Making sense of the market in early 2022
It’s been some time since I’ve written on this blog. I plan on going deeper on an industry-specific level soon, but here’s where I landed instead for my next topic: what the f*ck is going on? Business fundamentals in private technology markets have not changed drastically the past few months, but given the backdrop of a larger macro environment, there is a lot more noise and volatility of opinion right now. This is far from an “RIP good times” memo – it’s more of an attempt to synthesize the facts on the ground in real time in case it’s useful to entrepreneurs, company builders, and other investors in the ecosystem. Taking an alarmed position right now might be overblown or it might not be – it’s hard to tell. All I can say is that we are in a higher uncertainty environment right now (for private technology markets) than we were a few months ago so it’s important to take inventory of what’s happening.
Liquid Asset Volatility
Heightened fears about potential interest rate hikes from the Fed have caused high growth tech stocks to crater from all time highs. These are typically long duration assets (investing now for profits and cash flows on a longer time horizon), so they are more sensitive to changes in interest rates. Pandemic darlings like $ZM, $SHOP, $NET, $TWLO along with recent IPOs like $IOT, $AMPL, and $TOST are all well in the red over the past couple months. Major indices like the NASDAQ composite and the S&P 500 have fallen, and multiples for SaaS and cloud companies are at or around pre-Covid levels (some may argue those were already premium). One thing to be aware of is the extent to which machines are market participants, where algorithmic rules determine buying and selling, so there can be forced sales if prices fall under a certain threshold.
The volatility in public high growth names has only led to confusion, as it becomes an opportune moment for cynics to finally say “I told you so” and optimists to guide towards holding the course, promising a generational buying opportunity. Personally, I’m a long term believer in the durability, strength, and the undertaking of these technology and software businesses, but I also know that time frames and multiples play a big role in shaping returns i.e. you can invest in great companies and make average returns.
Aside from public stocks, there has also been a slide in the prices of major cryptocurrencies this year, including Bitcoin, Ethereum, and Solana. The price correlation to other “risk-on” assets has done short term damage to the “crypto is an independent and uncorrelated asset set” narrative1 and more to empower the “crypto was a liquidity fueled bubble” story. As more liquidity entered the system over the past few years, investors pushed further out on the risk curve. Broadly, there are two ways to think about the value of an asset – a) intrinsic to its fundamental nature and independent of market forces b) determined in part by liquidity i.e. “the water it swims in.” I’d argue the latter is more de jour these days (even in private markets).
Why does any of the above matter to private technology market actors? We operate above the fray! On longer time horizons! There is truth to this, but there are a handful of ways private tech companies and their constituents (founders, employees, investors) feel an impact if the correction sustains.
Public Comps - For many late stage startups, growth investors do implicit (or explicit) comparisons to the valuation, revenue, and other relevant metrics of more mature companies in the public markets. If the valuations of those public companies decline or multiples compress over a longer period of time, it’s suddenly a lot harder to justify investing in privates at 100x ARR.
Crossover Fund Liquidity - Many market participants in venture and growth have large public portfolios indexed heavily to technology that have taken a beating in recent months. These are sophisticated funds who know how to manage liquidity and risk at scale, so it’s unlikely there will be substantial pullback from private investing. Furthermore, many of them have dedicated, committed pools of capital for private investments. But if your book (broadly) is substantially down, it’s hard not to think about the opportunity cost of new investments.
LP Portfolio Allocations - Crossover funds aren’t the only actors in the ecosystem holding on to fluctuating liquid assets. Institutional investors into venture capital tend to manage broader portfolios that cover public equities, bonds, real estate, commodities, etc. With wild movements in other categories, LPs may watch their de novo commitments into venture, especially after a surge of new managers got off the ground the last few years. It will continue to happen, but the situation is worth monitoring and has a downstream impact on who funds seed and early stage startups.
Exit Pathways for Private Companies - The primary two avenues for startups to exit are IPO (or direct listing / SPAC) or M&A. If recent public listings continue a weak performance for the next few quarters, the boards and CFOs of unicorns may feel as if the “IPO window” closes in the near future and have to seek capital elsewhere. Some companies have prepped for a year to go public in 2022 so it can still happen and others have found other creative ways to get cash on their balance sheet. In terms of M&A, the buyer universe who can support meaningful outcomes for the ecosystem might be feeling the squeeze on their stock price.
Talent Option Set - I’ve had recent conversations with employees at growth stage tech businesses who feel as if their company has a Series D level valuation with Series A risk. This is a slight exaggeration, but talent wants to see meaningful upside on their equity given the risk and liquidity they take on. If the public comps are down and this story becomes harder to spell out, employees are left with tough choices.
Behavioral Fallacies - I haven’t invested for that long, but I do remember the COVID “flash crash” in VC in March and April of 2020. It was a scary time for the world, but nothing fundamentally changed then about the supply of capital and demand of companies seeking it. There was a lot of money sitting around, and if anything, Zoom investing was like lubricant on the deal making process. This all goes to say that venture investors tend to be herd animals and the perception of risk can do more to press pause than the reality of it.
Despite all of these factors, I’m not 100% sure deal making has changed in any meaningful way since the end of 2021. I still hear about many of the types of “wild” rounds that were happening last year. I’m not even 100% sure market conditions will change in the future – I’m just outlining some possibilities given the parameters.
Everything I’ve highlighted is a supply side issue i.e. what’s happening in the capital markets that support the technology and startup ecosystem? I see this as a tail risk (and it’s effectively impossible to predict), but is there an outside chance that business and consumer spending slow in a worsening economic environment?
Flashing back, COVID was a catalytic event for digital-first industries, and some startups (which were among the fastest growing software companies of all time) capitalized on major dislocations. Hopin in virtual events and Deel in international payroll were signatures of that phenomenon. Businesses digitized across the board so SaaS (application, infra, and vertical) thrived. With a potential “reset” happening, it’s hard to see who benefits in a clear way. But who knows what exogenous factors 2022 and 2023 will throw at us?
Ultimately, the best companies and assets that compound over a long time frame almost seemingly break free of macro cycles. So if I were a founder, I might pay less attention to the macro forces at play on the demand side of the equation.
How I Approach It
I hope this was a helpful framework for what’s happened over the past couple weeks and what we may expect to see going forward. Some people have asked me how I’m thinking about everything — here’s my stance:
I continue to spend time investing in products that lend themselves to permissionless innovation, focus on end user oriented adoption, and build organic communities.
As a venture investor, one is relatively tethered to the cycle of the asset class as a whole. The best course of action is to keep pace and keep investing. Entrepreneurship keeps going. Neither snow nor rain nor heat nor gloom…
Although it’s likely still best to think about BTC as digital-native money and ETH / SOL as new computers in the long run.