Beyond the Coronavirus Fog
The current coronavirus pandemic has created one of the biggest challenges of our generation. At Eudemian Ventures, we have tried to put things into perspective and make sense of what the “new world” means from a public health, economic and market perspective and what role technology and venture capital play in it. While acknowledging the current grim situation, we also feel that it is important to see through the fog today and uncover tomorrow’s new sunrays of opportunity. Here are our views.
1. Perspective on the Coronavirus-Pandemic
Since it is the very nature of global pandemics to evolve rapidly and create complex ripple effects impacting many aspects of the economy and society, views expressed here may become outdated quickly, but we will nevertheless attempt to provide a perspective on the current development and likely future scenarios to unfold. However, we will do so by relying on expert analyses referenced below rather than claiming a unique, but largely unfounded, point of view.
For a general assessment of the public health situation, we would like to refer to the most insightful article we have come across over the past few weeks. It can be accessed here and goes an important step beyond the prominent paper published in March by the Imperial College London, which has guided the decision-making of several heads of state in Western countries.
The analysis concludes that the severity and timeliness of measures taken by policymakers will dramatically impact the eventual outcome of this pandemic. If the “hammer” approach is taken in time with drastic and early “suppression” measures like in countries or regions such as China, South Korea, Singapore, Taiwan, Austria or the State of California, it seems possible (and is partly already proven) that the virus can be largely contained over a period of 3–7 weeks, even if the eventual conquest of the virus will likely take until next year when a vaccine should become available.
If, however, politicians go for what we could call a “velvet glove” approach only trying to mitigate (like we have been observing in the UK, Sweden or in the US at a federal level) or even deny the problem (like in Brazil until very recently) or if they are unable to properly enforce suppression (like what will likely be the case in very poor regions), the pandemic could run its natural course which would infect a large percentage of the population over a 2–3-month period and likely lead to high average mortality rates of 5% or more because of health systems collapse.
Given these very different scenarios, it seems likely that this pandemic will unfold in different ways in different regions like it has already done so far. However, from a Western countries’ perspective, it appears that we will see the apex of this outbreak during Q2 2020 regardless of which scenario unfolds. While the timeline may be similar, the eventual outcome and human tragedy would be very different in these two scenarios.
The best case “hammer” scenario would likely result in hundreds of thousands of global deaths — a toll comparable to that of the seasonal flu which claims up to 500K lives worldwide over the course of a year. By contrast, the “velvet glove” scenario could potentially claim tens of millions of lives or up to 1% of world population.
While anything resembling a worst-case scenario in this case would be unprecedented in our life experience, it would not be for humankind. Past pandemics like for example the Antonine Plague (165–180 AD) or the Spanish Flu (1918–1920) killed up to 5% of the population, whereas the Plague of Justinian (541–542 AD) or the Black Death (1340–1350) killed up to 50% of the population. In a more contemporary context, approximately 20M people die every year from cardiovascular diseases. More than 30M people have died from HIV/Aids so far.
While this pandemic still has the potential to reach historic proportions, it appears likely that the outcome will be much less drastic in our fortunate age of understanding viruses (e.g. the flu virus that caused the devastating 1918 pandemic was first isolated in 1933!) and of being able to deploy unprecedented human, financial and technological resources to develop tests, treatments, cures and vaccines to hopefully win this battle over a period of months, not years or a decade like in the past.
However, putting things into perspective is of little solace in this case. But there is reason for hope. Based on the article referred to above and current actions taken by most governments, a realistic scenario far from the worst case could look like the following from a “Western countries” perspective:
A “very tough” Q2 with a peak in infections and deaths and a string of very bad news, a “turning of the corner” past the peak as different regions get control over new infections, a progressive lifting of restrictions from late Q2 / early Q3 and return to a “more normal” life for most of us followed by a sustained recovery from Q4. There is even additional well-grounded hope that positive developments can be accelerated by potential seasonality impacts on the virus (similar to flu seasonality), rapid expansion of testing and treatment capacity, potential repurposing of existing drugs to alleviate symptoms and vaccine development and approval at record speed.
2. Perspective on the Economic Impact
Depending on the severity and timeline of the possible pandemic scenarios playing out (and their complex ripple effects into the financial systems, government and corporate debt levels, unemployment rates, etc.), economists are currently trying to assess whether we will get a V-, U- or L-shaped economic recovery.
“V” would mean a quick recovery from the sudden shock starting from Q3 that would allow governments and central banks to properly “bridge” the temporary freezing of economic activity without severe long-term effects on bankruptcies, defaults or unemployment rates. In this case, economists currently predict a relatively mild recession in 2020 and strong GDP growth in 2021. “U” would mean that longer-term ripple effects would come into play with a medium-term reduction in investment and consumer spending, which may delay recovery until Q4 or into next year. In this case, economists currently predict a more severe recession in 2020, but GDP growth in 2021 again, albeit at a slower pace. “L” would mean a protracted macro-economic impact that would look more like a great recession or depression and only allow for a later recovery.
While most economists currently predict historically unprecedented but temporary economic contraction and unemployment spikes in Q2 2020, they are largely optimistic about the potential for a V-shaped recovery from Q3, which would be in line with the realistic pandemic scenario described in the previous section. The current consensus seems to be that an “L” seems unlikely, because, unlike in a war, the core capital stock and labor force remain intact throughout the pandemic.
We don’t know which scenario will eventually prevail, but we do know that each crisis, however severe, ultimately results in some winners and losers. From an industry perspective, we have already seen some mass economic casualties in travel and transportation (airlines, cruise lines), hospitality, or live entertainment to name but a few. On the other hand, there are also significant winners like e.g. in home-entertainment, work-from-home or biotech, many of which are driven by technology.
While we were already in the third major historic revolution to change human life before this pandemic, the first one being the agricultural revolution about 10,000 years ago, the second one being the industrial revolution about 200 years ago and now the digital revolution, the current event will likely accelerate the latter even more.
The world will forever draw its conclusions from this traumatic experience and we do not expect that it will fully revert back to the “old ways” even once this pandemic’s smoke has cleared. Many of the “new ways” of living and working will be fundamentally different and underpinned by technology to a large degree. Apart from biotechnology, digitization can and is expected to play a major role in reigning in the current pandemic and in preventing or mitigating future ones.
3. Perspective on the Market Impact
Uncertain times may naturally result in questions regarding how an investor should think about the daily gyrations of the stock market and how to balance allocations across the six main types of asset classes (stocks, bonds, cash, real estate, private equity including venture capital and commodities). Given the pervasiveness of the current crisis, no market or asset class remains unaffected, but the effects on them are expected to differ substantially with both positive and negative impacts.
We want to specifically provide a perspective on public stock markets and private equity markets, which include venture capital as a distinct sub-segment. We also want to shed light on the role venture capital can play in minimizing portfolio risk in times of crisis and market turmoil.
a. Public Stock Market Impact
In line with the unprecedented scale of this “Black Swan”-event, major global stock markets have lost between 30–40% of their value at record speeds over the past few weeks before staging an initial recovery more recently. To also put this into historic context: Of the 13 bear markets the S&P 500 experienced since 1929, the average pullback from the previous top reached amounted to 39.9% (Source: S&P Dow Jones Indices). Unless the current situation becomes a Great Depression like in the 1930s, it seems likely that the public markets are not too far from their bottoms or may have already found them.
In general, we can reasonably expect volatile market swings driven by daily developments to persist in Q2 until uncertainty about the full health and economic impact including their ripple effects subsides. Within this context, it is helpful to remember a frequent historic pattern in public markets: The first reaction to external shocks is mostly a “flight to safety” where riskier assets are sold indiscriminately and the negative trend becomes self-reinforcing.
The initial sell-off is frequently followed by a period of very high volatility as long as uncertainty prevails, but once the full negative impact becomes clear, markets often begin to recover 6–12 months before the economy or underlying earnings do. The reason for this is simple: Markets discount future cash-flows (and their potential) for a period of 10–20 years, which means that even horrific GDP numbers or corporate earnings for one year have less of an impact on valuations than frequently assumed.
From a “winners and losers” perspective, another typical characteristic of public markets is to quickly discern between them after the initial indiscriminate selling is over. As an example, we had mentioned airlines as being losers and work-from-home technology companies as being winners before. While major US airlines like United or American have lost more than 50% of their value from late February until late March, video-conferencing leader Zoom has gained 50% in value during the same time. With a market cap of more than $30B, Zoom was suddenly worth more than 3x of what both traditional airlines combined were valued at.
b. Private Equity / Venture Capital Market Impact
The impact of the current crisis on private market valuations is expected to be different for Private Equity, Late-Stage Venture Capital and Early-Stage Venture Capital.
Private Equity and Late-Stage Venture Capital will be affected in similar ways by the almost certain slowdown in IPOs and M&A transactions limiting exit options. The same can be said for average valuations, where these two categories are expected to show high correlations with the public stock markets. Secondary markets data on Late-Stage VC suggests for example that valuations will come down as much as 30–50%, which we had anticipated already before this crisis though given unsustainable valuation inflation over the past few years.
Given the liquid nature of public markets, they tend to show much more violent swings in valuations with shorter durations between asset deflation and inflation. The private markets in turn are typically less volatile, but average valuation changes tend to persists for longer periods of time. As a result, we expect early-stage valuations to be approximately 10–25% lower (depending on sub-stage) over the next 12–18 months compared to last year’s levels.
From a “winners and losers” perspective, private markets can be even more ruthless in discriminating between them than public markets. Just like in the public markets, private equity and venture backed companies with exposure to physical consumer interaction will see a tough situation right now. But unlike public markets, other aspects of winners that we believe are more prevalent in private markets, and especially venture capital, are the liquidity situation, leadership strength of only a handful of people and the quality of investors in a company, with top-tier investor presence on the cap table expected to significantly increase chances of making it through crisis periods.
c. The Role of Venture Capital in Minimizing Portfolio Risk
Various data sources show that the correlation between the public stock markets and venture capital is low. A study from Invesco of quarterly returns over the 25-year period 1990–2014 resulted in the following correlations between large-cap public equity and other asset classes: Private Equity (0.46), Venture Capital (-0.06), Real Estate (0.13), Bonds (0.13). Venture Capital shows the lowest correlation to public equities among all major asset classes.
Furthermore, stock market annual returns can be strongly negative from one year to the next like we have seen this year and in many past bear markets. Venture capital returns by contrast tend to fluctuate much less and benefit most from weak stock markets as they drag down private market valuations over time. In fact, funds that start deploying capital shortly after major market crashes tend to perform best:
Figure 1: 2007–2017 Performance Comparison — S&P 500 vs. US Early-Stage-VC Index (Source: Yahoo Finance, Cambridge Associates)
Figure 1 shows that while the S&P 500 crashed between 30 and 40% during the 2008/2009 great recession, venture capital returns still stayed in a positive 10-to-20%-range during this period since they generally average out over multi-year periods. Funds started in 2010 right after the downturn in fact had the best average annual Early-Stage Venture Capital returns of the past decade with more than 30%. Lowercase Capital Fund I, reportedly the best performing venture fund in history returning more than 200x of capital invested, started in 2009 and ramped up deployment in 2010 (Source: Fortune). Jason Calacanis, one of the most successful seed investors in history claiming an angel portfolio return of 1,000x in one of his recent books, also started deployment during this period.
Knowing this, Yale Endowment, one of the three largest US endowments with assets of more than $25B and arguably one of the most sophisticated and successful university and college investors achieving average annualized returns of more than 11% over the past 20 years, kept increasing their VC allocation during the great recession. It more than doubled VC exposure from 5% in 2008 to 10.3% in 2011 contributing significantly to their outperformance of endowment average returns of 6.5% over the same period.
To summarize, we expect Early-Stage Venture Capital funds early in their deployment cycles to benefit significantly from the new market reality, while funds late in their deployment cycles and/or Late-Stage Venture Capital or Private Equity funds are expected to be adversely impacted by severe valuation contraction and limited exit options at least in the near term.
So, while there is still a lot of uncertainty around the eventual outcome of the coronavirus pandemic and its economic effects, all those who focus on the next generation of digital leaders and have stored enough “dry powder” should find the current market environment to be very beneficial, particularly over the next one to two years. It may pay off to imagine the sunrays while still being surrounded by fog.
Authors
Raoul Felix Maier, Founding Partner @ Eudemian Ventures
Ilan Pragaspathy, Venture Partner @ Eudemian Ventures
Legal Disclaimer
This article is not an advertisement, serves general information purposes only and includes the authors’ personal opinions, beliefs and viewpoints. Neither the authors nor Eudemian Ventures, LLC make any representations or warranties of any kind, express or implied about the completeness, accuracy, reliability or suitability of any information or viewpoints provided. Nothing in this article should be construed as professional or legal advice and no investment, business, legal or any other decision should be based on it.