acquisition costs, lifetime values and payback periods has become critical for companies’ planning and investors’ attention.
- Start-ups and scale-ups should beware the enterprise ‘shoe to drop’. COVID-19 has caused radical, immediate and visible changes in consumer behaviour. Changes in corporate behaviour will be less sudden but as significant.
- After 2008, rounds shrank 20%-40% and remained smaller for 4+ years. Rounds reduced by investment stage. In 2020 deals will shrink 25%-50% as large ‘offence’ rounds are replaced with ‘defence’ raises and capital becomes scarcer and more expensive, with later stage rounds more affected.
- After 2008 valuations declined 15%-40% and took three years to recover. Valuations compressed progressively by stage. In 2020 we expect greater — 25%-50% — compression given public market declines and the tripling (Series A, B and C) or quadrupling (Series D) of valuations in the run up to 2020. Extraordinary companies can sustain a pricing premium.
- Total investment in start-ups and scale-ups followed a multi-year ‘U-shaped’ decline and recovery after 2001 and 2008. In 2020–2021 private capital will likely exhibit a ‘U-shape’ again, weighed by the ‘denominator effect’ — but long term rotation into private markets will lessen the depth of the pullback.
- ‘COVID Convertibles’ and ‘Insider+’ rounds will dominate in 2020. Frequently, priced rounds with multiple new leads will be replaced with convertible structures comprising insiders and, perhaps, a new investor — with whom the Company or shareholders have some familiarity
- Customer acquisition, talent and rent will become cheaper in 2020, increasing companies’ capital efficiency. The cost of impressions on Facebook has declined 53% in 30 days.
- For ‘disruptors’, beyond accelerating digitisation COVID-19 will re-shape adoption, catalyse the ‘home economy’, evolve public/private engagement and accelerate the decline of incumbents.
- Accelerated adoption, weakened incumbents, enhanced access to talent and more discriminating capital will bolster leading disruptors’ comparative advantage, presenting opportunity.
- While fewer, less valuable exits will weigh on current fund returns and liquidity, average returns from private market investment made through the downturn will increase given lower valuations, greater capital efficiency and accelerated adoption of innovation. Average multiples from in-year investments increased by 1.25 and 1 turn following 2001 and 2008 respectively.
- If your company is a beneficiary of COVID-19 with a strong secular growth story, in a deteriorating funding environment raise capital while you can attract investors’ attention and ‘dry powder’.
- Best-in-class companies with strong structural growth stories, weakened incumbents and solid unit economics can attract investors’ interest even if short-term performance is impaired by COVID–19.
- With capital allocation to private markets set to reduce, be proactive in seeking capital. Better to be at the front of the queue than the back of a stampede.
- Appetite for new investments is diverging according to firms’ risk tolerance, portfolio obligations and ‘dry powder’. Seek targeted introductions and guidance regarding individual partners’ preferences.
- Re-cut capital raising plans to replace large ‘offence’ rounds with tactical ‘defence’ raises. Expect like-for-like round sizes to shrink 20%-40%.
- Investors are refocusing on fundamentals. When raising capital highlight robust unit economics and present a plan for achieving positive cash flow without further funds.
- After 200% (Series A/B/C) and 300% (Series D) run-ups in recent years, re-adjust valuation expectations. While extraordinary companies can sustain premium pricing, anticipate compression given 25%-50% general declines in private market valuations.
- Defer pricing, save time and reduce risk by structuring rounds as ‘COVID Convertibles’ (convertible structures specifying a percentage discount to a future round) with ‘Insider+’ participation (existing shareholders plus one new investor with whom you or your shareholders have a relationship).
- With the cost of capital increasing for two to three years, re-evaluate investment initiatives. Not all undertakings that produced a return one month ago will do so going forward.
- Take advantage of reduced customer acquisition costs (Facebook CPMs -53% in 30 days), cheaper talent and falling rents to extend runway, boost capital efficiency and gain share.
- B2B companies should beware the enterprise ‘shoe to drop’. Lengthening sales cycles are a pre-cursor to changes in corporate behaviour that are less sudden but as significant as changes in consumer activity.
- Beyond ‘accelerating digitisation’, evaluate how COVID-19 will reshape your company’s fundamentals — from user demographics to the positioning of incumbents — and present opportunity.
1. Fewer new deals and a shift to follow-ons
COVID-19 is resulting in fewer investments into new companies and a mix shift to follow-on, as: a greater proportion of investors’ time and capital is required to support existing portfolio companies; building relationships and undertaking diligence becomes more challenging without physical meetings; and corporate venture capital retrenches.
“We spent the last month focusing on the portfolio.”
“Investors are very focused on their own portfolios.”
“There’s an inevitable refocusing of time spent.”
Following both 2001 and 2008 crises, private market deal volumes declined sharply. After 2001 deal volumes followed an ‘L-shape’, gapping down at all stages and remaining at pre-crisis (and pre-bubble) levels for at least four years. Early stage volumes were more impacted initially — in 2002, Angel & Seed transactions plummeted 85%, Series A over 70% and Series B over 75%.
After 2008 deal volumes followed a ‘V-shape’. While 4Q08 activity declined quarter-on-quarter, volumes quickly reasserted through 2009. Deal volumes in 2008 typically exceed 2007 and 2008. Angel & Seed activity recovered immediately and powered to new multi-year highs.
With the 2020 recession deeper, broader and likely longer than precedents, new investment will decline significantly in the short term. Eight in ten investors expect to reduce capital deployment into new investment (NfX).
“The public messaging is ‘we’re open for business’. The reality is different. We’re taking meetings but it’s clear that risk has come off.”
“Volumes of new investments are definitely reducing.”
“A lot of funds are open for follow-ons, but for new deals there hasn’t been a lot of activity.”
“There’s a slowdown for a period of time.”
Appetite for new investment is also diverging according to firms’ risk tolerance, portfolio obligations, fund lifecycle and amount of ‘dry powder’ — necessitating targeted introductions and guidance regarding individual investors’ preferences.
In the medium term, transaction volumes will be bolstered by two factors absent in 2001 and 2008:
- unprecedented levels of ‘dry powder’. In the last 24 months Accel, Atomico, Balderton and Index alone have raised $7.4B for venture and growth investment.
- the rise of the European ecosystem: since 2010, the number of European ‘unicorns’ has grown ten-fold, reflecting significant potential for value creation outside the US, while Europe’s share of US and European investment has doubled by value and tripled by volume.
“90% of the Series A market is sitting on dry powder.”
2. Selectivity is replacing shock
Public markets influence private market activity. In public markets, after moving in lock-step, sub-sector performance is diverging — with variance between daily sector changes quadrupling since mid-February.
In private markets, similarly, selectivity is displacing shock.
“It’s a flight to quality. If you’ve only got a couple of bullets, you want the deals you do to be attractive.”
It is well understood that some sub-sectors (grocery delivery, telemedicine, remote working, gaming and e-sports) are beneficiaries of COVID-19 while others (travel, hospitality, leisure, recruitment, physical retail) are impaired.
But investors are evaluating a separate (although related) question: post-crisis, which companies’ fundamentals are (re-)aligned for absolute and relative advantage?
“There will be winners in a post-COVID recessionary-type environment.”
“We’re trying to distinguish between what is a permanent behavioural shift and what’s temporary.”
Best-in-class companies with: strong or strengthened structural growth stories; incumbents whose decline is accelerated by COVID-19; robust unit economics; and scope for returns on investment amidst a higher cost of capital are proving attractive irrespective of short-term ‘air pockets’ in demand’ — and vice versa.
“We’re asking: where do long-term fundamentals remain the same but there is good value available now.”
“Places like travel…is where incumbents are most vulnerable. Some of these categories are good places to hunt.”
“I’m not interested in the ‘hotter’ sectors. I’m interested in good quality names that have been difficult to engage with earlier or overpriced.”
Investors’ greater selectivity — and companies’ differing proactivity in capitailsing upon it — will amplify companies’ comparative (dis)advantage, leading to a wider gulf between leaders and challengers in markets where previously plentiful capital has allowed all to scale.
3. Investors are refocusing on fundamentals
With capital scarcer and more expensive, focus on unit economics has increased. Validating the accuracy and viability of customer acquisition costs, lifetime values and payback periods has become critical for companies’ planning and investors’ attention.
“Investors are less…chasing the heat.”
“We’re looking for more capital efficient growth than we have in the past.”
Within ten days of the crisis, six in ten growth growth investors somewhat or strongly believed that scale-ups should re-prioritise profitability over growth (Numis Growth Capital Survey).
Given a lower probability of attracting new investors in future, many investors are requiring loss-making portfolio companies to re-plan for cashflow breakeven at the expense of growth.
4. Beware the enterprise ‘shoe to drop’
“There will be an enterprise shake-up.”
COVID-19 has caused radical, immediate and visible changes in consumer behaviour. Changes in corporate behaviour will be less sudden and apparent but nearly as significant.
Sales cycles will extend and budgets will freeze. Contract renewals will be fewer and fiercer. Payment cycles will expand and concern about suppliers’ viability will increase.
While the feedback cycle from boardroom to supplier can be less immediate than from consumer to provider, start-ups and scale-ups should anticipate pronounced changes in corporate behaviour.
“People think software and SaaS are defensible, but that’s just because procurement managers’ credit cards haven’t been shut off yet. The bigger cuts are being made first.”
“A lot of the spend adjustment that companies have made have been made at the highest level — but haven’t yet trickled down to other parts of the business.
5. Round sizes will shrink 25%-50%
“A lot of round are getting smaller.”
Following the 2008 crisis, rounds shrank 20%-40% and remained smaller for at least four years.
Rounds generally shrank with stage. A year after the crisis, deals were smaller by an average: 6% (Angel/Seed); 22% (Series A); 31% (Series B); 39% (Series C) and 36% (Series D). Deal sizes typically recovered progressively, year by year.
Following a multi-year increase in round sizes, in 2020 deals will shrink 25%-50% as:
- large ‘offence’ rounds to catalyse growth are delayed to 2021 and replaced with interim ‘defence’ rounds;
- capital becomes scarcer and more expensive;
- more companies rely on existing shareholders;
- companies’ cash requirements are reduced.
The blended impact will likely increase with stage, with the mix shift from ‘offence’ to ‘defence’ rounds disproportionately affecting later stage fundings.
6. Valuations will compress 20%-50%
After 2008, valuations declined 15%-40% and took three years to recover to pre-crisis levels.
Reflecting increasing proximity to public market peers, valuations compressed with stage. A year after the Global Financial Crisis valuations has compressed by an average:
- 14% (Series A);
- 19% (Series B);
- 35% (Series C);
- 36% (Series D).
In 2020-2021 we expect, and see, many valuations to compress 25%-50%. Valuation decreases may be masked by convertibles, warrants and other structuring.
“We’ve seen valuations come down 25%-50%.”
“We’re seeing down 25% at least, down 40% — a couple down 50%.”
“20%-40% down on expectations.”
Valuations will likely compress more than following 2008 given:
- greater public market declines, which inform growth stage valuations.
- the aggressive increase in private company valuations between 2012 and 2019, when Series A, B and C valuations nearly tripled and Series D valuations nearly quadrupled.
“The last five years weren’t normal — they were exuberant. This isn’t understood on the entrepreneur side.”
“The valuation run up before the GFC was less than the lead up to today.”
Extraordinary companies can sustain premium pricing, relative to broader market declines.
“You’ll see a bifurcation. For the best opportunities there will still be auctions.”
“There will still be some companies that get premium valuations.”
As occurred post-2008, we expect average later stage valuations to be impacted more than earlier stage pricing, given closer proximity to public market comparables and less formulaic dilution assumptions in later stage financings.
“Valuations get tougher at the growth stage because we read across to public markets.”
The second and third quarters of 2020 will exhibit unprecedented volatility in valuations as private markets adjust.
“There’s a lot of volatility in valuation.”
“Post-2008 it took several quarters for valuations to stabilise.”
7. Private market investment will follow a U-shape
After previous crises, total investment in start-ups and scale-ups followed a multi-year ‘U-shaped’ decline and recovery. Capital allocation is slower to adjust than transaction volume.
After 2001, total investment followed an ‘L-shape’ relative to bubble years but a ‘U-shape’ compared with underlying (pre-bubble) activity. After 2008, investment again followed a ‘U-shape’ recovery.
After both crises, later stage capital recovered faster — in two years after 2008 compared with three years for earlier stage investment.
In 2020–2021 private capital will likely exhibit a U-shape again, anticipating the ‘denominator effect’ — whereby a fixed percentage (typically 5%-10%) of asset managers’ capital is allocated to private market investment. Pre-crisis, an asset manager with $100B might seek $5B of private market exposure. Post-crisis with, say, $75B the manager must reduce her exposure to $3.75B (5% of $75B).
“Private market allocations will have some reassessment.”
“There’s a slowdown for a period.”
Extensive ‘dry powder’ and ongoing secular rotation into private markets will likely lessen the depth of the pullback, as traditional asset managers and public-private ‘crossover’ funds continue their drive for greater exposure to private market innovation and returns over the long term. A pending UK Government start-up support scheme (likely, matching venture capital investment with state-backed convertible debt) will also assist.
“90% of the Series A market is sitting on dry powder.”
“In the UK and Europe the amount of capital is unprecedented.”
8. Expect ‘COVID Convertibles’ and ‘Insider+’
With revenue forecasts less certain than ever, pricing rounds is challenging and time-consuming. As reduced runways necessitate earlier investment than planned for many, we see and anticipate a further mix shift to ‘COVID Convertibles’ — simple convertible structures that specify a percentage discount to a future (priced) round with no valuation cap on that round. Discounts of 25%-30%, which are higher than pre-COVID levels, will be common.
“Rounds will look funky — convertible structures, warrants, different bits and pieces.”
Deferring pricing to 2021 will delay visibility into ownership and dilution for founders and investors. With COVID-19 increasing the divergence in companies’ performance, 2021 will crystallise increased comparative advantage for some while entrenching weakness in others.
The shape of participation in financings will also change. With more of investors’ time focused on their portfolios, financings timed for necessity instead of choice and the challenge of building relationships remotely, a greater proportion of rounds will comprise existing investors only. ‘Insider+’ rounds — comprising current shareholders and a perhaps a new shareholder close to the founder and existing investors — will become more common.
“I’m seeing Insider+ rounds all over the shop.”
“Top up rounds are mainly insider money.”
For the fewer new or ‘offence’ rounds, however, new names on the cap table are still expected.
“New rounds, or big rounds, need externals.”
9. Cheaper customer acquisition, talent and rent will boost capital efficiency
Customer acquisition, talent and rent will become cheaper in 2020, increasing companies’ capital efficiency.
Advertising expenditure is highly correlated with GDP. Advertising spend shrank 25% following the 2008 crisis, after which growing demand boosted prices for a decade.
Today’s recession, which is greater in depth and breadth, will significantly reduce companies’ cost of acquisition. In the last 30 days, the cost of impressions and click-throughs on Facebook, Instagram and Messenger has fallen 53% and 46% respectively (Google Data Studio).
Technology salaries are highly correlated with general job vacancies. Between 2015 and 2018, demand for roles in digital technology grew 150% — sustaining ever-higher salaries.
Following the 2008 crisis, general job vacancies declined 36%. Regrettably, since March 11th 2020 over 25,000 employees have been laid off from 260 startups — and the pace is accelerating (Lee). Overall in the US economy, more jobs have been lost in the last three weeks — 15 million — than in 18 months of the 2008 recession (US Labor Department).
“We expect people to have made their first wave of cost reductions. Be prepared for the second. People haven’t felt the second and third.”
With personnel averaging over 70% of a private company’s costs, from 2020 less expensive talent will significantly increase companies’ capital efficiency.
Further, rents will fall as lower employment and a greater propensity for some remote working in the longer term reduce demand for office space — providing a further boost to private companies’ return on capital.
10. COVID-19 will reshape behaviours and disruptors’ environment
“There will be winners in a post-COVID recessionary-type environment.”
Beyond accelerating adoption of e-commerce, videoconferencing and virtual consultations, COVID-19 will reshape consumer behaviour and the landscape for innovative ‘disruptors’. COVID-19 will:
- reshape, as well as accelerate, adoption of online services (groceries, healthcare consultations, meetings and gaming). For Echo, an online prescription fulfilment service, users aged 65 or over increased from 20% of the Company’s user base to 50% in three weeks. Having accessed online shopping or consultations, seniors are unlikely to revert.
- catalyse the ‘home economy’ as populations with new experience of at-home functionality and autonomy embrace new models of commerce, food and entertainment. For the first time, Universal is making films available to stream on the same day they appear in cinemas. Not all consumer and vendor dynamics will revert to pre-COVID dynamics after the crisis passes.
- reshape public/private engagement and procurement dynamics — as COVID-19 highlights the value of state support combined with private logistics, and the possibility of accelerated procurement (in place of a multi-month program, NHS England issued a 48 hour tender for the immediate provision of online primary care).
- accelerate the decline of offline incumbents, many of which will struggle to survive the additional financial challenges posed COVID-19 and are less capable of adapting their service offerings to emerging consumer demands.
“Places like travel are painful right now — but also where incumbents are most vulnerable and where buyers will committ to efficiency gains.”
Accelerated adoption, weakened incumbents, enhanced access to talent and more discriminating capital will bolster leading disruptors’ comparative advantage, presenting opportunity.
11. Returns from private market investment will increase
While fewer, less valuable exits will weigh on current fund returns and liquidity, venture capital investment made through the downturn will likely deliver enhanced returns.
After 2001 and 2008, average realised multiples from in-year investments increased significantly — by 1.25 turns after 2001 and nearly 1 turn after 2008. Returns peaked on investments made in the two years following the crises.
Lower valuations, leaner companies, less expensive talent, lower marketing costs and accelerated dislocation increase returns, capital efficiency and the adoption of innovative solutions.
We expect returns from private capital invested in 2020–2022 to exceed those of recent years, as historic patterns repeat from a pronounced base:
- Following a near-tripling (Series A/B/C) or quadrupling (Series D) of valuations between 2012 and 2019, investors’ entry points will reduce by 20%-50%.
- Investees’ marketing and salary costs will also fall after years of increases, boosting capital efficiency.
- Capital outflows from private markets will reduce competition.
“It’s been startling how little competition for deals there is.”
The combination of the above can enable investors to realise significant opportunity. New fund managers, without portfolios and with lower blended entry prices, may be particularly well positioned.
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