What Happens to VC in an Economic Downturn?

I was recently talking with a close friend of mine about the U.S. economy and he asked me how an economic recession would affect the venture capital industry. He works in the heavy equipment leasing industry and he was telling me that he’s beginning to see some companies postpone capital spending on construction projects because of concerns about the economy. I always enjoy hearing his perspective on the macro economy because he has an “on-the-field” perspective of what many of us read about in the papers. 

When the yield curve inverted in August of this year investors were naturally cautious. The threat of slowing GDP growth, tightening credit markets, and inflation is enough to make anyone antsy. In addition, the Federal Reserve has cut interest rates three times this year, the latest of which occurred today, lowering the Federal Funds rate to a range of 1.50% to 1.75%. Reserve Chairman Jerome Powell justified the rate calling it a “midcycle adjustment in a maturing economy.”  What’s odd about the current state of the economy is that there are signals that suggest we’re headed into a recession and there are signals that suggest recessionary concerns are overheated. For example, while GDP has slowed to 1.9%, many on Wall Street estimated it would be slightly lower. Also, consumer spending remains robust and unemployment remains low at 3.5%, which are both positive signals.

If a recession were to occur then it’s likely there will also be a slowdown in the pace of venture capital funding as well as a slowdown in the number of venture-backed company exits. A handful of high-profile, VC-backed companies such as WeWork and Postmates delayed going public in 2019, with Postmates stating “market conditions” as the primary reason for their delay. On one hand, some argue that market conditions are ideal for companies seeking to go public. And on the other hand, there are others that say companies with high-priced valuations and low prospects for near-term profitability should be concerned. 

The venture capital industry tends to move at a moderately different pace than the public markets, so if a recession does occur the negative effects could be slightly delayed. Despite the concern of a possible recession, venture capital firms continue to raise record amounts of capital. According to Pitch Q3 NVCA report, VC fundraising is on pace to match the $30+ billion mark achieved in each of the past five years. The bulk of the capital raised has gone to a smaller number of larger VC funds, as evidenced by the reduction in the number of closed funds in 2019 (162 funds so far) compared to number closed in 2018 (290 funds).

When it comes to VC exit activity, the majority of VC-backed companies exit via merger or acquisition. As such, if a recession occurs it’s likely acquirers will reduce spending thereby causing a slowdown in VC-backed exits. This then could lead to reduced private-market valuations amongst companies seeking to exit in a less robust market environment. But I’m curious to see how this plays out in the long run especially as larger investors like Softbank and large PE firms enter the VC market and provide liquidity by buying out early stage investors. I also wonder if direct listings will rise in popularity amongst late-stage technology companies.  But given that there are very few recent examples of companies listing directly, it’s hard to predict how fruitful this could be for investors.  

The public and private markets are very frothy, and this is likely to persist for a while. If a recession does occur the venture capital industry will be impacted right along with everyone else, although the impact might not occur in lockstep with the public markets as some might expect. The big question is, what should people do about it? Personally, I’m a big believer in diversification and not attempting to time the market. At our company’s annual meeting last week, I had a slide in my presentation that highlighted a number of companies including SpaceX and Airbnb that were brought to market during a recession. With that being said, even though it’s difficult to predict exactly what will happen in the public or private markets, it’s important to understand what’s going on even if we can’t control every aspect of it. 

Cheers – KM

Photo by Lee Weng on Unsplash

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