Everyone is fascinated with predicting when the market will turn, especially venture capitalists. Perhaps now that Game of Thrones is over, we can put a merciful death to the refrains of “winter is coming” that seemed so much more clever seven seasons ago.
And while Chamath Palihapitiya of Social Capital recently suggested that quantitative easing could prevent most recessions in the future, the rest of the industry seems steeled for the inevitable. At the 2019 Global Corporate Venturing & Innovation Summit in Monterey, Mark Boslet of the Venture Capital Journal interviewed me, Quinn Li of Qualcomm, Bonny Simi of JetBlue, and other professionals from our community, to discuss how corporate investors (“CVCs”) might be affected in the next economic down cycle.
Boslet wanted to discuss which programs might pull back or shut down, and he was keenly attuned to our industry’s post-traumatic stress disorder:
Corporate venture suffered a tarnished reputation in the wake of the dot-com crash, when dozens of programs exited the business and left portfolio companies short of follow-on capital. Whether a similar exodus, and stain, follows the next economic downturn is a hot question”
For many, the emotional flashpoint that signals an economic downturn is a stock market crash. Morningstar stock market data from 1926 to 2014 shows that a typical bear market lasted 1.3 years with an average cumulative loss of 41%, while annualized losses for bear markets range from about 20% to nearly 50%.
In a downturn, all investors have a natural tendency to pull back. Let’s examine how the three main types of venture capital investors — angels, institutional venture capitalists, and corporate investors — are affected by a bear market:
Let’s start by looking at how angels are affected by a market crash, assuming the DJIA and NASDAQ Composite lose value according to Morningstar’s predicted averages. Modern portfolio theory assumes the typical investor keeps 50% of her net worth in public equities, but wealthy investors target approximately 34% of their net worth in stocks, partially because angels have the resources to make venture investments and other risky allocations. Cash and equivalents are 24% of a typical angel’s net worth.
In our hypothetical bear market, the angel investor loses 13.9% of her net worth. Angels may fund their venture capital deals with proceeds from other startup investments that have been sold or gone public, rolling these into new investments. Or they may liquidate stocks at a high price and use the profits to invest in startups. Neither of these is a great option in a downturn, because a) few venture investments are getting liquid at attractive prices during a bear market, and b) stocks are now low, not high, so unless the angel is ready to take a loss, the strategy of liquidating stocks is less applicable. The angels still have cash, but are likely “feeling the pinch” and may be careful about making new commitments to long-term, illiquid investments. As a result, many angels pull back from new investing.
For angels, it is the reduction of value in liquid assets that drives retrenchment.
- Institutional VCs
Institutional venture capitalists are impacted not by reduction in value of liquid assets, but by asset allocation rebalancing . This is because venture capital funds get most of their money from pension funds, university endowments, and other institutions. These institutional investors, known as limited partners, maintain explicit target allocations for what percentage of their assets belongs in risky investments like venture capital.
Prior to starting Touchdown Ventures, I spent the bulk of my career as an institutional investor. My anchor limited partner was CalPERS, the world’s largest pension fund, which publishes its target allocations. The most recent published data specifies 46% in public equities and 8% in private equity, which includes venture capital. These target allocations are fairly typical in my experience.
Target allocations are thrown out of balance in our hypothetical crash. Because the value of the public stocks decrease by 41%, the value of the entire portfolio declines by 18.9%. As a result, other assets make up a greater percentage of the overall pie. If there is no change in the value of a pension fund’s private equity holdings, they will automatically compose 10% of overall assets, instead of the target 8%. Pension funds will then often freeze commitments to new private equity funds in an effort to rebalance its target allocations.
When limited partners signal to VCs that they shouldn’t feel too secure about the next fund, VCs naturally slow down. Without limited partners, institutional VCs are out of business. Because most venture funds are designed as ten year entities, we don’t immediately see a wave of firm closures. Managers who never receive another allocation from institutional limited partners following a crash must still manage out their funds.
This rebalancing has nothing to do with the performance of the venture capital industry. Perversely, the better the private equity industry performs after a public market downturn, the more institutional limited partners would need to cut back. The pension funds and other institutions are simply managing the relative values of their various asset classes, and the performance of the public market can directly impact capital supply for future VC funds.
- Corporate VCs
How about corporate venture capital funds, which have been so maligned as quickest to lose their lunches at the first sight of blood?
For corporations, liquid asset value is relatively unaffected by a stock market crash, and target asset allocation rebalancing is mostly irrelevant. For many corporations, balance sheet cash is the primary source of funding for CVC programs. Cash is minimally impacted by stock market crashes, and few CVCs have outside limited partner investors that worry about rebalancing. Corporate investors are actually in a great position to maintain their CVC programs following a crash.
So why might corporations lose their appetite for venturing activity following a crash? Psychological effects will be real. Poor employee morale, declining sales growth, and reduction in profits that could cause a future reduction in cash might all contribute to a short term mentality, and venture capital requires a long term perspective.
As a result, some CVCs will indeed decide that they do not have the stomach for long-term investments when the economy crashes—and it would benefit our entire industry to consider how to manage these transitions professionally, avoiding the reputation damage that resulted from what was perceived as an “exodus” in the last downturn. After all, if you are driving on the Autobahn and would like to be on a different road, it’s a good idea to slow down, pull over, and check your map. Few would open the door, roll out of the driver’s seat, and expect good results.
Most importantly, CVCs should recognize we do not need to rush for the exits when the next crash occurs . In fact, corporates might have the greatest structural opportunity to stay in the game when it is most advantageous to do so. As Mark Boslet wrote, “There are good reasons to believe the VC community is more durable this time, and that corporates better understand the need for innovation and the way to structure investment efforts for longevity.”
Commentary is the author’s opinion and is not investment advice. We make no representations as to accuracy or completeness and have no duty to update. Past performance does not predict future results.
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