Is VC Investing today’s safe-haven?

Introduction – another one bites the dust

Nearly in my 25th year in my career and yet another very volatile period! The 7th one to be precise. So when I was asked this morning if it was a good idea to develop a VC investment execution platform at this moment in time, I could not say anything else than it is.

For a very simple fact: VC, unlike private equity or other alternatives, is about building businesses and creating jobs to solve problems. It is about fundamentals, not financial engineering i.e. creating complex financial mechanisms to juice extra profit by indebting (aka leveraging) a business. As such VC is, by definition, the long-term hedge: aren’t the biggest tech successes such as AirBnB, Uber, Google[1]… launched at time of crisis and uncertainty?  

Crisis requires creativity. Entrepreneurs enable this creativity as Schumpeter so well described: They are those who use new combinations of resources to create new products, services, means of production… As my former HBS Entrepreneurship Professor, Lynda Applegate says: entrepreneurs make it happen, whatever it takes. Plus, secular shifts such as climate change, economic inequality, educational needs, population ageing will not disappear overnight simply because investors lose their nerves. Therefore, why miss out on it at an earlier stage. As Nathan Rothschild once said fortunes are made by buying early on and selling too soon.

A- The Value of VC Investing

This is indeed what VCs are about. They play a critical role to filter out those hopefully more able to perform and help them grow one way or another by bringing the talents and material support needed. Since VC is the asset class where past success ranking is a positive indicator of future performance ranking, one can argue that the higher quartile VC shall be able to keep on performing as evidenced by the chart below.

Of course, one may very legitimately argue that I am biased. I indeed am! I promote VC and, as an economist by education who identifies with the Austrian traditions, what else can I write. How can I argue VC investing is a safe-haven when launching start-ups is a very difficult and risky endeavours with naturally high default rates that only a handful successes over-compensate for?

We all agree that investment return is the expression of value changes. A company’s value[2] is the sum of its expected future flow divided by a risk factor which financiers call a discount factor. Such factor is equal to (risk free rate + inflation + risk premia) with risk premia = f(liquidity risk, growth prospect, failure risk). Thus we must question VCs’ ability to help increase the numerator’s value (i.e. top cash-flow increase) and/or decrease the denominator (i.e. mitigate risk premia factors as they can neither control the risk-free rate nor inflation fully).

B-  A bear market?

With the current environment, more and more people talk about a bear environment for VCs. A time of lower valuation as demonstrated below by the graph from Carta:

This is creating some behavioural changes with some VCs embracing transparency about the way they interact with their portfolio companies in such an environment (see here).

Is it however Armageddon or a great entry point? Does it however require a revised allocation policy or justify a complete stop on allocating to VCs? Successful VC allocation is not about picking one fund but build a diversified yet focused allocation to top decile VCs. It is not about allocation randomly to one vintage but diversify across multiple vintages.

C-  Scenario analysis

Let’s thus look more closely at what one can, if not rationally, at least reasonably expect from VC in these volatile conditions.

(1)  Stagflation[3]

This is the economists’ nightmare: high inflation and no growth at best. Something that seems plausible as commodity prices hikes and supply-side constraint pushes prices up whilst creating substantial unemployment. Something climate instability can reinforce. This environment is mainly negative for the values of assets that rely on credit such as bonds, property or leveraged buy-outs.

This is about being back the 1970s and early 1980s which still brought successful exits for VC investors and created some of today’s biggest companies: Apple, Genentech, FedEx, Microsoft, and Electronic Arts. 

It does not hinder entrepreneurial opportunities but rather seems to provide investors with lower entry points at seed stage and upward. VCs going for material opportunities, cash-flow growth should remain, which inflation may reinforce. With this in mind, an element to further assess would each GPs’ know-how to arbitrage growth versus profitability and whether this may justify longer investments periods.

(2)  High interest rates

A much less frightful environment than the stagflation one as there is still a quantifiable form of growth that remains superior to 0 in real terms, possibly making secular shifts more easily addressable than in a strict stagflationary context.

The value of assets whose financing requires substantial leverage would still suffer in the short to mid-terms before bouncing back onto a different levels of equilibrium. This will lower PE valuation the same way it will lower the value of real assets such as properties. Although they look like a good hedge against inflation, the influence of interest rate levels remains too strong on such asset values

As in stagflation, start-up valuation will remain lower in the short to mid-term thus offering a good entry point to start-up investors. There again, exit value may be better than what appears now, depending on the problem they tackle such as higher productivity, greater inclusion etc. And probably more attractive than other assets.

(3)  Geopolitical crisis

By geopolitical crisis, we mean war. Not just a few regional wars but multiple conflicts that amount to something similar to a form of world war. The 1980s-like cold war but with more physical conflicts than those experienced in developing countries back then.

De facto, we are talking about an economy of wars where products and services depending on consumers’ confidence and physical factories will clearly suffer substantial haircut. Will there still be entrepreneurs? Probably but rather organised in a parallel sort of economy and less transparent sources of financing.

Even more than for stagflation or inflationary environments, conjecturing about such future is far less purposeful as no one has a true idea of what such a conflict would be like as well as of its social consequences. Unparallel public policies will have to be put together, taking what it takes to deliver a battle. That would likely require the evident help of entrepreneurs, innovators as well as established industrialists. Warlike VC then.

Conclusion

Therefore fearing to allocate to top decile VCs because of the current environment is a tragically missed opportunity. VC is an excellent economic hedge in the long run as it is about designing the economies of tomorrow whilst addressing today’s challenges. Key secular paradigm shifts we are faced with are not disappearing.

Entrepreneurs will not cease to exist. They will remain, embodying with full force the principle of creative destruction regardless of any economic context.

This is why VC is about long-term fundamentals whilst betting on a variety of innovations whose success at solving economic contingencies remain contingent, therefore reinforcing the principle of a portfolio across top decile GPs, sectors, and vintages. With that in mind today’s environment offers an even better entry to VC investors as well as GPs. As Nathan Rothschild would have said: “fortunes are made by buying low and sell too soon”. That is what VC is about. Loyal to his family’s tradition, VC allocation would be a massive part of his portfolio as hotels and railways were back in the mid 19th century, a period of greater instability than now. Let’s do us a favour by not  pulling the plug on what keeps us all going.

Jean-Bernard Tanqueray

Additional readings

Importance Of Venture Capital In Portfolios | Russell Investments

Rethinking Venture Capital for Long-Term Institutional Investors

Venture Returns Outperform Public Markets Over Many Periods

We Have Met the Enemy… and He Is Us | Lessons from Twenty Years of the Kauffman Foundation’s Investments in Venture Capital Funds and The Triumph of Hope over Experience

Has Persistence Persisted in Private Equity? Evidence from Buyout and Venture Capital Funds

The persistent effect of initial success: Evidence from venture capita

https://www.sciencedirect.com/science/article/pii/S0304405X20300337

Craft Ventures: Operating during a downturn

[1] AirBnB was founded in August 2008; Uber in March 2009 and Google in 1998 during the Russian crisis

[2] https://corporatefinanceinstitute.com/resources/knowledge/valuation/valuation-methods/#:~:text=When%20valuing%20a%20company%20as,and%20(3)%20precedent%20transactions.

[3] https://www.tandfonline.com/doi/full/10.1080/00036846.2016.1176118#:~:text=formula%20to%20zoom.-,ABSTRACT,growth%2C%20hyperinflation%20and%20high%20unemployment.