Three Market Observations
Thoughts on the COVID-19 market environment
Having spoken with dozens of investors and entrepreneurs over the past few weeks of the COVID-19 crisis, I have three market observations:
(1) Established investment firms have their hands tied up in existing portfolio companies at the moment. Right now, these investors’ main concerns are to ensure their existing portfolio companies survive, which results in less attention (and capital allocated) to new deals. As an anecdote, several friends who are founders of VC-backed businesses recently went out to raise an extension on their last round; the only term sheets that came in were from their existing investors, who felt comfort in shoring up (and owning up in) their portfolio companies. This leads to an opportunity for new fund managers that have no existing portfolio to prioritize and therefore have an advantage (via more time, capital, and scrappiness) in focusing all of their attention on new investment opportunities while established funds have their hands full.
(2) It seems that valuation resets may take several months (or more) to occur. Several reasons why that is:
(i) For B2B businesses: New customer leads drop off in the near term, which impacts conversions to sales at a lag equal to a company’s sales cycle (e.g. inability to go to industry conferences today means sales in six months from now will be adversely affected, even if near-term pipeline is still closing. This means the real hit on growth is “delayed” until later, while companies are now still closing deals and growing.)
(ii) For B2C businesses: Unemployment numbers continue to grow as the prolonged shutdown forces more businesses to close. Money from government aid helps, but businesses aren’t designed to stay alive for months without revenue (and this may last many more than the 2.5 months of salary PPP is granting). That means sales for many consumer goods are still ok for now — and may even be increasing for certain categories like DTC consumables — but ultimately the aggregate consumer purchasing power will decrease.
(iii) In some cases, there is a natural divide between the value founders ascribe to their business and what investors are willing to pay. Founders are optimistic (as they should be) that they’ll survive and thrive post-COVID and therefore expect to raise capital at pre-COVID valuations. Investors, on the other hand, are seeking lower valuations (relative to the past year’s mega bull market), not only due to different supply-demand dynamics (a pullback of capital availability in the marketplace), but also due to increased risk being priced in (given the volatile market environment). Interestingly, many major PE firms (e.g. Vista, TPG, etc.) have shifted their attention for the time being from private to public markets because, due to the liquidity of public equities, share prices have adjusted more immediately. There is no “right” answer — and valuation dynamics of course differ on a case-by-case basis — which ultimately leads to a waiting game for some founders and investors to see where market clearing prices shake out.
As a result of these impacts, I believe there will be great investment opportunities not just now, but also in the coming quarters from now. Therefore, funds should remain aggressive yet opportunistic throughout this period, balancing capital deployment for exciting near-term opportunities with the preservation of cash for future attractive opportunities that are bound to surface.
(3) There may be significant changes in consumer behavior going forward — the question is what those behavioral shifts will be, what the second- and third-order consequences of these shifts might be, and, perhaps most importantly from an investor’s perspective, whether these shifts will be permanent or fleeting.
For instance, if there is a reversal in urbanization because consumers want more space, what does that mean for home prices in the suburbs and real estate prices in cities? Or, do people have short-term memories and continue to pile into cities once COVID is behind us?
If legacy, paper-based industries are forced into a more rapid shift to digital, which industries are prime candidates? Will this shift to digital increase productivity by augmenting humans, or replace human labor in many cases altogether? Or, do these businesses return back to their old pen-and-paper ways once the quarantining period is over?
If remote work sticks around, will it revolutionize the commercial office space industry given less demand? Or, will people be mentally scarred from all these hours spent at home, balancing work and family in confined quarters, and therefore spend even more time at their company’s dedicated offices going forward?
If unemployment remains high, will startups figure out new, unique ways to put unemployed people to work? Companies like DoorDash and Instacart are seeing value accretion by doing so effectively; what other ways can we facilitate the “gig economy”? Or, will we have a V-shaped recovery where unemployment returns to record-low levels, diminishing the supply of workers available for these types of platforms?
I don’t know how things will end up, but these potential changes in consumer behavior are top of mind for me and can have lucrative ramifications for investors and entrepreneurs. What I do know is that, while I’m interested in meeting with businesses in and around these potential trends, I continue to seek out the best capital efficient businesses that will perform well in any environment.
