The Current State of APAC VC

If you haven't read through this Twitter thread by QED Investors’ co-founder Frank Rotman (@fintechjunkie) on the seismic changes happening in venture capital right now, I recommend you do so. It’s incredibly insightful, and desite its obvious focus on the United States, I was struck by how much of it applies to Southeast Asia.

Frank's thread outlines the changes in the VC and startup ecosystems over the past few years, identifying three distinct phases:

1. The Acceleration Phase (2020 + 2021): This phase was characterized by an abundance of capital, rapid growth, and soaring valuations. The startup ecosystem was booming, and venture capital was pouring in.
2. The Correction Phase (2022): As macroeconomic conditions deteriorated due to factors like inflation, aggressive Fed tightening, and the Russia/Ukraine war, the public markets took a hit. This led to a shift in the private markets, where capital efficiency and profitability became the new priorities for startups. Additionally, consider the Denominator Effect and its impact on LPs, which forced them to re-balance their portfolios and reduce exposure to venture capital.
3. The New Normal Phase (Now and Beyond): In this phase, LPs are focusing on proven VCs, VCs are being more selective with their investments, disciplined founders are thriving, and marginal businesses are struggling to find capital. This phase is expected to reward disciplined investing behaviors among LPs, VCs, and startups, encouraging natural selection in the market.

So how does this apply to Southeast Asia?

• Much like the United States, early-stage venture in APAC has closely followed the Acceleration Phase and the Correction Phase.
• Many founders raised large rounds at lofty valuations from 2019 to 2021, particularly in hot industries such as digital brokerages, agritech, B2B SaaS, and marketplaces. I found myself saying no to more good deals in 2021 alone than in the previous ten years combined because the math wasn't mathing: potential returns couldn't justify the opportunity cost.
• Founders weren't solely responsible for this; they were enabled by valuation-insensitive investors who feasted on cheap capital. The jump in average fund sizes between vintages in the mid-to-late 2010s/early 2020s was remarkable and, to be blunt, unjustifiable.
• Both founders and investors assumed that another fund would always be downstream to pick up the tab. In fairness, they were right: late-stage funds, tourist VCs, cross-over funds, PE, and sovereign wealth all displayed a voracious appetite for leading the next rounds of sexy startups in sexy spaces.
• This triggered a positive (albeit destructive) feedback loop from 2018 onwards, where eye-popping paper mark-ups catalyzed company fundraising, driving mark-ups even higher. With meaningful DPI nearly a decade away, paper mark-ups became the standard bellwether for fund performance, ratcheting up the pressure on founders to grow fast and raise even faster.
• By 2021, the chasm between capital formation and startup formation was deeply entrenched in APAC, resulting in:

1. Accelerated deployment schedules
2. Increasing frequency of insider rounds
3. Over-indexing on first cheques (at the expense of tapping pro-rata reserves)
4. Breathtaking mark-ups.

• By the end of 2021, the venture capital and startup ecosystem was, in a word, structurally dysfunctional. (I remember catching flak for calling valuations "irrational" in December 2021; in hindsight, I clearly misspoke. I should have said "indefensibly stupid.")
• When APAC entered the Correction Phase in 2022, the effects were similarly staggering:
• Founders had to quickly, painfully readjust to the new normal: layoffs began in earnest around Q2 and continue to this day; growth-at-all-costs jarringly took a backseat to "cost rationalisation" and "revenue optimisation"; ambitious, region-wide plans gave way to far more humble goals like profitability, positive cash-flow, or simply survival.
• The impact on early-stage financing was particularly acute: insider rounds transformed from a sign of strength to an acknowledgement that the next round could not be taken for granted; small premiums turned into flat rounds, which turned into down rounds, and term sheets were renegotiated or even rescinded; additional downside protections were drafted, including penny warrant coverage, full-ratchet anti-dilution, >3x liquidation preferences, and more. This started in Q2 2022 and continues to this day.
• The impact on VCs was just as severe, albeit more opaque to the layperson. The negative consequences of accelerated deployment schedules, overweightage on first cheques, and reliance on mark-ups would be grudgingly acknowledged by the end of Q2, prompting a reorientation of fund strategy: the size and pace of new deals declined, and focus shifted back to existing portfolio companies. Insider rounds, extensions, and bridges aimed to extend company runways. However, by year-end, fear and desperation set in as external capital remained on the sidelines.
• The panic in APAC stemmed from two root causes: the destructive feedback loop between plummeting portfolio mark-downs and shrinking capital access (the inverse of the dysfunctional cycle of exploding investment mark-ups and abundant capital allocation that had dominated the industry in prior years) and the dwindling interest from limited partners (LPs), the institutional investors that financed these funds.
• As capital dried up, investments were marked down; mark-downs made it harder to justify financing these companies further, an already difficult task due to diminished reserves for many funds; this, in turn, reduced investment inflows even more. Company slowdowns gave way to shutdowns, accelerating the (unrealized) decline in average portfolio performance across the entire industry and recent vintages.
• The third, silent party, LPs, had viewed APAC as a tantalizing investment opportunity for the past decade, especially for those who missed out on India or China. As fund performance declined and global and regional sentiment shifted, so did LP appetite: perhaps APAC was not quite mature enough? As markdowns became more prevalent, LP interest and commitment to the region grew more tenuous. For investors planning a fundraise in the short-to-mid-term, or worse, those currently in the middle of a raise, this could be catastrophic.
• As a result, numerous funds in APAC and around the world find themselves at a critical juncture, facing a spectrum of less-than-ideal choices: salvaging viable investments from doomed ones and allocating remaining reserves accordingly; orchestrating smooth and not-so-smooth transitions through acquisitions, acquihires, mergers, or any other means that generate even middling returns but can still be framed as a victory; or letting portfolio performance naturally attrite, which would make any current or future fundraising efforts significantly more difficult. Good fund performance (e.g., 4x gross MOIC, or the top quartile of fund performance) is a non-starter for many at this point; returning what capital they can, from wherever they can, is all that matters now.
• It's interesting to note how similar and yet divergent catastrophic market changes can impact startups and VCs: for founders, the paradigm shift in market sentiment and its subsequent impact on capital availability is akin to driving straight into a wall at 120km/h; for VCs, it's more like a shipwreck, resulting in a slow but inexorable implosion in fund performance. Many are now running for the lifeboats, some are still rearranging the deck chairs, but the ship is still going down.
• So what does this mean? What do founders need to prepare for the remainder of the year and beyond?
• On average, it takes 8 years for a successful company to go from ideation to IPO. Statistically, there will be at least one downturn during that period when funding dries up. Reversals and recessions are normal; they are a part of every economic cycle. Unfortunately, APAC founders are now experiencing their first downturn, which might be the worst in a generation or more. Ironically, it comes after one of the longest boom cycles in history. Founders experienced venture capital at its headiest, and now they will see it at its harshest.
• The economic forecast is confusing. There is a high likelihood of a recession in the United States; most experts disagree on timing but agree that one is forthcoming. Some even argue that we're already entering one, or that we've been in a mild one that's set to worsen. Again: confusing. Uncertainty warrants caution.
• If the United States is set to enter (or prolong) a recession by the end of the year, be prepared for regional funds to remain conservative well into 2024. This is not to say venture rounds won't be done, but the compressed valuation multiples we saw in 2023 are likely to be sustained, and may get worse (e.g., the 10x revenue multiples commonplace in 2021 dropping to 5x or lower). Due diligence will take longer, twice as long or more for larger, late-stage rounds, but even seed rounds will close more slowly.
• With capital waiting on the sidelines and slow to deploy, capital conservation will be key. Growth can be tempered, growth forecasts amended, planned milestones delayed, all of it necessary and appropriate if it means you can extend your runway as far as possible. And if that means you have to raise flat or even down, that is better than the alternative. Up rounds are still possible in this environment, but that will now depend almost exclusively on the performance, growth, and financial health of the business; investor FOMO, competitors' valuations, or price insensitivity due to capital oversaturation will not figure into investors' valuation methodology in today's climate.
• One significant difference today is that the most important determining factor between raising a modest up round or a dramatic down round is the last round's valuation. If the last round was reasonably priced, it is certainly possible to step up in price; if the last round was not reasonably priced, that outcome becomes much less likely. Plan accordingly.
• Raise only what is needed. It should be abundantly clear that raising more than you need, at valuations you can't justify, is not the great deal you thought it to be. Raise only what you need, not what your competitor raised in 2021, not what your board thinks you should raise because they'd really like to sell the mark-up to their LPs, not what your ego thinks is a sexy number or because you don't think a down round is fair. Never forget, whether in good times or bad, investors always have downside protection; founders never do. Cheap capital still comes with strings, even during the best times. So raise only what you need. Raise. Only. What. You. Need.
• Become educated in alternative financing mechanisms or strategies that can help bridge the valuation gap between investor and founder, or reduce your dilutive burden. These include warrants, valuation cap tranches or step-ups, performance-based ESOP rewards, even hybrid pre-/post-money ESOP adjustments. Anything that helps tie valuation or ownership increases to performance is an easier sell to investors.
• As always, beware predatory investors. They are coming out of the woodwork. When in doubt, speak to other founders. Always speak to other founders. Always. Speak. To. Other. Founders. I can't stress this enough.
• However, a caveat: do not mistake genuinely predatory behavior with the industry-wide reversion to the mean for valuation methodologies: just because investors are no longer willing to underwrite the 20x revenue multiple of the boom years does not mean they're trying to cut you off at the knees. It means paying those prices is no longer justifiable to themselves or their LPs, either because the market has violently and mercilessly demonstrated that lesson or just as likely they no longer have the capacity to do so.
• There is absolutely no shame in preemptively shutting down the company. If you are a post-Series A company and you believe, deep down, that you don't have product-market fit, you're unlikely to find it in the foreseeable future, and the thought of doing this for another three years or more causes real physical or emotional distress (founder burnout, anxiety, and depression are deadly serious issues that deserve more attention and empathy), there is no shame in shutting down the company and returning whatever capital is left to investors. Often times you can even negotiate some kind of severance. In my opinion, this is a deeply personal decision and so should only be made by the founders; some investors may aggressively push you to do this (more on this later) but it's the founders that will ultimately live with the consequences of their decision, both positive and negative; it should be they who decide.
• There will be a sustained flight to quality deals; indeed, I'm still hearing instances of that happening even today, although rare. A quality deal would be one with a serial founder, or a founder with a strong technical or professional pedigree, in a space with a very large market size, attractive competitive or economic dynamics, and usually a validated business model. These founders will have an easier -- for emphasis: not easy, but easier -- time fundraising. Even rarer will be the founder that can actually command a high premium that harks back to the frothiest valuations of 2020 and 2021, but these kinds of rounds will be difficult to predict and even harder to deliberately orchestrate. Do not plan on being the outlier, plan for what is realistic and attainable given market conditions. There is an opportunity cost for every day wasted fundraising.
• A final, crucial warning: for post-Series A companies without strong product-market fit, or for those companies still sitting on a meaningful amount of capital in the bank, you are vulnerable. For those companies that are both: it is time to immediately focus on your board.
• Why is this the case? Because right now many funds in APAC are scared: they're scared fund performance will continue to decline; some are scared they may not be able to raise another fund; others are scared they won't be able to hit IRR or DPI targets. And when funds are scared, funds behave erratically. I do not say this to denigrate or dismiss; I've been a VC in Southeast Asia longer than most, so I obviously empathize with general partners and the pressures they're experiencing right now.
• But that awareness also helps me identify and understand what I'm witnessing now, and what I will probably continue witnessing throughout 2023: funds orchestrating unappealing deals or transactions that do not uniformly benefit founders or co-investors; funds renegotiating terms and agreements agreed upon months or sometimes years ago; or even shutting down companies outright. Anything and everything is on the table if it means returning even a small amount of capital to LPs and salvaging what they can.
• To founders, especially those I mention above: you better learn about boardroom management, and learn it quickly. Do everything to get your board in line, and ensure there is continued alignment with the company and you as the founder. That means you cajole, persuade, compromise: talk about what you've accomplished, what is going well, what isn't and how the board can help. Fix whatever needs fixing, and over-share and over-communicate what you've done and what you plan to do. Sell your vision, your story, and why you’re the right person for the job and how getting through this downturn will ultimately result in a stronger company, a better competitive landscape, and a meaningful return for all investors. If this sounds like a pitch, well, that's because it is. You have to pitch to your board again and again and again because your board, whether they admit it or not, is scared.

You're used to leading your company. You better start leading your board.