VCs have to save themselves from themselves

Let me start on a lighter note. The VC mark-ups are like post-dated cheques. They are first issued by the start-ups to the VCs and then issued by VCs to the LPs. The receiver is initially very happy to smell the cheque and see the large amount on the cheque. However, the receiver can encash the cheque only at a future date. A lot can happen from the time the receiver gets the cheque to the receiver encashing that cheque. Let us say the issuer, in this case a VC funded start-up, has been facing financial stress due to funding winter as the business is not bringing enough margins and cash flows to survive. The issuer, in such a situation, now requests an extension to the original date of encashing the post-dated cheque. The receiver, a VC fund, cannot bear this anxiety anymore, as he / she has issued back-to-back post-dated cheques to an LP up in the chain. Fed-up, the receiver, a VC fund, goes to the issuer to assess the reasonability of an immediate pay. The issuer makes an offer at 40% of the original amount as full & final settlement! Many of the VC funds, who were aggressive in 2021, are experiencing this now. When access > diligence and financial engineering > quality of growth, obviously at some point in time, the model will break, and the excessive gains must be given up.??

Indian venture capital (VC) industry has experienced two phases of exuberance in the last decade ending 2022. In the first phase, 2015 & 2016, VCs were apparently investing in category creators and valued them as if they had winner take all characteristics. Well over half a decade since then, VCs must do an honest assessment of how their assumptions for their portfolio start-ups and category has panned out. In hindsight, we may have declared the winners and the winning team too soon by simply blessing them with abundant capital. In the second phase, 2021, VCs were investing as technology intensity across categories was pulled forward due to Covid-19. However, in many of these categories, we may have extrapolated from one historical context of 2021 and as a result overestimated what can be achieved in the near term. In hindsight, we may have invested in too many, too soon, too much and at too high a price. Cheap capital made everything look very easy in the venture space in the last few years and hit its peak in 2021. The $ net IRR for bottom quartile VC funds, as per Preqin, for vintages 2016, 2017 and 2018 (for US VC funds) are tracking in the range of mid to high teens. Not bad for what sounds like bottom quartile VC funds when combined with less volatility. This up-trend is observed in Europe and ROW too. It will be reasonable to assume the same being true for Indian VCs as well. The elevated returns for bottom quartile VC funds led to overall increase in capital flows, chasing more ideas and birthing many more founders. The elevated returns for bottom quartile VC funds had created an illusion that they have superior quality of deal flow and disciplined process resulting in superior investments. I have doubts on all the three and unfortunately, it will take a while to show-up. They, however, distort the marketplace, temporarily, across the value chain of inputs in the venture ecosystem – quality of start-ups being funded, valuations being offered, talent costs, customer acquisitions, among others. I am afraid, many of these investments will not be able to survive the ongoing funding winter and will end up returning less than the invested capital (principal). The top quartile VC funds will also give up excessive gains but the same when it happens for the bottom quartile it will be disastrous as they will struggle to return even 1.0x of invested capital!?

I have outlined brief observations during these exuberant times as below.

In 2021, the more risk you took, the more you were rewarded as a VC. To be able to exploit the ongoing market dislocations in 2022 and 2023E, as a VC, you should not have been fully invested in 2021 trying to maximize your gain. The biggest test now will be to hold the portfolio at full valuations over the next 18 – 24 months and higher likelihood that the portfolios have subdued demand outlook for the near term. Further, the rising cost of capital has materially deflated the magnitude of a winner in a VC portfolio. The 50x winner in the portfolio may look more like a 10x.?The 10x mark-up is still awesome, provided it is held in a right sized fund and the ownership in such a winner is material to the fund level returns. However, in 2021, many VCs raised more than what could be profitably deployed in their strategy / stage and were not disciplined about initial ownerships.

We must recognize that the two biggest sources for recent elevated returns was the presence of eager later stage investors willing to pay survival premium and scarcity premium. Both these sources are fast disappearing, certainly the scarcity premium has not played out well for recently listed internet stocks. In my view, the reversal to the mean would be when investors reframe their valuation models to give higher weightage to execution premium and for that they must reasonably assess “what it takes” i.e., the execution required. The current slowdown will unlock the most precious asset, the founders’ bandwidth. The wise founders will allocate this time in customer conversations and validation, extracting organic growth and demonstrating operating leverage. I already see founders shifting focus from relative performance benchmarking to focusing on absolute performance i.e., to deliver efficiency gains and improve trajectory of internal operating metrics. Select few may choose to go on offense too if their unit economics is proven and has the backing of their investors. 2023E will be a pivotal year where we should see wide divergence in the operating performances of start-ups and VC funds, and it will determine what gets funded in the future.?

(Disclaimer : Views expressed are strictly personal)