Why 2023 Is The Best Time For Billion-Dollar VC Decisions

Over coffee at The Service on London’s Savile Row, the partner of a $3 billion family office tells me, "We are sitting on a sh*t ton of money and don't know where to allocate it; 50% of our fund is in cash for now.” With nearly 40 years in the business, he remembers far worse crises, but he has never had so few investment prospects as he does now.

In terms of new investment, venture capital was a popular asset class, with around 39% of family offices intending to increase their allocation in 2023. However, between rocked financial markets and U.S. inflation reaching a 40-year high, family offices now see big risks for 2023 and remain cautious. “What multiples should be considered fair today? Companies we like are valued at +40x P/E. Does it make sense to allocate money there today? The long-term debt market looks overly risky relative to its risk-return profile. Pre-IPO investments we’ve made in 2021/2022 are likely to be greatly overvalued. We are interested in venture capital, but our existing position in tech startups and VC funds significantly exceeds a healthy 10-15% allocation, thanks to poor performance of the rest of the portfolio in 2022. It would be difficult to persuade our board to increase VC exposure today,” he notes.

Problems

As you may know, the tech sector is currently facing numerous problems, many of which are a result of the pandemic. Additionally, the current low cycle affects tech startups as well as VC funds. Tech companies that are heavily dependent on fundraising are having a difficult time raising right now (“grow faster, don’t worry about profitability, new money is not an issue” was the general advice from most, if not all “value-add” investors over the last few years):

• Business angels became poorer in 2022 and reduced their interest in new deals. Traditionally, every February I used to receive a lot of calls from friends from global investment banks/PEs, asking for a good allocation in early-stage tech companies. There was radio silence in 2023, with few calls from SVB and Credit Suisse managers looking for secondaries opportunities within their tech portfolios. Quite a change.
• A lot of big VC funds invested at unsustainable valuations from 2018-2021 and are now moving available cash from new investments to follow-ons because their portfolio companies are running out of cash (otherwise, 50-60% of the portfolio could be easily written off or dramatically revalued downwards). Sweden-based Klarna, best known as a “buy now, pay later” service provider, is a good example. Once Europe’s most valuable private tech company, it was only able to raise $800 million at a $6.7 billion valuation, representing an 85% drop on its $45.6 billion valuation exactly a year ago. According to Klarna, its peers were down 80-90% from peak valuations, so its own decline since June 2021 was on par with them.
• Family offices are still "in the money," but given the drop in equity and bond markets, their allocation to venture has become significantly higher than the benchmark 10-15% and the appetite for new deals has decreased. “Last year we lost 18% on the equity market, automatically increasing our allocation to venture capital up to 33%, which is quite a lot for our mandate,” says the manager from an EU family office (investor in 30+ VC funds and 20+ startups)

A recent Crunchbase report shows that global startup funding in Q1 2023 was down 53% year over year (66% in Europe). This is a strong sign that the tech industry is still suffering from 2022’s high interest rates and global economic uncertainty, and the majority of industry players believe that we have yet to reach the bottom.

For the first time in several years, many investors are focused on their current existing portfolio and do not have the available funds or appetite for making new deals. This was bound to happen sooner or later because the tech industry has not historically been cyclical since it grew from a relatively low base. Now, the role of tech in the wider economy is so significant that the industry will inevitably be cyclical, just as all other sectors have been for decades.

LPs who invested in venture funds also noticed the liquidity cycle crisis that is happening in venture. Exits and IPOs have been axed for now while capital calls continue to be made regularly. There are also more and more signs on the market when VC funds simply cannot make a capital call due to defaults or unwillingness to honor the call on their investors’ side.

How It All Happened And Who Is To Blame

The hype around and the promise of insane returns in the venture industry over the last 5-7 years attracted many investors (ranging from the sophisticated to the less experienced). It seemed like valuations and valuation multiples for tech companies could keep rising indefinitely, and many investments were made with significant deviation from one of Warren Buffett's main principles: “A good business is more important than a good founder.” VCs often valued the talent of a good fundraiser (looking at you, Adam Neumann) way more than the entrepreneurial or managerial talent.

At some point, there were so many VC investors that tier-1 players began offering $25-30 million checks on pre-seed, boosting or inflating valuations to secure deals with the best founders while new and smaller funds were literally begging to get even a tiny allocation for co-investment. Many GPs believed their greatest risk was losing a big investment opportunity, not losing investor's money (“There’s always more where that came from” was the common misconception).

FOMO (fear of missing out) is deeply embedded in the human psyche. When the valuations were extremely high, thousands of new funds entered the market (hundreds as first-time VCs). Raising a venture fund over the past four years was easier than ever before: Pitchbook’s NVCA Venture Monitor reported that first-time managers notched $45.3 billion across 801 funds from 2018-2021.

Window Of Opportunity

We see a lot of “fake news” on the activities of global VCs. They travel, post on social media, gather at events and write articles (guilty) but they do a very limited number of new deals outside their current portfolio, and they look very sad. The late-stage VC investment industry is dead. It is impossible to hire an investment bank for an IPO in spring 2024; all slots are fully booked, but there are a lot of doubts that companies will go for it in the current market environment.

The only active industry in the tech space is generative AI, which also shows signals of a huge bubble. Remember all of those search engine startups that raised huge amounts of capital or the thousands of startups in the self-driving space? Only a limited number of companies will survive and become huge. Market conditions are very challenging for the vast majority of the current VCs that allocated their capital in 2018-2022. Unfortunately, investors who allocated their capital in generalist funds (index funds) may suffer from painful losses. The current situation on the market may be perfectly described by A.A. Milne:

“It rained, and it rained, and it rained. Pooh splashed to his door and looked out... “This is serious,” he said. “I must have an Escape.” So he took his largest pot of honey and escaped with it to a broad branch of his tree, well above the water”

With the current market environment, VC fund managers may become very similar to hedge-fund managers who brag to their peers and investors that their losses are smaller than the industry average.

It's true that many investors tend to switch between strategies at precisely the wrong time, and humans are generally bad at timing the market; it feels very uncomfortable to be a contrarian, especially in market downturns. There was too much money in the industry, and unfortunately, many investors will see negative returns from the 2019-2021 vintages.

However, it's important to note that whether investing in VC or a tech company right now is a contrarian strategy or not depends on the specific circumstances of the market. Money flows into and out of markets and funds at exactly the wrong times (lots of money after they have risen, lots of withdrawals after they have fallen). While it may have been a crowded trade a few years ago, it may be a more attractive opportunity to invest in VC and the start-up ecosystem now. Here’s why:

• Tech will continue to grow; it hasn’t reached anywhere near its peak in terms of the change it can bring to economies and societies at large. Only the emergence of new generations of AI and deep tech software may hugely accelerate the tech industry, such as what happened in the late 2000s when the iPhone launched the smartphone era.
• When “money is free” there is a boom of hype projects like NFTs, Web3 and, 15-min delivery, but the majority of them tend to be more exciting stories than good businesses. The next 3-4 years will be the time when solid, long-lasting businesses with strong tech components will be created.
• When the money stops flowing freely, valuations become attractive. The first indications of this happening for start-ups are already there. Current funds’ pipelines are better than ever (or “better than we deserve,” says my colleague, who raised her first fund in 2022 and definitely hadn’t built a brand name yet) but there is not enough capital to invest into all these exciting new start-ups. According to Pitchbook, European early-stage valuations began to cool in Q3 2022 and dropped to $5.5 million in Q4 from $8.5 in Q2. The majority of experts are quite confident that valuations will continue to decline for both early and late stages in 2023. Investors may have been handing out blank checks in 2021, but I think the 2023 conversation will be quite the opposite.

Investment in VC in 2023-2024 will be a difficult decision. Investors will not have enough time to recover from losses, and new investments after the series of failures will seem too risky. However, if the hypothesis that we are currently facing the low cycle in the tech industry is true, investors allocating money into VC funds in 2023-2024 will benefit from the new high cycle exits 8-10 years from now, especially in low-maturity markets where VCs are more likely to get a 10x return on their investments.