Young VCs Are About to Face Their Greatest Test

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Between 2009 and 2021, the stock market enjoyed its longest bullish market in history, with returns in excess of 400%. But what goes up has to go down. While the economy managed to recover quickly after the immediate downturn caused by the Covid-19, it seems that we are now really experiencing a recession, meaning a whole generation is about to experience a bearish market for first time.

This will likely be a shock to many home traders, but the impact will be especially brutal for venture capitalists. After years of successfully “picking winners” that yielded impressive returns (especially in the tech sector), these investors are about to find out how good they really are. Were they doing their due diligence on the basics of the market or just following the trends and going with theirs? The next few months and years are about to be a serious check of reality.

Related: How (and when) to save during an economic crisis

Is the tech bubble bursting?

In recent years, any discussion of “high-growth stocks” or “industries to see” has focused heavily on technology in its many forms: fintech, software as a service (SaaS), clean technology. Now, however, these sectors are experiencing the most painful fall.

The stock market has fallen by about 18% overall (delivery or take a few percentage points depending on the day) and technology stocks have experienced a drop closer to 30%. Given that these tech companies accounted for about 25% of the S&P 500 in 2021, they not only fall faster than anything else, but are an important factor in why the stock market as a whole is declining. The Tiger Global Fund, for example, which focuses on the Internet, software and fintech sectors, lost 52% last year alone.

So what’s going on? When the pandemic first hit, software solutions suddenly became a crucial part of everyday life and workplaces, with people and businesses forced to go digital. Stock prices soared for companies like Zoom and Netflix, and 2,490 companies reached so-called unicorn status in the first six months of 2021 alone (i.e., valuations of $ 1 billion or more) . Moreover, all this was happening in the context of more than 10 years of low interest rates.

But now, with inflation on the rise and a correction, it looks like the market may have been overexcited, with many tech companies overrated by pure speculation. For example, Zoom went from a stock price of $ 73 in January 2020 to $ 349 a year later, and has now dropped back to $ 109.

Some have compared the current situation to the so-called point bubble as of the early 2000s, which saw many investors pour their money into almost any internet-related company in hopes of becoming “the next big thing. “, despite some. of those companies that do not have a genuine value proposition. is the classic example.

As before, investors have continued to invest large amounts in business models and sectors that they always truly understand (Web 3.0, anyone?), And the economy may finally be catching up. In addition, recent transactions have taken “futuristic” valuations to a whole new level, causing investors to be hyper-focused on specific start-up categories (such as SAAS) that tend to trade with multiple high incomes, thus creating a large amount. of overrated startups. who have not always validated their fit in the product market or have a path to a solid business model, not to mention profitability or a decent track record.

Related: How to make smarter and safer investments in the stock market

What it means for investors

Venture capital investors have one main goal: to identify young companies with high growth potential and to invest in the hope of generating large profits later. In recent years, the “big profits” have been associated primarily with the technology industry, especially after the digital acceleration caused by the pandemic. Suddenly, tech companies didn’t need much to get good valuations, regardless of whether they really boasted good market fundamentals, so they didn’t exactly need a great investment strategy to achieve impressive returns.

As this trend continued over time, investor confidence grew and some became more careless. Maybe they had forgotten that there was a possibility that the whole buzz was a bubble, or maybe they just didn’t care. Because while valuations continued to rise in subsequent rounds of financing, everything went well in the world of illiquid assets.

In 2021, VC’s exit values ​​reached $ 774 billion in the U.S. and venture capital surpassed all other asset classes. But now that boom time is finally coming to an end, bad luck and the wave will no longer reduce it.

Over the next few years, the investors who earn will be those who have done their due diligence: those who, instead of just following through the crowd, examined the crucial fundamentals of the market, such as a company’s product, validation market, management, business model, etc. Not to mention those who were fiscally responsible enough to save money for harder times and preserve a decent track.

Related: Revealing signs that you should not raise venture capital

What does the future hold for us?

Current downward market trends are not just pure speculation. At the moment, inflation is skyrocketing (8.3% between April 2021 and April 2022), which reduces the purchasing power of consumers and businesses and makes it more difficult to make sales. It also makes it difficult for companies to make budgets and plan for the future.

With rising interest rates to fight inflation, debt is more expensive than before, which will naturally lead to lower valuations and a tougher environment, at least in the foreseeable future. Interest rates were one of the main factors driving growth in the first place, so they will be a crucial factor in changing the environment.

However, there is also a lot to be optimistic about: the downward trend is probably a temporary blow, rather than a bursting bubble. The role of the Internet is now cemented, technology is going nowhere, and therefore there will always be valuable technology actions and companies that will continue to deliver fundamental value.

While some companies (and maybe even funds) will go down, this is actually a healthy fix for the market as a whole. Solid companies with a good product that are solving a major problem still have room. In addition, companies with sound management that know how to adapt to markets and optimize in the long run are likely to do well in the long run, having the unique opportunity to increase their market share as their competitors fall. After all, while many companies fared poorly during the fall of the dot-coms, there were also a few that survived and thrived, such as Amazon, eBay and PayPal.

Today’s young venture capitalists hope to be one step ahead of their peers. Those who did their homework, those who did the due diligence, developed an investment thesis and did not completely ignore the basics can come out well, while others could be in hot water. Either way, for the two VC startups, this is likely to separate men from boys, leading to a stronger, healthier economy.

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