What does the crisis mean for growth capital and VC?

A lot of people have been asking me what impact the global financial crisis has on the business of venture capital and growth equity.  The short answer to this question is: not much.  The slightly longer answer is: not much, yet.

Let me explain.

If you are currently raising a venture capital or growth capital fund, the paralysis of investors worldwide means slower decision-making and a longer fund-raising cycle.  You may even lose some previously committed investors who are now conserving cash to cover losses in other asset classes.  If you have recently raised a fund then you are in good shape.  As banks, non-bank companies and consumers are rapidly finding out, when credit is tight cash is king.

But what about the impact on our business of investing in businesses?  Our existing portfolio companies will feel the crisis on two fronts: commercial performance and exit horizon. 

First, a prolonged recession will make it harder to land customers and grow revenues.  This means that business plans will take longer to achieve.  The exception may be in countercyclical or recession-proof segments, such low-priced entertainment (eg, games), discount retail (eCommerce), cost-reduction tools (eSourcing, supply chain optimisation), and products that address the current crisis directly (like compliance software, or trading platforms for previously 'hidden' financial assets). More on the latter category in a future post.

Second, as the IPO window remains shut for longer and M&A activity slows, there will be fewer buyers for companies and acquisition prices will be depressed.  We already saw throughout 2008 a flight to quality: companies with strong topline growth and high profitability are still being acquired and achieving good valuations.  The companies best able to survive this environment are those with strong 'operating leverage' -- that's VC-speak for high gross margins.  High margins reduce the effect of slower revenue growth and give companies more flexibility to reduce their cost structure as the market slows.

For investors, the key is to be able to wait for the right time to sell a company. This means both the internal timing (strong operations, good growth, a clean balance sheet) and external timing (market interest).  Companies that are profitable or close to profitability have a huge advantage in this market.

The impact on the private equity industry will vary drastically.  At the top end, LBO funds have already seen a huge increase in their equity cost as they refinance debt packages with equity, while their companies' earnings decline.  This is a continuation of the shake-out that started a year ago.

The second most affected category will be early-stage VC.  Most VC-backed companies are loss-making and were valued at the time of investment on the basis of aggressive growth forecasts, or expected strategic value on exit, or both.   Slower growth and a longer-time-to-exit means they will need to raise more capital, probably on worse terms.  This increases the equity cost of their investors and extends their investment horizon, depressing rates of return. 

Already we are seeing VC firms increase the follow-on reserves for existing portfolio companies, which will mean less capital available for new investments.  In the last downturn, many shifted their focus to later-stage investments, leading to a funding drought for pre-revenue companies.  More on the dilemma for early-stage companies on Fred Wilson's blog here, and Jason Calacanis' here.

The least affected, in my view, will be growth equity and midmarket buyout firms.  Growth equity portfolio companies typically have little or no debt financing and are cash-generative (or can get there quickly).  This means they can adapt their operations to slower market conditions, invest in discrete growth opportunities, and wait for the right time to exit.  The best ones will be acquired for the quality of their earnings by savvy buyers even during the downturn.  Growth equity investors can focus these businesses on improving the quality of the business and finding pockets of higher growth while positioning the business with potential acquirers.

Lastly, the more unpredictable effect is on the making of new investments in the technology markets.  In the 2001-2003 downturn (which was heavily weighted toward the technology industry) few entrepreneurs felt confident enough to write aggressive growth plans, and as a result it was difficult to find quality companies to invest in.  But I think this one is going to be different.  Here's why:

First, this recession is going to be more generalised, similar to the banking-led industrial downturn of 1980-82, with a correspondingly smaller effect on the technology industry itself. 

Second, the European investment eco-system is far deeper and more mature than it was in 2001.  Back then, a nascent VC and entrepreneurship market was nearly wiped out by the collapse in stock market values.  Today, we are tracking thousands of European technology companies that have shown more than 5 years of continuous growth, are profitable and in many cases geographically diversified.  This represents a very deep pool of potential investments, which are supported by a broad universe of specialised lawyers, bankers, recruiters, and angel investors.  So, I think that for investors with funds, good research capability and a broad network of sources for dealflow, there will be no shortage of investment opportunities.  Equally, for entrepreneurs with capital-efficient businesses, that have demonstrated an ability to prosper in good times and bad, there will be no shortage of investment capital.

Let's see how it plays out.

Comments

[FFD]

A friend of mine brought up the point that "alternative investments" such as venture capital might actually attract more capital now because the public stock market looks so bad and bank accounts became unsafe.

Is this a valid point? This friend is wealthy, so he cannot be completely off the track ;-)

[maxbley]

I think it is valid if you have a long-term investment horizon (eg 5 yrs+). But you need to make sure the strategy of the fund you invest in has legs in both recessionary and growth environments.