The New Normal for Growth Fundraising and Investing
Market Environment: The global downturn has led to significant business stress and nowhere is this more evident than in earlier stage businesses. Dramatic declines in revenue for start-up firms, many with little or no profitability means companies are draining cash reserves with each passing day. Clear survivors fall into two camps: those companies and businesses that are benefitting from the crisis and those which have adequate cash reserves or access to finance to survive the downturn.
The lens of attractiveness may now change. We think the downturn will sharpen investor focus on profits, not just growth at any price. Proven business models that show resilience through the crisis are likely to be favoured. Management teams who can cut costs, lower the cash burn, maintain the relevance of the customer proposition and keep employee morale high will define the new leadership talent. Confidence and communication skills of founders will also be key differentiating qualities.
Lofty pre-crisis valuations needed to adjust, and founders and their VC investors are well-aware that ‘nose-bleed’ valuations are now a thing of the past. New financing rounds are likely to experience a significant downward adjustment in both absolute terms, and from the last round. The downturn will likely mark the end of one venture capital cycle and the start of another. In our experience, private market valuations take longer to reflect the new recessionary environment than public markets. As a result, we anticipate many of the best ‘price’ adjustments will start to emerge in Q3. A lot will depend on public technology stocks, as these are often a common (liquid) proxy benchmarks to use by comparison. The largest discounts will likely be seen in those companies who need liquidity to survive. The largest discounts will be available through secondary transactions as early employees and angel investors seek liquidity. The best deals will be off market, presented quietly to investors who have longstanding, trusting relationships with founders and boards. Alvarium’s vast network of investors and founders is critical in this regard.
Implications for pre-crisis vintages: Clearly, the new environment will be challenging for fully deployed funds with large portfolios as many companies in the most negatively affected sectors are facing revenue shortfalls of 50%-100%. Flat to down rounds will become the new normal across many sectors, even for top quartile companies. Many smaller VC firms will only have time to focus on existing portfolio companies.
In previous bear markets, we have seen venture capital deployment fall significantly for an extended period of time: in the 2008 crash, we saw venture investment in series A through C fall from $21bn in 2007 to a trough of $10.3bn.1 It is not unreasonable to expect a similar scenario today.
Vintage returns post crisis, however, can be outsized: The transition to this new venture cycle presents an exceptional opportunity to deploy cash, because lower entry-point valuations drive improved fund returns. Investors who retreated from venture capital during the Global Financial Crisis missed one of the best-performing start-up cohorts of all time, including Airbnb, Uber, Pinterest, WhatsApp, Stripe, Square, GitHub, Cloudfare, Nutanix, PagerDuty, Sendgrid, Twilio, Yammer, and Slack (in its original incarnation).
50% of Fortune 500 companies were founded in a recession or bear market, including Microsoft, IBM, GE, Disney, FedEx, EA and General Motors. Venture returns and vintages post crisis (typically defined as two to three years out from an economic recession) are typically 2-3 times the normal VC median return of 20%.2
Environments of stress favour larger funds and more established managers. Excellent later stage companies who might have been expecting an IPO or other exit now need to remain private for longer; they will seek the most experienced and cash heavy VCs. Founders also know that VC firms with reliable track records, are likely to be most trusted by limited partners. Experience and clout are needed to know when and where to commit funds at a time when many companies are stressed, and valuations are falling. Additionally, start-ups will likely increasingly favour VC firms that can add operational value.
We have already seen some impact in the data coming out of the US: for Q1 2020, investment funds below $100m made up only 3% of the total. This highlights how smaller and more emerging managers might already be struggling. Investors are likely to adopt flight-to-quality approach, opting for those VC managers with the longest and strongest tracks and larger capital bases.3 This is supported by data on the recent raisings of Lightspeed, one of the largest VC firms which has just announced three new funds, including its largest ever at $1.83bn.
New Normal Brings New Innovation
Recent events have demonstrated the importance of digitalisation trends ‘everywhere’. The immediate fallout from this pandemic has precipitated a rapid and dramatic shift in the way we manage our lives, both personal and professional. This pandemic has also shed light on how technology and all things digital can be used to rethink many core services, such as how we work, how we access healthcare, online education and how we interact with each other, but from a distance.
Digital collaboration moves to a new level: Covid-19 did not launch the remote working revolution but has probably accelerated its acceptance some five years. One of the clear winners of the work and educate from home ‘new normal’ has been the boom in videoconferencing and team collaboration platforms. Zoom recently achieved a market cap of $45 billion, making the 9-year old company worth more than General Motors.
Enhancements in functionality are in a nascent stage as is a new willingness to entertain digital collaboration in a range of areas: entertainment, sports, athletics and online learning. Advances in virtual and augmented reality can usher in a range of new features and functionality, particularly in the gaming sector.
We believe that companies that can address some of the early challenges around platform ease of use, privacy and cyber security will be in demand, for personal, educational and enterprise use. This is an exploding area for investment opportunities.
Demand for home entertainment: On the face of it, the entertainment industry has been hit hard by Covid-19. Some headlines have reflected the complete shutdown of public entertainment venues such as concert arenas and theatres, others have focussed on the anticipated downturn in television advertising as a result of the upcoming recession.
Limiting the analysis to these statements, however, would be to ignore the fact that the entertainment industry is consistently and demonstrably uncorrelated. Instead, it is driven by two elements. First is the quality of content on offer; people will listen to music they like and watch programmes they enjoy. Second is the availability of technology to make accessing content easier. The current period is unprecedented, on both counts. For the past few years, more and better programmes have been produced. At the same time, streaming platforms have made it easier for people to consume to content when and how they want. And, last but not least, by its very nature, streaming is social distancing compliant!
Content remains king and streaming platforms have firmly established themselves as the engine for the future of the industry. While the consumption of entertainment in crowded settings will take time to recover, home entertainment is the obvious winner, with the lockdown economy benefiting streaming platforms. In the first 3 months of 2020, Netflix added nearly 16 million new subscribers, more than double its forecast, lifting its global subscriber base to just shy of 183 million. Following the success of its US rollout, Disney+ has accelerated its launch in the UK and recently surpassed all expectations by reaching 50 million global subscribers in its first 6 months, something that took Netflix 7 years to achieve. AT&T’s HBO Max, Comcast’s Peacock and others are on track to launch their own services in short order. These companies are only as attractive to their subscribers as the content they offer. With nearly all content production currently on hold globally due to Covid-19, TV broadcasters and streaming services are currently relying on back catalogues to fill the potential holes in their schedules. There is every evidence, therefore, that high demand for quality new content will continue.
Even when looking at traditional linear television, previous economic downturns have obviously seen a marked impact on advertising spend, but these are usually short lived, and recovery is always robust. There is no indication that the situation should be any different this time.
Healthcare innovation: At the centre of this crisis is human health. And the fact that healthcare systems have been quickly overwhelmed makes the case that innovation is needed to combat this type of health care crisis in the future. It also points to woeful under-investment in this sector, with funding likely to come from both the private sector and governments in the future.
The ultimate solution to this crisis will be the development of a vaccine, which will most likely be provided by an innovative private sector company. But other solutions will be important as well. Telemedicine, drug discovery and diagnostic testing are all important areas that will receive funding going forward. They also promise to lower the cost of healthcare service delivery and extend its reach, helping to strengthen the resilience of globally less developed societies.
The need for sophisticated technology has also become more apparent. We expect significant advances in health care data analytics using Artificial Intelligence (AI). We also think new business models with advances in infection and contamination prevention will emerge for a host of common use areas such as offices, airports and restaurants, by way of example.
Supply chain management: The crisis has thrown a mirror on just how painful disrupted supply chain management can be. The impact on supply chains has been widespread with a host of firms and sectors all facing headwinds from reduced availability of parts and materials.
Many companies had already been restructuring their supply chains away from China and the experience will provide a further catalyst for governments to look for domestic sources, particularly for critical goods and supplies. Companies focused on more efficient domestic production of critical care goods and materials will rise in importance. Software to better manage supply chains in times of crisis are likely to be in greater demand. We also expect of host of new logistics business opportunities to emerge.
Ecommerce continues: The crisis has accelerated the trend in online shopping. Digital brands and digital to consumer companies that have no bricks and mortar origin, have seen huge growth in popularity. These companies are not new but home lockdown, and time, have brought new acceptance to this sector.
A company we have been working with in the online grocery market (Farmdrop) has seen its operations explode since early March; trading was historically between £140k and £160k turnover per week but this increased to £420k at the end of March as a result of the surge in online shopping in response the crisis. The company achieved its full month-end target of 1,600 new customers less halfway through March. New customers introduced to such a platform will continue to be consumers as social distancing measures stay in place and even after as the ease with which grocery shopping can be managed this way has become more apparent.
Companies in the clothing and cosmetic space have been particularly well supported by the new “at home” status. We expect to see a range of new digital brands and platforms take hold as consumers accelerate the use of digital means to purchase goods and services to enhance choice, reduce time and increase purchasing power and price discovery.
Well-being is on the rise: As a result of the changes we are being forced to make to our daily routines, demand has also surged in areas that make us feel safe and mental wellness is a good example. Calm epitomises this burgeoning trend, as demonstrated by the app’s steep rise in ranking from number 175 to number 63 in the US App Store charts. Calm’s mission is to make the world happier and healthier. As people struggle through isolation, but with more at-home screen time, we expect the mental wellness digital trend to continue to accelerate.
Healthcare and well-being more generally are set to see continued innovation, whether it be through personal monitoring using wearables and diagnostics or companies focusing on digital pharmaceutical and drugs online education and access. All these areas are poised for change, enhanced functionality and greater adoption.
These are but a few of the emerging trends. On-going needs for social distancing, new-found focus on pandemic preparedness and greater comfort with all things digital, from experience to collaboration, are likely going to pave the path of new trends in innovation.
With Crisis Comes Opportunity
We are at a powerful intersection for returns from innovation: a time when acceptance of new business models in digital will be in demand, but where turbulence has brought new-found discipline in valuation. Recent data suggests that investors’ allocation to private markets going into this crisis were relatively underweight compared with the global crisis of 2008, and thus the demand for venture opportunities may well be on the rise.
The pandemic has the potential to pull technology forward three to five years and thus picking winners will be more rewarding than ever. Not every venture firm will get it right. But, by investing in a diversified pool of the most coveted venture managers and companies, we believe that investors can increase the likelihood of having exposure to the most important and profitable emerging trends.
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