State of the Markets
UNPRECEDENTED TIMESThe global economy has rapidly deteriorated, and the tech ecosystem is bracing for impact. Loss-making companies with limited runway are at risk of failure—volatility reigns.
There are two reassuring caveats: first, the VC ecosystem has weathered recessions before, and tech tends to enjoy a strong relative performance during the recovery. This will be especially true in segments with direct relevance to the pandemic, such as remote collaboration software and healthtech. Second, many of the trends that seem to be emerging predate it. Examples here include the decline of growth-at-all-costs and supply chain shifts.
The innovators we serve remain adaptable and optimistic, but also realistic. We are in for a pullback, and SVB will lead the way out.
As COVID-19 spreads across the globe, markets have fallen fast and growth has come to a halt. The market decline has been steeper than any before, reaching bear market territory in less than a month —marking the worst first quarter in history. Economists have slashed growth projections as businesses close and employees are laid off. Tech has weathered the storm well —even benefiting from policies like shelter-in-place. When we do enter recovery, tech should benefit from structural changes such as remote work, accelerated cloud demand and more.
March Sees Global Fiscal Surge
As economic activity has slowed amidst COVID-19’s international spread, many governments have introduced significant fiscal stimulus.
As fiscal positions have worsened, countries have seen their sovereign debt yields increase as investors have fled to safer U.S. Treasuries.
This is in spite of the dire consequences that the $2T U.S. package may have on the federal budget deficit. As the package includes loan programs, some of this spending will be recouped in future years.
Monetary Policy Pushes the Limit
Major central banks have taken bold and decisive action to prop up the economy, ramping up asset purchasing and adding new types of securities to their balance sheets, such as corporate bonds and nonfinancial commercial paper. The ECB and BoJ have been restrained on rate cuts, as policy rates in those economies have already been negative for years.
Research has shown that monetary policy can be less effective when interest rates are already low. There is evidence, however, that it can still be effective in alleviating acute financial crises.
As the “Great Lockdown” continues, cost reductions including layoffs and furloughs are rippling through startups. Even those that have recently raised are using this as an opportunity to right size their costs. As most companies adjust to the remote working model and implement new tools and procedures to maintain productivity, fixed costs like rent begin to look discretionary. Rent alone is not a sizable cost, yet when adding insurance, utilities, perks and more, it can start to add up. Companies that help facilitate remote work, such as Zoom and Microsoft Teams, have seen tremendous growth in daily active users in 2020.
The Expansion Generation of VCs
In venture capital (VC), experience matters, especially in tougher environments. During the GFC, managers who had been active during the Dot-Com bust saw far less performance variance than those who hadn’t, suggesting a better risk-adjusted return. This could be due to well-developed firm-level investment strategies or better deal access.
Today, the majority of active VC firms has never seen a recession. This is less the case for firms that raise larger funds. More experienced firms might be more risk averse in a recessionary environment.
Venturing through Downturns
The link between public markets and VC valuations is somewhat nebulous, but the last two recessions coincided with corrections in the private markets. This time around, valuations are yet to fall meaningfully, perhaps due to larger deals already in the works closing.
We expect the late stage to take a larger hit; 38% of late stage deals involve nontraditional investors, such as asset managers and private equity firms, that have more sensitivity to public market performance. Furthermore, later stage companies are more comparable to public peers for benchmarking valuations.
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Performance through Past Cycles
Companies founded per VC fund closed is a leading indicator of startup valuations and VC performance. When the companies founded per fund closed is below average, entrepreneurs hold more power, which is observed in more favorable terms and higher valuations. Since 2014, company formation has declined and the number of VC firms has increased, which gives entrepreneurs more power. We expect the current environment to put downward pressure on valuations once activity picks up, with weaker growth expectations for startups used as the rationale for the drop.
Adversity Drives Innovation
With high unemployment leading to an ample supply of talented workers, lower opportunity costs and the potential to ride the next wave of economic growth, recessions provide a great opportunity for entrepreneurs.
With unemployment reaching ~10% post-Global Financial Crisis, annual company formation reached a record high. Around 41% of today’s unicorns were founded during or in the aftermath of the GFC1. Today, 9% of the constituents of the Nasdaq were founded between 2008 and 2012.
The Remote Pandemic
Despite the current economic climate, some industries are getting a boost. Consumer interest in remote healthcare technology saw the biggest boost, followed by food delivery, remote work, and remote learning. As organizations realize the gains to efficiency from going remote, structural changes from decreased business travel to working from home will likely persist after the pandemic subsides. These changes will hurt airlines and hotels, while enterprise software companies and remote healthcare companies will benefit.
COVID-19 Increases In-Patient Services
The surge in hospital care due to COVID-19 is projected to cause in-patient expenses to rise by 65% due to the high cost of treating these patients.
As healthcare costs rise, the wasteful spending within the system grows with the Provider Operations and Alternative Care sectors seeing the largest increases.
Outside these sectors, Healthcare Navigation companies can also help curb the additional healthcare expenditure. For example, companies such as Grand Rounds and Pager are helping route patients through the healthcare system.
Runway as Recession Immunity
As the global economy falls into recession, the VC funding market is unlikely to be spared. Absent funding, unprofitable companies’ days are numbered. Some segments have a healthier cash cushion and thus a better chance of riding out a VC cooldown.
Of course, there is the ever-present risk of a pandemic resurgence. Though the International Monetary Fund expects growth to pick up in the back half of 2020, it underscored in its April World Economic Outlook that there is great uncertainty around this baseline.
COVID Pushes the Bar Higher Still
It is useful to consider the pandemic-related pullback in context –there was already a sea change taking place which shifted investor focus from explosive growth to good unit economics. This is especially visible for the cohort of companies that is more mature. Deal activity for this cohort, though limited this year, has shown a growing preference for stronger margins –even if “stronger” only means less negative.
This raising of the bar is closely related to a general decline in deal activity, which we have observed in 2020 thus far.
(Don't) Burn Baby Burn
With many preparing for a prolonged downturn, venture capitalists are recommending founders slash expenses, suspend non-essential projects and revise their forecasts. They’re also advising portfolio companies take out or draw down debt to extend their cash runway for at least 18 to 24 months. Convertible debt issuers, amidst uncertainty around COVID-19, tensions with Iran and an impending election, tapped the public markets, thereby taking advantage of the open window to access the market before it dramatically slowed in the second week of March.
Plenty in the Coffers, for Now
Combined, Venture Capital and Private Equity dry powder is at a record high. However, during the GFC dry powder started to moderate as new fund creation dropped by ~40%. For Limited Partners, dips in the public markets will trigger a rebalancing of portfolios, similar to what occurred in 2009, which, in turn, could lower allocations to PE and VC. Allocations from the biggest contributors, such as pensions, endowments and foundations, had been rising, but we now expect these to fall, leading to a tougher fundraising environment in 2020.
Time for a PE Turnaround?
March marked the first month since 2008 that the institutional leveraged loan market closed with no new issuances. This was driven in large part by M&A auctions breaking down as lenders struggled to underwrite and price risk amid unprecedented uncertainty. As loan prices in the secondary market plummeted, lenders struggled to justify buying new issuances. Meanwhile, PE firms will be eager to deploy at a discount to pre-pandemic prices. Only when the leveraged loan market stabilizes will sponsors find lenders more willing to transact.
FinTech Surge Overshadowed
Before the COVID-19 outbreak and the ensuing bear market grabbed the headlines, FinTech had its best first quarter ever as VC-backed companies like Credit Karma and Plaid got scooped up by larger public FinTechs. With a tougher fundraising environment ahead and healthy public FinTech cash balances, FinTech startups will likely consider M&A a more appealing exit opportunity. Additionally, larger public FinTechs will be looking to enhance their digital platforms, increase their capabilities and diversify their customer base once things start to get back to normal.
A STAR Burns Brighter
As China attempts to rebound from COVID-19, it has a few tailwinds. China recently revised its Securities Law, expanding registration-based IPOs to all exchanges, which was a major bottleneck. This not only increases the number of places companies can list, but also the potential pool of companies who could list, including non-tech firms. If China’s economy rebounds well and investors believe financial market reform holds, we could see Chinese companies that are listed on U.S. or HK-based exchanges re-list on the mainland exchanges.
COVID-19 Accelerates Trade Shifts
Even before the pandemic, China’s share of U.S. tech imports was in decline. Shipping from China to the U.S. decreased in every month of 2019, while a handful of countries, including Vietnam and Thailand, have snatched up share of U.S. high-tech supply chains.
In February, 15% of U.S. imports underlying advanced technology were from China. This figure was as high as 48% in 2014. Anecdotally, big names in tech have shifted a portion of production elsewhere.
This material including, without limitation, to the statistical information herein, is provided for informational purposes only. The material is based in part on information from third-party sources that we believe to be reliable but which have not been independently verified by us, and for this reason, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice, nor is it to be relied on in making an investment or other decision. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction.
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