Understanding the Current State of Venture, and Why Markets Seem So Crazy

Image source: MarketWatch

“All markets are cyclical. Specifically, human behavior is cyclical; and while a global pandemic is unprecedented in our lifetime, it is not unprecedented.”

In the first half of 2021, the Nasdaq logged 18 new all-time highs, while the S&P 500 achieved 32 fresh records (MarketWatch).

Meanwhile, global venture funding reached new heights, surpassing $288B, up from the previous record of $179B in H2 2020 (Crunchbase).

Over the past 12-months, public markets have been on fire while the pace of private funding (and valuations) has increased to unprecedented levels.

To help us understand the current forces at play in public & private markets, let's break down the current market cycle, starting from the last major inflection point: the 2008 Global Financial Crisis (GFC).

2009–2016:

• Governments inject trillions of dollars into the global economy following the GFC. Central Bank’s drop interest rates to near-zero. Money is cheaper & more prevalent than ever.
• Everything investors touch goes up. Buy & hold is a fool-proof strategy as equity markets begin a 10-year bull run.
• With the influx of capital, venture-backed companies choose to stay private for longer, allowing VCs to pass the ball and generate attractive markups; while portco’s avoid the scrutiny of being a public company.

2017–2018:

• Private companies realized just how much capital they are leaving on the table through the traditional IPO process.
• SPACs & Direct Listings gain in popularity (ex: Spotify).
• However, public markets aren’t as accepting of the growth-at-all-costs VC model, placing a greater emphasis on profitability & strong economics. As a result, to achieve desired alpha, large funds begin moving upstream, targeting earlier/growth-stage pre-IPO companies.

2019:

• Fearing the end of a decade-long bull market, a wave of unicorns go public (Uber, Lyft, Pinterest, Peloton, etc.).
• Results are mixed. Not all unicorns receive equal praise from public markets.

March 2020:

• Covid strikes. Trade & travel grind to a halt while governments implement full lockdowns.
• Fear & panic set in, creating a global liquidity squeeze.
• Markets fall, including traditional safe havens like gold & bonds.
• Institutional investors become heavily overweight VC/PE, while VC funds stop writing cheques and shift to triage of existing portco’s.
• Trillions of dollars in value evaporate from markets, seemingly overnight.

Q3 2020:

• We realize the world is not ending; pandemics are temporary but lockdowns persist.
• Central Banks drop interest rates back to historic lows while governments begin injecting trillions of stimulus dollars into economies.
• With nowhere to go and nothing to do, personal savings rates soar to all-time highs.
• Investors begin to redeploy capital while the work-from-home crowd (lured by cheap money & recency bias) abandon downtown cores, opting into euphoric bidding wars for a slice of suburban heaven.

Q4 2020: A Convergence of Market Forces

• In retail markets, stimulus money continues to flow while disposable income mounts.
• The USD$ is losing value due to an unprecedented surge in monetary policy.
• Purchasing power declines. Investors realize they should not sit in cash and must own inflation-hedged assets.
• Sitting at home and with nowhere to go, many retail investors discover public markets, turning to popular commission-free trading apps.
• Bitcoin and other cryptocurrencies gain traction as a hedge against inflation, while the DeFi movement gains momentum.

Meanwhile, in private markets, there is a convergence of three critical forces:

1. A decade-long trend of companies staying private for longer;
2. Lower barriers to entry into public markets (i.e. SPACs & Direct Listings), and;
3. An unprecedented printing of dollars & subsequent influx of capital.

As a result, large investors are forced further upstream to achieve their desired alpha, creating a ripple effect throughout the entire funding chain.

For instance:

• With such large amounts of capital to deploy, large funds move to disrupt traditional growth-stage investors by overpaying and arbitraging between private & public markets (ex: Tiger Global).
• This creates a ripple effect, hiking valuations from pre-IPO to Pre-Seed.
• In response, traditional Series E/F investors get out-bid, forcing them to drop down and overpay into Series C/D, thus pushing Series C/D investors into A/B, and finally, A/B investors into Pre/Seed, inflating valuations at each stage.
• Forgoing traditional diligence, many top-tier Series A/B investors implement a call option strategy of writing smaller cheques into Pre/Seed-stage companies as a means of gaining first access to the Series A.
• As a result, Seed participation among top-tier funds creates competitive pressure and a subsequent frenzy among angels & micro VCs, leading to an overemphasis on brand-name co-investors while disregarding entry price, economics & control.

H1 2021:

• The quantity & valuation of private funding soars to record levels, while public equities climb to recurrent all-time highs.
• Sophisticated real estate investors & PE funds buy up swaths of cheap downtown properties in anticipation of a reverse migration to cities.

Q3 2021:

• Vaccination rates rise & economies begin to reopen.
• Consumers swap Zoom & sweatpants for airplanes & restaurants.
• Fears of inflation begin to take hold and markets receive a much-needed cool off, while disposable income redirects back into travel & entertainment.

Where do we go from here? Who knows. But if I had to guess…

H2 2021:

• Covid variants capture headlines, but vaccination rates continue higher and booster shots become a regular occurrence.
• Central banks ease bond buying, while retail banks shift loan loss provisions back to the bottom line.
• Corporate earnings outperform and markets continue higher as GDP expands at a pace not seen since the 1980s. Undervalued Financials, REITs, commodities & value stocks lead the way. Emerging markets lag due to lower vaccination rates.
• Suburbanites start getting called back to the office, forcing a rebound in automotive sales, a spike in oil prices, the cooling of suburban housing markets, and increased competition for downtown real estate.
• Most companies move to a hybrid work-from-home model, requiring workers to be in the office 3–4 days per week.

2022–2024:

• Emerging markets are slow to recover as many supply chains are redistributed & repatriated. The threat of vaccine-resistant covid variants persists.
• Bored and faced with rising interest rates, newly minted suburbanites yearn to be back at the heart of the action, living in downtown centers and eating crushed avo on toast. Suburban home prices plateau, forcing many homeowners to sell at a loss or remain house poor.
• As interest rates rise, public markets taper off to more sustainable levels of ~9% annual growth.
• Meanwhile, in private markets, a mix of down rounds and lacklustre public offerings take place.
• Private valuations begin a regression to the mean as many startups close shop, failing to grow into their prior inflated valuation.
• Those startups which maintained emotional discipline throughout 2020–21 (i.e. staying focused on product, customers, team and a responsible valuation) emerge as the next cohort of billion-dollar unicorns; as we saw in the dot-com bubble (Amazon, Google, eBay, Priceline) and 2008 GFC (Uber, Airbnb, Spotify, Dropbox).
• The angels & micro VCs that disregarded entry price & terms find themselves getting wiped off cap tables through competitive pay-to-play provisions (or diluted to meaningless position sizes), as established funds take control of emerging unicorns.
• As capital redistributes and markets revert to normal levels, many angels & micros either consolidate or fail to raise a second fund; while those who maintained discipline emerge as the next generation of top tier funds; as we saw in the dot-com bubble (Benchmark, Khosla, Tiger, Index) and 2008 GFC (a16z, USV, General Catalyst, Y Combinator).

Barring any major black-swan events (i.e. health, environmental, or geopolitical), we are likely at the beginning of another expansionary cycle (albeit fragile).

Nevertheless, the key differentiator & driver of investing success within any market cycle remains the unwavering ability to maintain emotional discipline –– we all look brilliant when markets are going up.

As Seed investors, it’s important we stay grounded as markets go through phases of euphoria, mania & greed. If history tells us anything,

1. Entry price & terms matter.
2. Paper markups & artificial IRR ≠ performance. Only realized cash-on-cash exits = performance. It takes much longer than a few hot quarters to know if we are good Seed investors.
3. $100M+ companies can go to zero.

About the Author

Matthew is the Founder and Managing Director at Allied Venture Partners, Western Canada’s largest angel syndicate investing in early-stage tech startups across Canada & the United States. To learn more, please visit Allied.vc

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