As huge waves of capital have been deployed, valuations have been ramping up to, for some assets, unrealistic and unsustainable levels. We have now seen a sharp pricing rationalisation taking place, with one of the highest-profile examples being Klarna, the Swedish fintech whose most recent funding round saw its value slashed by 87% compared to a year earlier.
Over the past decade, driven largely by the tech boom, the scope to invest in high-growth tech start-ups and the potential for stand-out performance has made venture capital (VC) an extremely in-demand asset class, where assets under management hit $2trillion[1]. This continued market exuberance, where companies were choosing to stay private for longer than has historically been usual, is now in the grips of a severe reality check, where expectations will require a reset as the continuous upward trend comes to a pause. The outcome may be a long-overdue reset of valuations and may turn out to be no bad thing for savvy investors looking for credible investment prospects.
As huge waves of capital have been deployed, valuations have been ramping up to, for some assets, unrealistic and unsustainable levels. We have now seen a sharp pricing rationalisation taking place, with one of the highest-profile examples being Klarna, the Swedish fintech whose most recent funding round saw its value slashed by 87% compared to a year earlier[2]. Investors who jumped in near the top of this high growth tech market may be getting burnt, and fundraising (though still strong) has slowed this year, but this does not signal that that the era of VC opportunity is over. Rather it suggests that it pays to be discerning, disciplined and patient.
Positive market dynamics will endure
In the short-term, a widespread pricing correction and ‘down’ funding rounds (where funding fails to be raised at a premium to previous rounds) may be inevitable, especially for high risk, growth companies with high cash burn with the frequent need to seek private capital from continuous funding rounds, fuelled by the unrealistic expectation of growing valuations. The days of fast-money returns, where investors have come in at top, usually at the pre-IPO rounds in the expectation of a floatation at a substantial uptick shortly afterwards also appear to be at an end. These more speculative, pre-IPO buyers are stepping back – at least for now – and as a result their capital is no longer helping to buoy up the market. Moreover, geo-political instability and macro headwinds have led to increased volatility in public markets which has delayed flotations and those that have taken place have had their original valuations moderated.
Despite this, as markets adjust to the ‘new normal’, long-term it’s clear that positive market dynamics will endure in the VC space: these tech companies are vital to global GDP growth in the years ahead. From the digital platforms on which we increasingly conduct our working and personal lives, to disruptive new ideas, to the solutions of the future for problems like climate change, food security and healthcare, the prosperity of the human race depends on technological innovation and private capital VC funding is vital to their continued growth. The need for funding to commercialise that innovation and enable start-ups to achieve critical mass will of course not go away – it just needs a recalibration and to be done on a more level-headed basis than we have seen in some quarters lately.
An opportune time for sensible strategies
As is often the case, following a market correction, a buyer’s market is emerging as entry pricing is now more attractive. This is an opportune time for funds to deploy the abundance of dry powder on the right deals at a more realistic price, thereby embedding value from the outset. The reality is that VC should be viewed as ‘patient’ capital, with monies invested today looking to reach fruition in five to seven years from now, when the market conditions for an exit should be more favourable than they are at present, with vintage returns a possibility. And though there is plenty of scope for funds to be opportunistic, maintaining control is also vital. For the fund managers we’re working with, that means having the experience to identify fundamentally sound businesses, valuing them properly and sticking to their tried-and-tested early-stage or later-stage growth VC investment models.
When appraising how best to invest in this segment of the market, at this point, spreading risk is key and investors should seek out fund managers with provenance and possibly use a multi-manager (fund-of-funds) approach to provide an extra layer of protection. By taking this route, they will be able to create a diverse and granular portfolio, spreading risk across a range of funds with experienced VC managers who have a proven track records of identifying and investing in successful early-stage and growth companies across market cycles. This approach will enable private investors to access a dynamic and exciting – but highly specialist – asset class which has the potential to deliver strong returns over time.
The world of venture investing continues to evolve and mature. After this re-set, it will undoubtably recover but investors must be prepared to be in it for the long haul. Pursuing the right strategy is critical: choosing experienced fund managers who have the expertise to source the best opportunities at the right price and who don’t get caught up in short-termism or herd mentality, and – more than perhaps any other asset class - spreading investments to minimise risk and maximise returns. There’s a reason why VC has attracted so much attention in recent years: it’s where the winners of the future are to be found.
[1] Source: Preqin https://www.preqin.com/insights/research/blogs/venture-capital-becomes-second-private-capital-class-to-hit-2tn-aum
[2] Source: Financial Times https://www.ft.com/content/6395df7e-1bab-4ea1-a7ea-afaa71354fa0