The global pandemic caused by COVID-19 has thrown economies and entire financial systems into disarray. Q1 2020 GDP data for the United States and Europe released at the end of April confirm the hard truth none of us want to admit: A global recession, and maybe even a global depression, is now upon us.
As we look toward the new normal, we are reminded by history that deals struck in times of crises bring historically outsized returns. These lessons of history should inspire optimism, positivity and creativity for venture capital firms and entrepreneurs as we chart a path to recovery.
While the current crisis was triggered by a forced shutdown of global movement of people and commerce in an attempt to contain COVID-19, other post-World War II recessions were triggered by market, fiscal and monetary imbalances. Despite not yet having exited the first wave of the pandemic, COVID-19 has already prompted the most extensive financial stimulus plan the world has ever seen, with more fiscal stimulus on the table as of this writing.
For China, the United States, Europe, Japan and the U.K., aggregate fiscal deficits will exceed 1.5x levels seen following the great recession of 2008-2009. In fact, according to the CBO, the U.S. Federal Reserve’s balance sheet as of May 6 was a record $6.72 trillion, or approximately 33% of projected U.S. 2020 GDP ($20.14 trillion). This increase to the balance sheet overshadows the 20-percentage-point expansion during the Fed’s three stages of quantitative easing after 2008.
According to leading venture capitalists, the first proof points will come in Q2 2020. While 2019 showed strongly positive returns for the venture capital asset class as a whole, the sector had already expanded beyond the world of startups, with increasingly larger funds writing heftier checks to chase bigger “unicorns.” These unicorns, or private companies with valuations above $1 billion, were valued by venture capitalists using comparable emerging growth company transactions and multiples of financial results hidden in the dark pools of the private markets. The results were bid-up by other venture capital firms, sovereign wealth, hedge and mutual funds dipping into these markets for alpha.
These valuation methods were used instead of the more efficient metrics of valuation implied by public market trading comparables that had been used historically. Those methods were informed by publicly available and audited financial statements scrutinized by securities regulators and the plaintiffs’ bar. As public markets have shown unprecedented volatility and retreated into bearish territory, most VCs have pumped the brakes on investing in new deals. Meanwhile, founders are setting the bar for private capital deals even higher for those seeking to access venture capital funds.
According to Morgan Stanley, Q1 demonstrated weak results for U.S. venture capital as an asset class. But the full impact of the COVID-19 pandemic will likely intensify in Q2, reflecting a near total shutdown of the global economy during the months comprising the period. Q1 2020 venture data contained deals that were largely struck in the latter days of 2019. Q2 2020 data, by contrast, will include a larger number of 2020 deals and a reporting period where many later Q1 deals would have been completed.
Morgan Stanley estimates global economic contraction will cap off at 7.5% in Q2 of 2020. Currently, the number of high-frequency indicators tracked suggests that the global economy is in the process of bottoming. Consumers’ future expectations have improved, and consumer spending is contracting more slowly than at the onset of the outbreak as new signs of reopening sprout across the U.S., Asia and Europe.
As economies reopen and more people return to work, production levels should improve. U.S. economics and biotechnology teams estimate that 54% of the economy is in a reopening phase as of mid-May.
What will the remainder of 2020 look like?
It is likely that we will see more action in the public market and unicorns like Airbnb. There may also be some unpredictable outcomes from software companies like Zoom, for example, a hyper-growth company operating at a significant scale that garners large public market premiums. In addition, we will see a big uptick in SaaS B2B startups leveraging AI technology to help businesses thrive in the new data economy. For instance, Amazon and Google’s primary source of revenue is their web service solutions. This is because they have countless years of customer data – from search, social media posts, purchased products, music, etc.
Which industry verticals and categories will VCs target?
As the slow and steady economic reopening continues around the world, Morgan Stanley has monitored developments in China to see how sectors of the economy are normalizing and how China’s experiences might inform the rest of the world. In China’s case, the manufacturing, infrastructure and construction sectors recovered quickly. Data suggest that manufacturing is back in expansionary territory, while property sales and demand for steel and cement are growing again – 10 weeks after the peak in new COVID-19 cases. Supply-side disruptions have improved quickly.
However, since consumption powers the U.S. and European economies, investors are keeping a close eye on Chinese consumer activity, which is already improving. In fact, China’s online retail sales, which account for 30% of total sales, are back in positive territory year over year, and traffic to shopping malls is now 70% of normal levels. Also, China’s consumer goods companies expect normalization by the end of June.
Meanwhile, restaurants have 50-80% percent of their customer base back, but nightlife venues are still closed in Beijing, Shanghai, Guangzhou, and Shenzhen, and cinemas remained closed until early June. These channels are expected to fully reopen by the end of June or beginning of July, and traffic is projected to normalize in the third quarter of 2020.
As we approach the second half of 2020, we expect that stimulus will have worked its way through the economy, the economy will have largely reopened, and venture capital firms will begin again to deploy the vast amounts of dry powder at their disposal on buyer-friendly terms which should reinvigorate the innovation economy. Such a renewal should reinvigorate the innovation economy. While a second wave of the pandemic is expected, and more choppy waters lie ahead of us, there are reasons for optimism and positivity amid the creative responses to the crisis.
That being said, we expect the types of deals that get done and the terms upon which venture capital is deployed may be a lot different. While U.S. venture capital firms are sitting on $120 billion of dry powder, given the expected difficulties in raising new funds, we expect them to slow down their spending, and do fewer deals. We expect that venture capital firms will look into their existing portfolio and deploy reserve more capital for the likely winners, and cut loose the lesser probability exits, and have less capital available for new, riskier deals.
Early-stage financing could suffer. Valuations are coming down, and there are whispers in the deal market of a 25-30% cut from pre-COVID days. As to terms, deal-makers are seeing more full-ratchet anti-dilution provisions, liquidation preferences that include participation provisions, more board controls and other buyer-friendly provisions.
Finally, we expect to see more venture capital dollars deployed into “new normal” businesses that enable socially-distanced remote work and collaboration.