What the Global Financial Crisis can teach us about raising venture capital in the COVID-19 Crisis
By Q Motiwala, Managing Director at DNX Ventures, Rickie Koo, Investment VP at DNX Ventures
Invisible and indiscriminate, this novel coronavirus has created a humanitarian crisis at a global scale. We at DNX are indebted to the legions of healthcare, retail, and supply chain professionals who are rushing to the front lines of this battle — often without sufficient medical equipment — so that we can enjoy some modicum of normalcy. We will get through this — together.
Taking into consideration the unique economic, social, and health facets of the COVID-19 crisis, we studied past data from the venture ecosystem in the aftermath of the 2008 ~ 2009 Global Financial Crisis to understand how the venture capital industry may react to the current downturn. Obviously, there are many other events in our modern history that can help enrich this analysis and we are cognizant of the risk of recency bias (i.e., Global Financial Crisis happened most recently so we may over-index on those learnings, while neglecting those from events that happened farther back). For example, a thoughtful examination of the aftermath of the 9/11 terrorist attacks should also be done, to shed light on how entrepreneurs and investors respond to ‘black-swan’ type exogenous shocks. We chose to look at the Global Financial Crisis — for now — due to the scope of macroeconomic impact, the availability of consistent data, and the relative continuity in the venture market dynamics and practices.
Our hope is that this will serve as one of many guideposts for entrepreneurs looking to raise capital in these tumultuous times.
1. Venture market bottomed-out a whole 12 months after the Lehman Crisis
The bankruptcy of Lehman Brothers on September 15, 2008 was the largest bankruptcy filing in U.S. history (by assets), becoming the catalyst for what we now call the Global Financial Crisis. The crisis triggered a sharp sell-off with the S&P 500 losing 4.7%, making it the biggest one-day decline since Sept. 17, 2001 (the day markets reopened after 9/11). The S&P 500, however, did not bottom out until March 2nd, 2009, a whole two quarters after the shock. One possible explanation for this delay could be that the scope and impact of the downturn was not fully understood until much later, as more capital flow, unemployment and earnings data started to trickle in.
The venture capital market took even longer to bottom-out, as seed to late-stage deal count and value didn’t see the trough until Q3 2009 (see Exhibit B). The slower decline in investment pace may also have been due to two other factors. First, there were likely spillover deals from the pre-crisis period, as venture investments take much longer to consummate especially during an economic slowdown. Second, the venture asset class has a much longer time horizon than public equities, so investors likely kept investing with the hopes that it would yield value by the time the economy is back in an upswing. It’s for that reason that seed deal pace and value remained more resilient than that of later-stage deals.
Why then did venture investing decline at all? The first reason has to do with investment pace. When the prospects for raising a subsequent fund become bleaker, fund managers tend to space out their investments so that there aren’t any dry-spells in between funds. Second has to do with the uncertainty of raising a subsequent round and/or achieving an exit. A single VC rarely finances a company throughout the entire lifecycle and relies on “downstream” investors to continue supporting the company to an exit outcome. When the later stage and exit market shrank as it did from 2008 to 2010, many “upstream” investors (especially early-stage) pulled back investments. Finally, during an economic downturn, fund managers may refocus their attention to protecting their existing portfolio companies and less on executing new deals.
What about this time?
How might things be similar this time? Fast forward to today, the largest single-day drop in the S&P 500 since the Global Financial Crisis happened on March 26th, 2020, dropping by 11.98%. Yet it will likely take a few more quarters for the public markets to fully absorb the magnitude of the COVID-19. Even at the time of this writing, it’s not likely that the full impact of the COVID-19 crisis has been priced into the public equities, perhaps other than segments that have been disproportionately and very publicly affected (e.g. travel, hospitality, retail, and oil and gas). Like every recession before this, there will be short-lived rallies, followed by even steeper drops, as more macroeconomic and corporate earnings reports come to light. Q1 and Q2 earnings seasons should be a really revealing time and VCs will be looking at all of those results to determine; 1) which industries survive and/or thrive including any long term effects on consumer and enterprise spending behavior; 2) when should they be deploying their dry powder; and 3) how to price their rounds should they make investments. In the meantime, we should expect overall VC activity to drop.
How might things be different this time? A key difference is the fact that governments now wield an additional policy tool, one arguably more consequential than any fiscal or monetary policy deployed during the previous recession: the ability to reopen the economy. Whenever the governments decide to end the lockdown, we may see an economic resurgence from pent-up supply and demand. How quickly we return to pre-COVID era levels of economic and venture activity will be a function of the labor market’s ability to re-employ those who lost their jobs, if there are multiple waves of outbreaks, and the development of effective testing, therapeutic or vaccine programs. We should be closely observing how well China performs in the next few months, to see how quickly society and economy can ramp back up after a prolonged quarantine period.
2. Angel and Seed financings remained robust throughout the last recession
As mentioned earlier, seed and early-stage deal volume remained more resilient than that of early and late-stage deals (Exhibit C) during the last recession, with a slight decrease in average deal value. The reason for the strong seed deal flow is because companies at the seed stage typically are more focused on product and technology development, than business and customer acquisition benchmarks. The hope is that by the time the seed stage companies come for its Series A raise, the economy would be on an upward trajectory. Later stage deals are more impacted by public market comparables and enterprise and consumer changes in spending and therefore saw their deal count and value fall as the public market collapsed.
What about this time?
How might things be similar this time? The notion that seed stage companies can focus more on product and technology development during an economic downturn is still accurate, and we should continue to see a strong flow of seed-stage companies
How might things be different this time? The scale of the seed market in 2020 is very different from that of 2007; the market is now at least eight times larger in terms of annual deal count, with commensurate growth in the number of seed-focused funds (Exhibit D). It’s very unlikely that this seed investment pace will continue at this pace in the current downturn unless a large cohort of Series A funds decide to invest earlier.
3. There was a sharp drop in VC capital raised, new fund formation, and Fund Investor or Limited Partner (LP) contributions
The same year that deal count and value bottomed out, there was also a sharp drop in overall VC capital raised and funds formed (Exhibit E). This is likely because institutional LPs wanted to rebalance their portfolio towards less risky assets (e,g.,cash, gold, and treasuries). This type of rebalancing is typical during a downturn, especially if the weighting of risky assets, like venture, increases relative to its target allocation levels.
LP contributions (i.e., capital calls) also dropped in 2009, due to a combination of VCs slowing their investment pace and LPs requesting to delay — or even reneging — capital calls (Exhibit F).
In the seven years leading up to this current COVID-19 crisis, there has been an extraordinary growth in the number of venture funds and capital raised (Exhibit E). Part of this growth can be tied to very aggressive monetary policies. Specifically, the interest rate cuts and the quantitative easing programs that the Federal Reserve (“the Fed”) implemented in the aftermath of the Global Financial Crisis were designed to catalyze investments into more risky but “productive” assets like public equities, corporate bonds, private equity, and venture capital.
How did it work? In the Global Financial Crisis, portfolio managers naturally gravitated towards the safest short-term assets: cash and short-term treasuries. However, to deter this, the Fed slashed interest rates to record low levels in 2009 (Exhibit G), effectively nullifying the returns of those assets. Near-zero federal funds rates then pushed investors to invest in the next best thing — longer-term government bonds — which the Fed countered with Quantitative Easing. The goal of Quantitative Easing was to buy long-term government bonds and mortgage-backed securities from banks and financial institutions, thereby driving up their prices, lowering their yields (i.e., return), and simultaneously adding more liquidity in the money supply. With returns on those assets became so low, this then forced investors to seek returns from riskier assets such as longer-term corporate bonds and equities. Once those asset prices rose and became overvalued, which was roughly around 2013, money then poured into the riskier but higher-yielding asset class: private equity and venture capital.
What about this time?
How might things be similar this time? On March 15th, 2020, the Fed announced that it was dropping its federal funds' interest rate to zero and providing $2.3 trillion in loans to support the economy, including a broad-based Quantitative Easing program.
We’re starting to learn, however, that the scope of the Fed’s Quantitative Easing program this time is very different than before. During the previous crisis, the Fed purchased only treasuries and mortgage back securities. Now, in addition to those two, the Fed has explicitly added municipal, investment grade, and ‘fallen angel’ junk (i.e., investment-grade bonds, but have ‘fallen’ due to the crisis) bonds. For the municipal bonds, for example, the new Municipal Liquidity Facility will offer states and municipalities up to $500 billion in lending and will be backstopped with $35 billion from the Treasury to protect it from potential losses. Additionally, they have also said they are even willing to purchase ETFs to achieve their objectives.
What does this all mean for venture capital? As mentioned earlier, the resulting low expected returns on treasuries and mortgage-back securities during the previous recession encouraged investment in private equity and venture capital. This time, with the Fed “backstopping” municipal, investment-grade and junk bonds, institutional investors will likely allocate a much larger portion of their portfolio away from private equity and venture capital, and more into instruments with risk profiles that have been effectively eliminated by Fed policy measures. For example, an endowment whose objective was 7% annualized portfolio returns in the past needed the higher expected returns from private equity and venture capital because their entire fixed income portfolio was expected to return under 3%. Now that the Fed is “backstopping” investment-grade and junk, which yield 4 to 7%, there is much less of a need to allocate capital to private equity and venture capital to reach the return target.
Although the Fed’s policies are likely temporary, entrepreneurs should know that it may be a while before money flows back to the private equity and venture capital asset class at the rate that it did pre-COVID. We are already starting to hear news of limited partners reneging on their capital commitments, if not push back the wiring by a few weeks.
Entrepreneurs should know the level of dry powder that currently exists in the market. According to study done by Jon Sakoda, founder of the early-stage venture firm Decibel Partners, of the $279 billion venture capital raised since 2014, only half still remain as dry powder. About half (if not more) of that is likely earmarked as reserves for existing investments. If VCs continue investing as they did in 2019 — $136 billion per year — and did not raise any more money, they would only last one more year. To avoid that scenario, VCs might want to invest like it’s 2016, when they averaged an investment pace of $80 billion per year, stretching out their dry powder to nearly two years. For entrepreneurs, this all points to VCs dramatically decreasing the speed of their capital deployment.
4. Seed and Early-stage valuations remained largely unchanged, but late-stage valuations dropped significantly between 2009 ~ 2010
Between 2008 and 2010, there wasn’t a significant change in the seed and early-stage pre-money valuations, but late-stage valuations bore the brunt of the impact (Exhibit H). Given that the scale and growth rates of later-stage companies are more similar to that of public companies, their valuations are more directly affected by collapse in the public market comparables. We also saw a 2x YoY increase in flat and down rounds in 2009 — mostly from late-stage deals — but this largely returned to pre-recession levels by 2010 (Exhibit I).
What about this time?
How might things be similar this time? As shown in Exhibit F, both early-stage and later-stage pre-money valuations have trended significantly upward leading to 1Q’20. As the investment pace slows, we may see downward pressure on pre-money valuations across all stages, but especially in the later-stage markets, as investors become much more selective about the companies they invest in. We may also see a sharp spike in flat and down-rounds for companies that raised between 18 to 24 months ago.
Incentive alignment among investors, LPs, and founders will also be challenged during this downturn. For example, venture investors, expect to see more deals with some flavor of ‘pay-to-play’ terms, which are provisions that require existing investors to invest on a pro-rata basis in a financing round or risk losing some or all of their preferential rights (i.e., anti-dilution protection, liquidation preferences or certain voting rights).
Throughout history — such as the Black Death in the 14th century, the Aztec smallpox epidemic in the 16th century, the Spanish Flu of 1918, and AIDS epidemic in the 1980s — infectious pathogens have impacted the course of human history. We anticipate the COVID-19 pandemic to be no different. We could see shifts along geopolitical and political fault-lines (e.g., worsening international relations, 2020 US Presidential Election); and a reevaluation of medical, urban planning, education, supply chain, professional and social practices. The structural legacy of the crisis depends in large part on how quickly we are able to control the spread of the virus, how quickly we are able to find and deploy a treatment, how decisive government intervention will be, and how quickly the public markets bottom out.
Entrepreneurs and venture capitalists will no doubt also be challenged in this climate. However, we are reminded that some of the most monumental companies in history were created during recessions: Hewlett-Packard during the Great Depression, FedEx during the Energy Crisis of 1973, Electronic Arts during the 1980s Recession, and Uber and Airbnb during the Global Financial Crisis. It was precisely because of that economic hardship that these entrepreneurs were forced to hone their value-proposition, solidify their unit economics, and forge a culture of fortitude.
We believe strong and resilient entrepreneurial teams will rise to the top and having just raised a fresh $300M+ fund, DNX will be ready to greet them.
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