The risk for venture capital

The risk for venture capital

VC funds seem to be untouched by the economic crisis that comes with coronavirus. The danger lies in the long run

The coronavirus erased one third of the American economy and one eighth of the European – all that in just one quarter. And even after all that venture capital funds seem to remain somewhat untouched: startups still raise billions of dollars, and investors appear just as eager to give them money as the were an year ago. At first glance nothing in the VC sector points to the fact that the world is approaching its worst economic crisis of the last few decades. But hard times might come later.

Venture capital and investing during coronavirus will be one of the major topics during the tech conference DigitalK 2020, organized by Capital and LAUNCHub Ventures. The hybrid event will take place on October 15th and 16thand will include speakers from all around the world, online discussions and a live event in front of a limited crowd.

Venture capital is not alone in all this. In fact, it is just following the stock markets, and not the real economy. There is a ever-growing gap between the two: while businesses go bankrupt, major stock indices are still close to their all-time highs, and there are quite a few reasons about that: tech giants, the biggest winners of the crisis so far, the easy money from central banks and the enormous fiscal packages coming out of governments all around the world.

There is one extra reason for VC firms to keep on as if nothing has happened: most of their investments are in tech companies, that are some of the biggest beneficiaries from the mass digitalization and disruption wave that COVID-19 brought with itself. Nobody wants to risk passing on the next Google – or, actually, the next Zoom.

Still waters are dangerous

“I, along with everybody else here, was quite surprised that nothing in the VC world changed that much. When the first stay-at-home orders came in March, we thought that the climate will change. And we were not alone”, says Bogomil Balkansky, partner at Sequoia Capital, one of Sillicon Valley’s largest funds.

“At the beginning of the crisis we thought that it will be just like every other one – valuations will fall and it will get harder for companies to raise money. The truth is, none of that is happening. Valuations have not come down and the whole structure for raising money is still very solid”, adds Balkansky.

His explanation is that venture capital is indeed following stock markets, and not the economy itself. He expects that there eventually will be a change in climate, because the gap is growing larger and larger. “This is a much harsher crisis than the one in 2008. Sooner or later the real economy will overtake stock markets and VC itself will have to change.” This is already happening, even though much slower than expected.

Both the markets and the VC funds seem to think that the worst has already passed and recovery will have V turn. They are probably wrong: the consequences for many businesses  will come in later, when the purchasing power of their clients goes down. This includes many startups that VC funds invest in. Every different crisis during the years brought startup bankruptcies.

Better than all the rest

A report by researchers from Harvard University, Stanford University and University of British Columbia from mid-August confirms that the VC sector is in healthy condition. According to the report, the industry is doing much better during coronavirus times than most of the world economy.

A whole lot of 52% venture capitalists say that their portfolio is doing better or at the very least just as good. The poll was done between June 29th and July 15th with the participation of more than thousand institutional and corporate players in the VC sector.

According to the researchers, the strong performance of venture capital during economic shifts is to a certain extent coming from the nature of the business on one side – and the conservative approach on another. VC funds tend to have low levels of debt, large cash reserves and have no problem switching to remote work.

Of course, VC funds also profit from the fact that they usually invest in tech companies with the goal of disrupting traditional sectors – and this process is often accelerated by hard times. “If portfolio companies are real options on innovative technologies and business models, an increase in volatility may increase the value of those options,” the authors said in the paper. “The turbulence produced by the pandemic has created winners and losers, with the winning companies offsetting the losing companies for the typical fund.”

Other surveys give both good and bad news about the industry. According to Crunchbase, there were fewer investment deals from March to June in the US – but the average size of the deals did not come down. The implication is that venture capitalists are still looking for promising companies and in some segments the average deals are even bigger than an year ago. As one could imagine, there is large interest in AI and health tech companies – and not so much in hospitality and travel sectors.

The future risk

Although in good shape, the VC sector will face quite a lot of hurdles in the future. If VCs stay connected to stock markets, then investors will have to face the fear of the ever-growing gap between stocks and the economy. So far history shows that sooner or later there is a reality check for stock markets, because economic activity falls. On the other side, this is the first crisis in history in which the biggest companies in the world are not oil and manufacturing, but tech giants. Their clients, however, tend to be from the old economy.

VCs also reflect on the startup ecosystems, that just might start to feel the hard times because of the coronavirus. So far there has been no big Sillicon Valley startup to declare bankruptcy, but if at one point the investors have to tighten the rules on financing and valuations start to go down, the situation might change – and fast. This scenario seems to be a bad one for the VC funds, but, at the end of the day – hey, it’s a risky business.