Young VCs Are About to Face Their Greatest Test (a Downturn)

Young VCs Are About to Face Their Greatest Test (a Downturn)

A generation of venture capital investors are about to find out how good they really are, as a market downturn shows who really did their research and who got caught up with the hype.

Between 2009 and 2021, the stock market enjoyed its longest bull market ever, with returns of more than 400%. But what goes up must come down. Although the economy managed to bounce back quickly from the immediate crash brought on by Covid-19, it seems that we’re now well and truly experiencing a downturn — meaning an entire generation is about to experience a bear market for the first time.

This will likely come as a shock to many at-home traders, but the impact will be particularly brutal for venture capital investors. After years of successfully “picking winners” that went on to yield impressive returns (especially in the tech sector), these investors are about to discover how good they really are. Were they doing their due diligence about market fundamentals, or simply following the trends and getting away with it? The next few months and years are about to be a serious reality check.

Is the tech bubble bursting?

For the past few years, any discussion about “high-growth stocks” or “industries to watch” has largely centered around tech in its many forms — fintech, Software-as-a-service (SaaS), cleantech. Yet now, these sectors are experiencing the most painful drop.

The stock market is down around 18% overall (give or take a few percentage points depending on the day), and tech stocks have seen a drop closer to 30%. Given these tech companies made up around 25% of the S&P 500 in 2021, they’re not just falling faster than anything else — they’re a significant factor in why the stock market overall is declining. The Tiger Global Fund, for example, which focuses on the internet, software and fintech sectors, lost 52% just in the past year.

So, what’s going on? When the pandemic first hit, software solutions suddenly became a crucial part of everyday life and workplaces, with individuals and businesses forced to well and truly go digital. Share prices skyrocketed for companies like Zoom and Netflix, and 2490 firms achieved so-called unicorn status in the first six months of 2021 alone (meaning valuations of $1 billion or above). Moreover, this was all happening on the backdrop of 10+ years of low interest rates.

But now, with inflation up and a correction occurring, it seems the market may have gotten overexcited, with many tech firms overvalued due to pure speculation. For instance, Zoom went from a share price of $73 in January 2020 to $349 a year later — and now it’s back down to $109.

Some have compared the current situation to the so-called dot-com bubble of the early 2000s, which saw many investors pour their money into just about any internet-related company in hopes they’d become “the next big thing,” despite some of those firms lacking a genuine value proposition. Pets.com is the classic example.

Just like before, investors have continued to put vast sums into business models and sectors they that they always truly understand (Web 3.0, anyone?), and the economy may finally be catching up. Moreover, recent transactions have taken “forward-looking” valuations to a whole new level, causing investors to be hyper-focused on specific startup categories (such as SAAS) that tend to trade a high revenue multiples, thus creating a plethora of overvalued startups that haven’t always validated their product-market fit or have a path to a solid business model — not to mention profitability or a decent runway.

What it means for investors

Venture capital investors have one primary aim: to identify young companies with high growth potential and invest with the hopes of yielding big profits later on. In recent years, “big profits” have been mostly associated with the tech industry, especially following the digital acceleration brought on by the pandemic. Suddenly, it didn’t take much for tech companies to secure good valuations, regardless of whether they truly boasted good market fundamentals — so it didn’t exactly take a genius investment strategy to achieve impressive returns.

As this trend continued over time, the confidence of investors grew, and some became more careless. They may have forgotten there was a possibility of all the buzz being a bubble, or maybe they simply didn’t care. Because as long as the valuations kept going up in subsequent funding rounds, all was well in the world of non-liquid assets.

In 2021, VC exit values reached $774 billion in the U.S., and venture capital outperformed all other asset classes. But now that the boom time may finally be coming to an end, dumb luck and riding the wave aren’t going to cut it anymore.

Over the next few years, the investors who win out will be those who did their due diligence — those who, instead of simply following in the crowd, looked into crucial market fundamentals such as a company’s product, market validation, management, business model, etc. Not to mention those who were fiscally responsible enough to put money away for tougher times and preserve a decent runway.

What does the future hold?

The current downward trends of the market aren’t just pure speculation. Inflation is running rampant at the moment (8.3% between April 2021 and April 2022), which reduces the spending power of consumers and businesses alike and makes it tougher to make sales. It also makes it harder for businesses to budget and plan for the future.

With interest rates rising to combat inflation, borrowing is more expensive than before, which will naturally lead to lower valuations and a tougher environment, at least for the foreseeable future. Interest rates were one of the main factors driving growth in the first place, so they’ll be a crucial factor in changing the environment.

Yet there is also much to be optimistic about — the downward trend is likely a temporary blip, rather than a bubble bursting. The role of the internet is now cemented, technology is not going anywhere, and thus, there will always be valuable tech stocks and companies that will continue to provide fundamental value.

While some companies (and maybe even funds) will go down, this is actually a healthy correction for the market overall. Solid companies with a good product that are solving an important problem still have a place. Moreover, companies with strong management that know how to adapt to the markets and optimize for the long run, will likely do well long-term, getting the unique opportunity to increase their market share as their competitors drop down. After all, although plenty of companies fared poorly during the dot-com crash, there were also quite a few that survived and went on to thrive, such as Amazon, eBay and PayPal.

Today’s young venture capital investors had better hope they’re one step ahead of their peers. Those who did their homework, those who conducted due diligence, developed an investment thesis and didn’t completely ignore fundamentals may fare well, while others could be in hot water. Either way, for both VCs’ startups, this is likely to separate the men from the boys, resulting in a stronger and healthier economy.