Venture capital is critical to the global economy. Thankfully, it has survived the coronavirus pandemic despite experts’ predictions and will help the world recover.
Venture capital, or VC, is a form of private equity and financing that provides small businesses and startups with the funding to achieve long-term growth. By channeling financial resources to promising projects, it plays a crucial role in sustaining economic growth through transforming abstract ideas into commercially viable products and processes.
At the start of the coronavirus pandemic, experts feared a large contraction in the VC sector due to the cloud of uncertainty hanging over the world economy, prompting speculation that the traditional economic growth paradigm may have run its course. “The Global VC market has completely locked up,” wrote investor Gil Dibner for “Medium” back in March. Fears were based on the industry’s traditional reliance on face-to-face meetings and a prediction that VCs might understandably choose to save their funds for better economic times.
Fortunately, a recent study by Harvard Business School professor Paul Gompers and his colleagues suggests that reports of the VC sector’s imminent death are greatly exaggerated. Their research is based on a survey of nearly 1,000 US-based institutional VCs.
The study found that the pandemic had not hit the flow of new investments as badly as some feared.
During the first half of 2020, the VCs reported that their investments were proceeding at a pace equal to 71 percent of the normal for that period, and their expectations were that by the end of the year, the pace will have picked up to 81 percent.
While a decline of 19 percent may seem worryingly large, the dotcom bust of 2001-2002 witnessed a decline of over 50 percent. Likewise, at the peak of the global financial crisis in 2009, VC investments contracted by 30 percent. This is one of many examples where experts predicted apocalyptic coronavirus-related outcomes, accompanied by the “this time it’s different” headlines to which we have all become desensitized. The reality thankfully turned out to be more mundane.
The study did detect a change in the offers that VCs make to the founders of prospective fund companies.
Rising inequality has been one of the overarching themes of the pandemic, accentuated by unequal access to livelihoods and education. In the VC domain, this has translated to expectations of more “investor-friendly” terms, which is a euphemism for VCs using their market power to exploit nascent businesses. According to the survey, the VCs have themselves held this belief (albeit phrased more elegantly).
However, contrary to these expectations, VCs have generally not exploited this inequality to impose “investor-friendly” terms. The data gathered by Professor Gompers and his colleagues showed that the terms of actual investments in 2020 have become more “founder-friendly,” in other words better for the small businesses receiving investment, than in 2016. Thus, as policymakers consider the best ways to tackle rising inequality due to its adverse effect on social and economic stability, it appears as though VCs are not a primary culprit – for the time being at least.
Innovative startups supported by corporate venture capital grow faster than those without it. The connection is a competitive advantage.— Harvard Business (@HarvardHBS) June 21, 2012
The research team also found that more than half of the VCs’ existing portfolios (52 percent) had performed at either a stable or improved level in spite of the pandemic. Thirty-eight percent were negatively affected, but were not in critical condition, while 10 percent were experiencing a severe decline in performance or were staring down the barrel.
These findings were on a per-company (in the portfolio) basis, so they do not yield a complete picture of the actual rate of return on the VCs’ gross portfolios, as it could be that the size of the companies doing well differs systematically from those faring poorly. As it happens, direct questions about the VC funds’ internal rates of return (IRRs) found that there were down a modest 1.6 percent.
Moreover, the buoyancy of the realized rates of return compared to the grim-reaper scenarios circulating in the mainstream media was enough to make the VCs quite optimistic. Ninety-one percent of the surveyed VCs believed that they would outperform public markets, and 75 percent believed that the entire VC sector – and not just their own fund – would also perform better than public markets.
Professor Gompers and his coauthors offered some explanations for these unusually upbeat findings. They attributed the success partially to the logistical and financial attributes of VC funds: they are better placed than most organizations to switch their operations to remote work, and they also have large cash reserves and low levels of debt.
The authors also argued that VCs – by design – thrive in disruptive and unstable environments. The current state of economic panic is severe enough for most investors to steadfastly cling to their cash, passing up exciting opportunities out of risk aversion. VCs, on the other hand, have a business model that revolves around taking risks that mere mortals would baulk at. Or, as the American author John Shedd once remarked: “A ship is safe in harbor, but that's not what ships are for.”
In fact, world history is littered with examples of earth-shattering innovations during times of crisis. The second plague, known as the Black Death, started in the 14th century and unleashed a fortuitous chain of events concluding with the invention of the printing press circa 1440. The Long Depression of the late 19th century witnessed many advancements, including Thomas Edison’s development of the world’s first commercially successful lightbulb. Thus, 20 years from now, we may thank VCs for supporting a new, life-changing human invention during the depths of the coronavirus crisis.
Omar Al-Ubaydli (@omareconomics) is a researcher at Derasat, Bahrain.