The coronavirus pandemic and ensuing capital markets volatility present a crisis of magnitude on par with prior historic events that have reshaped economies in lasting ways.
As we begin to process the impact and reorient to the ongoing market turbulence, this uncertain period provides a valuable opportunity to evolve our ways of thinking and doing business. For investors and CIOs with exposure to venture capital, it means rethinking whether pre-COVID-19 allocation strategies continue to fit this precarious new environment.
Heading into 2020, venture capital had never been better capitalized. The size of the industry quintupled in the last decade, according to Crunchbase projections, to $294.8 billion in 2019 from $53 billion of capital deployed into startups in 2008. For good reason, venture capital has provided access to investment opportunities in game-changing companies that have disrupted entire industries.
Venture funds have distributed more capital to investors than called since 2012, breaking a prior 11-year streak. But with colossal market participants such as Softbank Group fueling an investment frenzy, capital oversupply led to inflated environments with significant pockets of dislocation supporting valuations that are often not based on a company's fundamentals or ability to drive true equity value.
One of the key signs of dislocation is the presence of an illiquidity premium in the pricing of companies where financing multiples dramatically exceed acquisition and public multiples. According to a recent paper in the Journal of Financial Economics, private investors often pay for the privilege of participation with an illiquidity premium of about 48%. Another sign of dislocation is when companies miss their projections by a wide margin and go on to raise at a significant increase in valuation shortly after prior rounds.
This phenomenon of dislocation does not imply that all venture-backed companies are mispriced. Some founders enforce discipline in their capitalization strategies, achieve profitability early on and reinvest their profits to maintain very high growth rates without having to burn capital or raise external financing. Others focus on managing for the highest exit possible, imposing sanity checks or reasonable constraints on growth investments that could lead to losses.
But dislocation does suggest that the correlation between the fundamentals and value of private companies varies widely across the spectrum of opportunities in the market. Prior market cycles and events have proven consistently that fundamentals matter and valuations eventually do converge with them, and this phenomenon of convergence will continue to hold true. Not all value can be created equally, especially when the drivers of value are different and track to distinct motivations. Value inequality means that different categories pose varying risks and time horizons, with some companies possessing shorter term, inherently less stable or ephemeral value. Inequality of value is reinforced in market environments that test the mettle of companies to execute across volatile conditions.
The current pandemic and resulting economic environment will no doubt test virtually every business. We can only begin to understand the impact of COVID-19 on venture capital investing, exits and fundraising so early in the crisis. If the unpredictability continues, with rapid market drops and sentiment swings to fear from exuberance, the fallout is likely to severely affect dislocated companies that have been priced for "future perfection" rather than with fundamentals.
When cash flow reverses and these companies find it harder to attract outside financing, they will be required to manage on their own merits. Those unable to operate a robust, financially dependable business or make the immediate shifts to do so may raise future capital or sell at a small fraction of their current values, if not disappear overnight. Exit caps resulting from finite market opportunities, along with price erosion in the face of slowing growth and other competitive challenges, may create further downward pressure on existing values. The spread in value or the illiquidity premium that has been paid for these companies may be more susceptible to loss or rapid dissipation and ultimately impact book values.
Book values for companies that poorly correlate with underlying fundamentals tend to be less stable and run shorter term than for companies that highly correlate. In the latter, there is less risk of value erosion, even under the most challenging of market environments, which often translates to more consistent value that is investible on a long-term horizon. Dislocated companies often present high risk of value erosion, with frothier values that only last short term. These opportunities have comprised a substantial percentage of companies funded during the hot zones of venture capital funding.
As a long-only strategy, traditional venture capital can only realize returns when values increase. It works well for companies oriented to generate long-term value and built for sustainable and aggressive scale. It is, however, limited in its ability to manage the challenges that dislocation presents to long-term investing and simultaneously misses the boat on the opportunity to capitalize on mispricings that arise in distorted markets.
Given the extent of inefficiency that we have seen in venture capital markets pre-COVID-19 as well as in nearly every segment of the current environment, the inability to defend against as well as to capitalize on dislocation means that venture capital is missing out on substantial opportunities and not fully realizing its return potential. To improve returns, venture capital would need to expand its ability to adapt to different investment scenarios and to discriminate across diverse sources of value under varying time horizons. One interesting approach for addressing market situations that are arising in this increasingly complex ecosystem is to employ a long/short strategy that is often used in the world of hedge fund investing to dynamically segment market opportunities.
The ability to assume a long position in game-changing companies such as Amazon.com, Apple or Uber, and to short irrationally exuberant pricing for companies such as WeWork, Theranos and other unicorn delusions, positions venture capital to offer enhanced upside on significantly reduced risk. It also offers rare exposure to less correlated if not uncorrelated sources of alpha. Allocators should investigate firms that offer new constructs for shorting private company stock to access a much more advanced payoff structure than they have historically been able to expect from this asset class. I believe it's possible to leverage derivative constructs to create synthetic shorting exposure to private companies. In general, allocators would benefit if private investors worked harder to innovate new options for shorting private company stock and other dynamic exposures to drive greater market efficiency.
For allocators, the limitations of the conventional venture capital approach may not optimally position them to achieve their aspired targets under more robust market conditions, let alone in the current shaky economic climate. As we embrace the new normal, allocators would benefit from reconsidering whether venture capital managers are employing the right strategies and can deliver on return expectations, given their current limits. As allocators reassess what they can achieve from their exposure to private markets, it is well worth considering the benefits of diversifying with alternative strategies that emerging managers can offer to unlock new sources of value that sit outside the view of traditional investing. As an asset class focused on financing innovation, there are good incentives for supporting venture investors that are also championing what we demand of our portfolio companies by pushing the boundaries of how we invest, how we create alignment and adapt to changing realities. Although this approach to allocation requires a flexible orientation, it positions a portfolio to capture a potentially limitless pipeline of opportunities in times of stability or volatility, in good markets or bad, for the promise of enduring alpha.
Natalie Hwang is founding managing partner of Apeira Capital Advisors LLC, New York. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.
