The Year Ahead - My Thoughts on 2023 and What Brought Us Here
“We’re all just one trade away from humility…”
John C. McKinley as Marv - Wall Street (1987)
2022 started to show us just what that humility is going to look like and should serve as a stark reminder that there’s always two sides to a business cycle – the “up” and the “down.”
Reflecting on the past fifteen years, the World witnessed significant advances in cloud computing, no-code/low-code frameworks, unstructured data management, eCommerce, Artificial Intelligence, Machine Learning, Natural Language Processing, and much more. These advancements in technology also coincided with a period of exceedingly cheap money as the Federal Funds Rate dropped from roughly 5% in 2006/2007 to 0% in 2020/2021, leading to a historically large number of technology startups being founded and funded as shown in the following graphic[1].
Source: Silicon Valley Bank
Normally, this wouldn’t be overly concerning, and for the first ten years of the cycle everything was following a usual pattern, albeit for longer than we’ve seen historically.
The emergence of the global Pandemic however threw the usual playbook straight out the window, as the public and private markets, along with the public at large, treated COVID as if it were an early Christmas. How else do you explain an exploding stock market and hundreds of billions being poured into private companies at a time when the US GDP was seeing its largest contraction in 70 years[2]. What should have kicked off a global retrenchment, had the exact opposite effect and led to one of the most irrationally exuberant market runs in recent memory, or arguably in history.
This is what I call “Moral Hazard at Scale”.
Venture capital and private equity funds raised larger and larger pools of capital at the fastest pace in history, with some stacking funds back-to-back. Now armed with a nearly inexhaustible supply of capital chasing what they believed to be the “next big thing”, standard due diligence processes and governance policies were relaxed as funds raced to deploy capital. This encouraged startups to adopt a growth at all costs mindset, spending larger and larger sums on marketing and customer acquisition with no thought to unit economics, capital efficiency or other traditional operating metrics - all to justify the increasing sums raised and the valuations commanded.
Which brings us to 2023 and the Great Reset.
The Great Reset begins with the current macro-economic environment – declining public equities, inflation, earnings, recession fears, rate hikes, you name it. This traditionally signals that investor capital allocation to the private markets is going to get cut back until the markets start to rebound. However, those allocations have already been been made for the next year or two, and now seem substantially outsized and ill-timed, causing some to wonder “Would an LP default on their private equity or VC commitments?” This very real concern has contributed to the nearly $260B of investment capital sitting on the sidelines as the market recovers from yesterday’s hedonism and investors find their footing again. The positive out of this is the much-needed forcing function on startups to drive new organizational behavior focused on building enduring, cash efficient and scalable businesses in partnership with their investors.
“It’s funny how all living organisms are alike… when the chips are down, when the pressure is on, every creature on the face of the Earth is interested in one thing and one thing only. Its own survival.”
Lois Smith as Dr. Iris Hineman, Minority Report (2002)
I believe that after a brief resetting period, we will see capital slowly come off the sidelines as more startups and private companies demonstrate their focus on building their businesses properly with solid unit and operating economics. Valuations will also rationalize and be driven by both option and execution value (a core tenant of what we call “Model Thinking” at WestRiver Group). And finally, First Principal investing will come back in style, hopefully demonstrating to LPs that investors are committed to acting as proper stewards of their capital.
For my part, I view these developments as a net positive and feel that this Reset has been long overdue. Over the next 12 to 24 months, I expect to see the following occur:
More rational valuations for early and late-stage companies
Increased due diligence by investors before funding an investment
Greater emphasis on formal and informal governance and oversight
An adherence to valid operating and profitability metrics by startups
It will be a bit of a bumpy ride to be sure, but I’m very bullish about the path ahead and what it means for the private equity and startup markets. If history is any guide, it is periods like these that have given rise to the Amazon’s, Microsoft’s, and Google’s of the world. Today we are already seeing several exciting opportunities, and more are on the horizon.
Now is the time to be investing in the private capital markets. Those with conviction and patience will be rewarded handsomely in years to come. They always are.
#ONWARD
[1] Silicon Valley Bank - Tech Trends 2022: VC activity and lessons from past downturns
[2] https://www.whitehouse.gov/wp-content/uploads/2022/04/Chapter-3-new.pdf
