Alpha Seeking in a Recession

Great venture capital vintages are often born in recessionary times, but tough economic conditions can also increase the risks of venture investing. What strategies can investors employ to mitigate risk?

Some of the most transformative venture-backed companies have been built during recessionary periods; Lyft (2007), Dropbox (2007), Pinterest (2008) and Airbnb (2008) sprung to life during the Global Financial Crisis, to name a few. While great entrepreneurs are able to innovate throughout market cycles, market disruptions can lead to innovative new products and services that address acute societal needs.  The 2020 coronavirus-related recession represents an opportunity potentially unprecedented in this regard. “We saw some of the best fund vintages in venture capital launch during 2008 to 2011, where there were great opportunities to invest. But many allocators left the space after the dot-com crash in 2000 and never returned,” said John Avirett, a General Partner with Greenspring Associates. “Today, we are anticipating really unique vintages ahead. And while these typically take time to play out, we’re already seeing how crucial technology is to navigating the pandemic.”

Venture-backed companies tend to be nimble, characterized by flexibility in their products, go-to-market strategy, pricing and other areas. The ability to pivot and adjust real-time may enable them to find growth even when overall economic conditions are weak. And while corporate budgets tend to contract during a recession, technology has proven mission-critical to businesses across the world as they find ways to navigate operations amid the coronavirus outbreak. Companies of all sizes are being pushed rapidly up the digital adoption curve across a range of verticals ripe for venture capital (VC) funding: productivity software (collaboration and distributed workforce support); cloud computing; communications infrastructure (i.e., bandwidth expansion); enterprise software (e.g., cyber security); automation; gaming; education technology; tele-health; fintech; and all manners of e-commerce.

Good Time for Investors

Market recessions can be a good entry point for investors in VC due to discounted valuations and a holding period conducive to greater premiums at exit, allowing for early-stage businesses to go from product design to go-to-market and then scale-up in a recovery-oriented world over a number of years.  That kind of potential may be part of the reason a third of institutional investors plan to increase non-traditional (alternatives) allocations over the next 6 to 12 months. (see chart)

Alternative Strategies Top of Mind

(Which of the following strategies do you plan to undertake in the next 6-12 months? Check all that apply.)

Source: Pensions & Investments June 2020.

Tough times may forge great companies, but they can also marginalize weaker ones. “In recessionary times, there tends to be wider performance dispersion within individual industry sectors and subsectors. The winners come out stronger with more market share, and the mediocre or losing companies recede,” Avirett said. “The dispersion between the best and worst returns are wider in VC than other asset classes. But zoom in on the upper quartile and you see not only strong performance, but strong risk-adjusted performance.” (see chart)

Since Inception IRRs and Equivalents by Vintage Year, 2000 - 2015

Source: Cambridge Associates Private Equity and Venture Capital Index and Selected Benchmark Statistics as of June 30, 2019.

The issue of dispersion, in both managers and underlying investments, is critical to risk management in the VC space. “If you are just investing with one, or a couple, of upper quartile managers, that may seem appealing, but it’s exposing you to a great deal of potential volatility and concentration risk,” said Avirett. “It may ultimately limit the level of VC exposure you can assume. A diversified approach to VC investing across stage, vintage year, geography and sector with access to the upper quartile, on the other hand, may help limit volatility and lead to better risk-adjusted VC returns.”

Two Important Considerations 

In the past decade, annual inflows to VC have increased from a low of $13B in 2010 to $56B in 2019, and the number of funds and managers has increased to meet growing demand. But this influx of cash raises questions of capacity. Can funds be deployed at scale in the return-seeking portion of a portfolio, sufficient to warrant any potential increase in risk? Avirett emphasizes that VC is not inherently a capacity-limited asset class, as many may think. But growing that segment of the portfolio does have associated risks, especially when dispersion is historically high.

“One would never be able to invest at scale if it was all early-stage. That’s why we advocate diversifying across sector, stage, geography and vintage through allocations to established and emerging seed, early stage and growth equity firms, early and growth stage companies backed by our underlying managers and a very robust and expanding fund and direct secondary market,” Avirett said. “But with that kind of increase in supply, one of the challenges is guarding against adverse selection. Trusted relationships are so important to gaining access to consistent quality deal flow in venture capital.”

Finally, Avirett highlights the risk of conflating public market performance with the return potential of venture capital. He cautions that near-term volatility in public markets has little bearing on exit risk for VC investors at any stage. “We’ve all fallen in love with news about some large unicorn IPO,” he said. “But ultimately, venture investors are able to exit part or all of their position prior to IPO, or outside of it entirely. The majority of VC exits are happening privately through M&A transactions.”

For additional Greenspring Associates Insights, please visit our blog or contact us at: Institutional@gpsring.com.

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