Situation Room #7: COVID-19 from the LP Perspective

Everybody’s talking about the startup funding climate during COVID-19. Are VCs still investing? Are angels pulling their funds away from venture? What about corporate VCs — will their mandate be limited? We asked the ones funding the funders, namely the Limited Partners (LPs), Chris Wade (Co-founder, Partner) & Catherine Dupere (Partner) from Isomer Capital and Mikkel Hesselgren (Head of Fund of funds) from Vækstfonden.

Read the below summary of this episode or listen to the recording here.

A situation report

Time for a thorough review

• We’ve been spending a lot of time on our portfolio, talking to our managers and looking at the underlying companies that our managers have invested in — to give an idea, that is a total of 632 companies across 31 countries — granting a fairly broad perspective
• Decided to survey the majority of our VC’s (looking at companies who are slightly more evolved and had taken venture capital for more than one source) and carry out an analysis based on two very simple questions:

1. Which bucket would you put them in? → RED(highly impacted), YELLOW → (slightly impacted) or GREEN (not impacted and in some cases positively impacted) by the current situation

2. How much cash do these companies have as an entrepreneur?

It is a particularly hard moment now, but the minute you set off on your company journey, you are on a long stream of hard things that entrepreneurs deal with. But if you have very little cash left before your company runs out of capital, then that’s tough. So we did this analysis and categorised them based on impact, then further broke down the cash element to three scenarios: less than six months, six to 12 months, and greater than 12 months.

19% out of the 400 sample set were in the red zone who were heavily impacted on their customer business, customer conversations and revenues — only 25 had less than 6 months of capital. The others in the yellow and green buckets and some that were unclear were about the same 20–20% each

Some observations

• The nature of venture capital: is a business by the very definition of the word of trying something out. Sometimes that doesn’t work and that doesn’t require a medical emergency for that to happen. There will be companies that have weak profits, companies that are not quick enough and so they fail. The current situation exacerbates when it’s going to happen. And that’s a good thing for venture capital because it means investors capital is being deployed appropriately, but it also means teams can go on and build the next company based on the experience
• On the other hand: there are some stunning entrepreneurs who are changing their business models and cost structures overnight and this is very wonderful to watch and just shows how quickly they go and what they do is they put themselves in a position for the VCs that have backed them to give them emergency funding. This is a team that gets it, that understands what it needs to do to survive.
• A word of advice: is to have capital at a company level until 2022 we do not think venture capital will return to a normal state or shall we say a state before this medical emergency until that time.

Brace for long-term impact

• It is difficult to predict when things will resume o back to the same kind of environment as prior to COVID–19 at, but 2022 is probably a decent guess.
• We definitely think this will have a long impact on a company level and it’ll take a good while before we are seeing similar patterns and similar environment
• This will very much depend on different sectors — there’ll be companies within certain industries that will have a long term perhaps even lasting negative impacts such as transportation and hospitality, Whereas other areas, once things reopen will quickly resume to normal levels.

Change is coming

• Digital-first and fast: Being digital is a familiar discussion pre-COVID-19 times, but what we will see is that more and more businesses (even big corporates) will transform into being more digital and adopting digital-based, tech platform business models. The ones already existing with a digital model will be even more relevant today and going forward — certain transitions that were already to be expected will advance and be accelerated as a result of COVID-19
• ‘You’ve changed’: Consumer behaviours will change more rapidly e.g. online shopping where many more consumers that are not comfortable and would have taken them longer to make that sort of behavioural change will adopt their purchasing habits quicker. Companies will adapt similarly and accelerate their behaviours e.g. buying in on enterprise software solutions
• … for the better?: There are a lot of challenges now both on fund levels and on individual portfolio company levels but we’re still optimistic. So a lot of short term hard decisions, really difficult decisions are being made at a manager level, but also at portfolio company levels. Sometimes it, means layoffs, postponed employments, postponed business, but some of these decisions are sort of required for securing the longterm success for the companies and for the funds in general.
• Change brings opportunity: There will be changes that we’ll see for good and there are transitions that will be accelerated during this period of time, which can represent fantastic business opportunities for new businesses or already existing incumbents as well as it represents great investment opportunities. Great companies are being created across financial and economic cycles. So, fundamentally we still believe that tech is a good place to be.

What does the future look like?

• The venture landscape in general: there will be a sort of rationalization of the industry of consolidation of the funds. Just like many companies won’t make it. They won’t make it through this crisis. A lot of funds will struggle. Funds won’t be able to raise the next vehicle. Funds that are just starting now may not be able to ever reach a viable size. And of course, that’s unfortunate but that’s a normal part of the cycle.
• Uncertainty for all: it’s a special situation as everyone’s affected. It’s not only the financial sector or tech, everyone is struggling and everyone has to reassess, so you never quite know how other parties in the markets will respond.
• Fundraising continues to be a question: certainly in the short term. Quite a few LPs are hesitant to deploy capital to new funds being raised. They are reserving a little bit more and being more cautious because they want to make sure that their existing portfolio of GPS are well covered before making new investments. The flow of capital is not as good as it was before COVID-19 and that’s also why the governments in Denmark, UK, France, Germany and other places in Europe and in the US as well are looking at various stimulus packages that would stimulate the capital to flow back to the entrepreneurs with an increased pace for the coming months.
• Short term challenges vs long term opportunities: the groups that are strong and taking the right measures will get some fantastic opportunities out of the current situation. 2020 and 2021 will turn out to be wonderful years for investments. What we are seeing now is likely a short term impact in the next few months that will certainly be around for a little while for venture firms. There will be challenges around capital calls, especially when you have investors that are not institutions. So family office and angel investors might be facing challenges around raising funds.
• Tech investing continues to be a great place to be: companies who are doing really extremely well right now are the ones helping people be more efficient with e-commerce, whether it’s related to marketing, deployment, logistics, and the ones who are adapting to the systemic changes we are seeing. Some LPs will want to remain diversified across ventures and different cycles, in which case they will carry on with their investment program, looking for new opportunities in making deals where strong innovations and creativity are uprising.

VCs’ take on funding from an LP’s perspective

• Higher reserve ratios: the amount of capital being left for backing the best parts of the portfolio is increasing.
• The bar is being raised for VC funds too: funds that thought they were in this ever-rising tide of capital coming into funds, quickly deploying cash, not have any significant returns and going back out there to raise again. This method of operation will be almost impossible in the coming years. VCs have to produce returns and if you have a poor performance you will quickly fall out of the market.
• Survival of the fittest: the bar of a great entrepreneur is also rising so that only the best can survive, which is a common feature when you have a rising market, which we’ve had for so many years.

Evaluating new fund managers now vs. before:

• What happens when the music stops; is one of the questions we always ask a manager in our DD and that we have asked every manager that we’ve met. What happens to this kind of business model? What happens to this kind of technology? Who is buying this product? Are there any potential exits? Are there any valuable bits of it that we can still have? Extract some money from if everything stops? Apart from the answers, the question is interesting because you’d be surprised at how often that’s not necessarily something that people have thought through as a result of the recent cycles that we’ve seen.
• Entrepreneurs make the best VCs: DD meetings will continue to be roughly the same format but understanding who the creative and resilient and what you call ‘the hustlers’ are, the VCs that will do anything for their portfolio, they’ll find a solution no matter the challenges — I think that’s an attribute we all look for in founders and you can apply this to a venture team. This is something that we’ve always cared about, but certainly, it’s becoming incredibly relevant.
• From finance to operational profiles: historically financial and investment bank profiles were sought after, whereas now the focus is increasingly becoming more about ex entrepreneurs and more operational profiles with relevant operational experience such as flexibility and agility who can help companies pivot towards something that can work and avoid the hurdles and the obstacles that a given situation like the current one may bring about, which may further underline the relevance of having an operational profile in favour.
• Ride or die attitude: One of the fundamental reasons that venture capital in Europe is becoming one of the most exciting parts of venture capital in the world is this notion of the coach, mentor, VC. We are not on opposite sides of the equation. We’re not on opposite sides of the game. We’re on the same team. We have the same goals, we have the same objectives and a VC who sits down with the entrepreneur who’s just spent the last two years building a team of 2050 people or whatever it is and says, you know, the right answer here is to remove half of these or furlough them or whatever we have to do, but let’s do it together and let’s figure out the best way to do this. Those VC’s that do this well will have a very strong competitive edge for the next generation of entrepreneurs.
• Time to shine: it’s ideal if you can take a partnership approach to make sure that you’re relevant with the best VCs also when they’re not in trouble – it’s probably a good idea to be around even during the hot times. The market remembers how you handle these difficult times and it goes on the GP to VC to founder level. So this is actually an important period where you can stand out as a VC and as a GP you can really build your brand in a situation like this if you really handle it well.

Government Initiatives

• Unfortunately, we’ve seen a downside from pretty much each government, certainly in France, Germany and the UK where normally lots of funding is being made available for startups and that takes shape in many different programs and initiatives. As for now, I haven’t seen any specific EIF programs coming together for GPS in VC funds as a response to the crisis.
• The Danish government is, very keen to try and intervene in the crisis and, and try and mitigate some of the adverse effects on the VC industry
• Vækstfonden will be operating certain programs on behalf of the Danish government to stimulate the market through certain schemes over the coming period starting very soon.

Final Words

Well done, you’ve made it to the bottom of the page. Hope you enjoyed attending, reading or listening to this episode. 🙏🏻

Next week, we will talk all things cybersecurity while working from home, with Caroline Wong from byFounders’ portfolio company Cobalt, and Ty Sbano, Chief Security and Trust Officer at Sisense who will share best practices security leaders can implement now to fend off threat actors during a time where everyone is more susceptible to hackers.

Join us in the conversation next week, and feel free to reach out to us if you want to hear about a specific topic or would like to participate as a panellist!