While April and May have seen a reprieve from the historic public market declines surrounding the Ides of March (after peaking in February, the S&P 500 fell 34% in a mere 23 trading days, setting the record for the fastest bear market in history), global markets appear to be in the early stages of a recession due to COVID-19’s devastating impact on jobs and growth. Several large corporate bankruptcies have already been announced, with more likely to follow, and uncertainties hang in the balance with respect to the development of a vaccine and the timeline for reopening global economies. Although the S&P 500’s subsequent ~30%+ rise from its trough exceeds the 20% benchmark gain empirically demarking a bull market, respondents to a widely followed Bank of America survey are largely skeptical that the gains will continue, believing instead that they represent a “bear market rally,”(1) and the World Economic Forum is reporting that risk managers foresee a prolonged global recession as a result of the pandemic (2). The outlook is murkier still for private market valuations which, lacking the instant pricing and immediate reaction to changing economic conditions inherent to publicly traded securities, typically lag public markets by four to six months.

Unpredictable Vintage Years Ahead or a Familiar Pattern? 

Following the coronavirus outbreak, investors have focused on stemming the impact of the crisis on their existing investment portfolios. However, if history is any indicator, the current recessionary environment presents a compelling opportunity for investors with patient capital to invest in venture capital and growth equity.  Vintage years in connection with fat tail market events have been characterized by venture market dislocation. Disruption in technology provides a fertile environment for innovation and the creation of value-driving venture investments, and nothing disrupts quite like an unprecedented global crisis.

Early-stage companies are often less affected by market cycles. In a market downturn, venture capital investors may benefit from discounted entry valuations and realize greater premiums at exit. This is more pronounced in early-stage investments, the hold period for which averages five to six years. Such investments are assumed to be operating in a changed economic environment post-recession and, ideally, one more supportive to premium valuations. We believe in the entrepreneur’s ability to innovate in all market cycles and anticipate that new opportunities will arise to follow in the steps of other recession-founded companies like Lyft, Dropbox, Pinterest, Slack and Airbnb. In fact, some of the most transformative venture-backed companies sprung to life during recessions or in subsequent months.

Ventured-Backed Companies Valued Over $1 Billion USD, by Year Founded

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Source: PitchBook. For illustrative purposes only. 

We expect later-stage venture-backed companies will be subject to a much tighter follow-on financing environment and limited liquidity options for the next few quarters. This could create arbitrage opportunities for investors positioned to transact in the venture secondary market, as well as enable fund managers with capital on-hand to price and lead later-stage or expansion-stage venture rounds at more attractive valuations. Furthermore, in juxtaposition to buyout companies, growth-stage companies typically feature little to no leverage, offering more flexibility to operate with lower levels of liquidity.

Change in Venture Pre-Money Valuations Pre- and Post-Economic Crisis

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Source: Greenspring Associates as of June 30, 2019

A Shift in Supply and Demand 

In keeping with data from the time period of 2000 to 2012, Greenspring anticipates that the number of venture funds raising capital will decline in the coming months, ultimately resulting in waning asset class inflows and a lower number of new companies getting financed. Accordingly, we expect the deals that do get accomplished to occur at more moderate valuations. This presents investment upside to those who transact in this environment, with the potential for meaningful exits as valuations rise over time.

Number of Global Buyout and Venture Funds Raised Annually, Vintage Years 2000 – 2012

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Source: Preqin/PERACS. June 30, 2019.

The current climate is certainly unprecedented and unpredictable. However, in a scenario where the peak-to-trough time period extends 15 to 30 months beyond March 2020, as was the case in the Global Financial Crisis and the dot-com correction in 2000, the duration of a full market recovery could be much shorter than that of the typical early-stage venture investment. In this scenario, venture-financed companies positioned to endure the downturn could be well situated to achieve accelerated growth and meaningful value creation in the future.

Relative Change in Late-Stage Pre-Money Valuations, 2006 - 2011

(Rolling 4-Quarter Median) 

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Source:  Pitchbook Data as of Q2 2019. Pre-Money Valuation is Median. Relative change based on 2008 reference year.

With the probability of decreased inflows into the venture capital asset class, we anticipate a decline in the number of companies able to secure financing. Those entrepreneurs who are positioned to launch companies will do so at a personal risk even greater than in a non-recessionary environment and are likely to face a higher standard prior to securing institutional investment. This will require a high level of conviction and grit, as well as the ability to find and create opportunities in new, overlooked or written-off spaces – qualities that define some of the most visionary entrepreneurs we’ve encountered. With these dynamics in play, we anticipate seeing compelling opportunities arise that are delivering real value, both to investors and to the world as it recovers from the pandemic.

Observations from Global Financial Crisis Vintage Year Funds

An analysis of top quartile global venture capital and buyout funds reveals interesting patterns during and subsequent to past market downturns. Funds raised during the Global Financial Crisis of 2007-2008, for example, produced strong long-term investment outcomes for venture managers, and we observe an exceptionally strong year thereafter in 2010. By investing with top quartile managers, investors can position their portfolios for long-term value creation. That being said, we are not encouraging market timing. Venture capital, in particular, is impossible to time, due to shifting variables over long time periods of entry and exit. We do, however, believe that venture capital can play an important role in the institutional portfolio during both favorable and more challenging market cycles, if portfolio liquidity requirements support it. By being a long-term platform-oriented investor, institutions can diversify venture portfolios across various years, positioning them to capture strong vintages.

Single Vintage Year TVPI Multiples Across Market Cycles

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Source: Cambridge Index and Selected Benchmark Statistics June 30, 2019.

Accelerated Growth in the Venture Secondary Market

In a capital constrained environment, we also expect an increase in private secondary market transactions as investors seek liquidity or are forced to rebalance portfolios. Limited cash  for corporate M&A transactions could result in longer times to exit, creating opportunities for private secondary buyers as fund managers, founders and employees seek near-term options for liquidity. Furthermore, as the supply of private markets sellers increases without an increase in demand, the economic equilibrium will shift and create discounts relative to 2019 levels, even for quality fund managers or portfolio companies. Although secondary investors are awaiting second and third quarter 2020 valuation marks prior to increasing investment activity, data on the broader private equity market indicates post-Q1 2020 valuation marks likely declined approximately 15-20% from Q4 of 2019, with further declines possible in the coming quarters. Within the venture capital asset class, we expect steeper discounts to arise in light of the restrictive nature of many fund managers and the complexities of valuing venture-backed companies, particularly at the early-stage. So, we expect deal activity in the second half of 2020 to increase as secondary investors gain visibility into valuations and seek to deploy capital in what is anticipated to be an attractive market. Given these dynamics, observations from 2006 to 2011 provide evidence that 2020 to 2021 could be a time of opportunity in the secondary venture markets.

Private Equity Risk/Return by Fund Type, Vintage Years 2007 - 2016

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Source: Preqin 2020 Global Private Equity Report February 2020.

Capturing Alpha and Diversification Benefits

Public markets volatility will likely continue in the months and quarters ahead, and valuations across venture, growth and buyout will undoubtedly decline. Ongoing uncertainty will create forced sellers to the benefit of investors deploying patient capital to the global innovation economy. The case for early-stage venture is compelling but complicated, due to the potential for breakthrough innovation amid the evolving disruption to our world and the nuances and challenges of valuing pre-revenue companies. Attractive opportunities for later-stage venture direct investments and secondary investments are also to be anticipated due to various arbitrage pricing opportunities.

IRR Dispersion, Single Vintage Years 2003—2014  

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Source: Cambridge Index and Selected Benchmark Statistics June 30, 2019.

The evergreen challenge remains how to identify and access value-driving venture capital fund managers and the breakout companies in their portfolios. Even then, investing opportunistically with a single manager or select co-investments introduces heightened portfolio risk. To effectively capture the alpha opportunity of venture capital while limiting unsystematic risk requires consistent investment diversified across fund managers, sectors, investment stage, vintage years and geography. Unlike buyout, which can be subject to greater sensitivity stemming from market downturns, venture capital investments position a portfolio to capture upside created during vintage years coinciding with public market downturns.

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This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for any investment decision in any private investment fund or other vehicle managed or sponsored by Greenspring Associates, LLC or its affiliates, or for any other investment decision.  Recipients are recommended to seek independent legal, financial and tax advice before making any investment decision. The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction. Information and opinions presented have been obtained or derived from sources generally believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. Any forward-looking statements, predictions or projections are subject to known and unknown risks, uncertainties and other factors which may cause actual results or occurrences to be materially different from those contemplated in such statements. The views contained herein are as of the date written and are subject to change without notice. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from Greenspring Associates, LLC.  The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.

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