3 Things That VCs Need to Know to Navigate the Current Economic Downturn
By Mark Peter Davis, managing partner at Interplay
When the market begins to crash, everyone in the business world has to change their game plan. That not only holds true for public market investors, it is also true for players in the private market. Venture Capitalists (VCs) are no exception. That might seem counterintuitive given that capital might be committed prior to a downturn and firms often nurture investments for around a decade before exiting. While VCs are playing one of the longest games in finance, the gravity of market forces will warp even the most insulated orbits.
So how should a VC’s mindset change when the market flips from bull to bear? Having seen the global financial crisis through the lens of a VC, here are three patterns to consider.
1. Get Ready for the Stampede
When valuations drop, a ton of great talent is typically released into the market. Executives hired into overvalued unicorns or recently IPO’d companies will realize that their stock options are below water, so they will leave to pursue more lucrative opportunities. If the job market starts to contract, as it did in 2008, many will take a stab at starting their own company. They will see if they have what it takes to be a founder. And some of these companies will be amazing, similar to the top unicorns that rose out of past recessionary periods (including Facebook, Google and Uber).
What does this mean? Opportunities. Whether it is finding and hiring new talent or keeping an eye on the new companies that are created by experienced executives, get ready for the stampede, and keep an eye out for the opportunities that will be left in its path.
2. Pace Your Investments
When the Net Asset Value of public equities drops, large limited partners (LPs) such as universities’ endowments, pensions, etc. tend to find themselves overweighted toward private assets such as venture capital. As a result, they slow their cadence of investing in firms. This is called the denominator effect. Most VCs know this, and firms that are in the middle or the end of their current fund’s life will slow their investment pace in order to time the raise of their next fundraise for when LPs are investing in VC again.
Why don’t VCs just take a vacation between funds then raise when the market picks up? Well, being out of the market can disrupt future deal flow and dilute reputations. These are two crucial components of the VC game, and both take time to build and require effort to maintain.
For the founders reading this…yes, this means valuations are likely to decline.
3. Quality Will Pay Off
Quality always beats quantity in normal size venture funds (normal here meaning 20-30 portfolio companies per fund). Even in an economic downturn there is capital floating around - just less of it. Higher quality companies with real business models tend to continue to get funded, and while the weaker companies in the herd may starve to death, the high-quality companies tend to continue to thrive.
What does this mean for your VC firm? Double down and support your winners, accept the losses of your failed investments (do not put good money after bad) and increasingly focus on viable business models for new investments.
Investors do not like uncertainty, but in uncertain times like these, the show will go on - with or without you. Figuring out how to navigate bear markets is crucial to a long and successful career in investing at any stage - and frankly in any asset class. When you think the market is changing direction, your team should be ready to adapt your strategy so you not only survive, but thrive.
These are a few of the strategies that have helped me make it through past down markets, but it’s important to remember that every crisis brings opportunities. You just need to change your perspective to see it.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.