In Part 1 of our Venture Capital Investing for Private Investors series, we discussed how technology has enabled more investors to harness the growth potential of these companies. Here, we will share some macroeconomic considerations specific to this asset class.
VC investment reached an all-time high of $130.9 billion in 2018, as shown in the accompanying chart from Pitchbook. Greater accessibility to private deals and the appeal of harnessing a fast-growing company makes this an exciting opportunity for private investors.
But it also introduces a lot of idiosyncratic risk and the risk/reward dynamic is much different from that of a publicly traded security.
As Crunchbase points out, “the time between Q4 2018 and Q1 2019 marked something of a turning point for the global venture capital ecosystem.” Basically, the global venture market has stagnated with all sectors except for seed-stage showing a slowdown in dollar volume and a recession in deal volume.
There are also macroeconomic headwinds to consider—trade wars, inverted yield curves, low inflation, tepid growth, etc. Should the economy tip into recession, venture could be particularly hampered for three reasons: a softening in liquidity, the illiquid nature of the asset class, and a general contraction in commerce. This is an important consideration because while we think venture can be a great way to diversify a portfolio for sophisticated investors, an over-reliance can create unintended consequences in the event of an economic downturn.
Even so, venture capital is now touching every single traditional industry, so like a diversified basket of publicly traded equities, we foresee privately traded cyclical and defensive investments as potentially being able to offset against investments in business models more reliant upon discretionary spending in such a scenario. In other words, while Airbnb might suffer in a downturn, there might be good opportunities in healthcare, for example, that can withstand such dynamics.
We think potential headwinds in the economy may deter some firms from temporarily going public—staying private for longer—to avoid the scrutiny of quarterly reporting in the middle of a downturn. If so, that could mean more opportunity to invest in a firm that has great growth potential. Finding these deals will require a robust and sophisticated ecosystem of founders, institutional investors, and advisors, exactly what we have sought to build at SWS.
Another risk factor to consider is the potentially negative impact of extreme size. We will delve deeper into this matter in Part 3 of our series.