When the ‘R’ word doesn’t stand for risk

In late 2007, when the NVCA was asked by the media whether the sub-prime credit crisis would hurt the venture capital industry, our answer was no. The steady pace of venture capital investment combined with the strong VC exit market in 2007 supported this theory that the industry would not be impacted in a meaningful way.

Yet, as the country’s economic challenges developed further in 2008, the question transformed into whether venture capital investment would be impacted by a recession. The answer here is more complex and less predictable. The long-term nature of the venture capital investment horizon would suggest that our asset class is, in many ways, recession proof. After all, the investments being made today won’t be ready for public consumption for five to 10 years, maybe longer.

Yet, the impact of a recession on the VC exit markets could indeed significantly impact investment decisions in the near term, depending on the length and severity of the downturn.

The largest threat is if the winds of recession result in a closing of the IPO window for several consecutive quarters. Successful public offerings largely drive venture returns, and the market was in a fragile state before talks of the “R” word. After two years of dismally low IPO volume, 2007 rallied to produce 86 venture-backed IPOs, a marked improvement but still not at the levels that would be considered undeniably healthy.

Slow start

In the first two months of 2008, there were only two venture-backed IPOs. While the first quarter is traditionally slow, this is not the year to be in a catch up position before reaching the halfway point.

Of equal concern is the mergers and acquisitions market, which has been the cornerstone of the venture-backed exit market since the late 1990s. If large corporations face increased earnings pressure, they may delay or abandon acquisitions or refuse to pay the prices that make such transactions attractive to venture capitalists and entrepreneurs. Like the IPO market, VC-backed M&A enjoyed a stronger year in 2007, with average disclosed transactions values at a seven-year high.

The long-term nature of the venture capital investment horizon would suggest that our asset class is, in many ways, recession proof.

Mark Heesen

Clearly the worst case scenario is one in which both the IPO and M&A markets suffer simultaneously for an extended period of time. Companies that are now ready to exit will be compelled to wait out the freeze, in some cases requiring an extra, unplanned round of funding. While such a situation can be sustained for a few quarters, a longer hold out will suck both VC time and money away from new investments.

We would not like to see venture capitalists in triage mode as we did post-bubble, but the potential is there. In this situation, we may finally see the rise of the alternative exits that everyone has been talking about for so long—with opportunities for hedge funds, investment banks, sovereign wealth funds and SPACS to buy VC-backed companies.

A recession will also impact portfolio companies directly. In a prolonged period of economic downturn, milestones may very well be missed.

Conventional wisdom would suggest that the life sciences sector would face a lesser challenge than industries such as cleantech, information technology and financial and business services. Yet, expectations all around may need to be reset.

If there is any good news, it is that it is too soon to tell how deep this downturn will go or how long it may last. We could still rally and have a decent 2008. But more importantly, companies that received their first round of funding during the last recession include Artisoft, Intuit, McAfee and Starbucks. Even in tough times, venture capitalists are optimists and opportunists. And history proves that the venture capital spirit is, in fact, recession proof.

Mark Heesen is president of the NVCA and can be reached at mheeen@nvca.org.