Venture capital funds have been overly eager to invest in tech start-ups, and now they’re facing the consequences. But market correction can only be a good thing, writes Mikael Johnsson
The past decade saw an unprecedented inflow of investment into the tech sector, fuelling companies geared towards growth at all costs. The looming global recession will bring an end to start-ups that have been growing rapidly off shaky foundations and huge losses for venture capital that over-invested in tech. But it’s not all bad – there are still plenty of opportunities for those who focus on the fundamentals.
As Warren Buffet famously said, “a rising tide floats all boats – only when the tide goes out do you discover who’s been swimming naked”. This is pretty much what’s been happening in the tech sector.
In a market where money was abundant, investors became overzealous. Between 2010 and 2021, the amount of venture capital invested into tech start-ups in the UK increased from £1.2bn to a staggering £29.4bn. Companies were seen as successful if top line growth was high.
But in a world of high inflation, extra-high interest rates and geo-political tensions, the availability and cost of capital have changed dramatically. Investors into venture capital funds can now find yields in less risky asset classes. The asset allocation decisions that saw inflows to VC funds increase by a factor of three during 2021 compared to the 10-year mean are now reversing rapidly, reducing the amount invested into these funds and therefore into start-ups. In this new environment, VC firms will have to moderate their rate of investment to make funds last two to three times longer as there simply isn’t sufficient available capital from investors to allocate into VC funds at the previous rate.
Last year we saw VC investment into UK start-ups drop by nearly a third. Now we’ll probably see a dramatic decrease in the amount of money invested into VC as an asset class. A new report by Prequin has found that VC fundraising dropped 65 per cent year-over-year in the fourth quarter of 2022 – the lowest total for that quarter since 2013.
While some are hopeful that an excess of dry powder in VC funds might revive the market, this is, to a large extent, wishful thinking. VCs will be playing it safe, reserving funds for promising companies with proven business models already in their portfolio. They’ll also dip into their capital reserves to save those start-ups in their portfolio that are worth continued backing. The first VC firms are already throwing in the towel on some of their funds, returning the capital to investors and downsizing their investment teams in reaction to the new market realities.
This money isn’t just sitting around ready to be invested at any moment. VCs get funds from limited partners, whose own funds depend on liquidity received from realising their other investments. Limited partners have invested at an unsustainable pace into venture funds during the last few years. There is also a decreasing appetite for acquisitions and M&A due to the global recession. So there is much less capital returned to investors that can be re-deployed into new VC funds. The capital that eventually does get returned can now be deployed with decent yields in less risky asset classes than venture capital.
But the market correction can only be a good thing. Granted, it means loss of money and businesses, but it will separate the real companies from the pretenders. In the past year alone, we have seen multiple companies, including double and even triple unicorns, resorting to several rounds of layoffs to manage their costs following untenably speedy expansions.
There will be a newfound focus on building and investing in quality businesses with strong foundations. Learning from past mistakes, base principles such as capital efficient revenue growth, customer satisfaction and long-term sustainable differentiations will now be what’s significant for businesses, rather than how much funding they’ve managed to raise.
There are so many advantages to this. Tighter budgets mean unnecessary spending gets curbed. Companies are forced to innovate to find the most financially efficient way to run their business. Many start-ups will reevaluate their offering, and survive the culling of resources. All of which will create a host of companies that deliver differentiated and sustainable value – something much more appealing to investors in the long term.
While this more pragmatic approach might mean a start-up doesn’t see a high valuation for several years, especially in this climate, VCs shouldn’t be deterred. Instead, those that focus on the fundamentals, remain patient and invest with historical average valuations in mind have a chance to thrive in a world where money is scarcer and competition less fierce.