Managing towards a downturn



The EuroVC market is hot hot hot !  Valuations are up, deal sizes are increasing fast to accomodate ownership requirements, and any respectable VC fund could probably close a deal a week given the quality of the dealflow.  There is a frenzy of dealmaking driven by the desire not to lose market share and to ride the wave.

Portfolio companies are currently in the same buoyant mood, partly because the capital markets are so supportive, and partly because we are again enjoying a period of "hyper-innovation".

Personally, having been through a couple of cycles and reading the tea leaves of the US economy, I am increasingly concerned about a market downturn sometime in 2007.

Having boarded the 05:34 Eurostar this morning (ouch) and left behind my lovely wife and kids, I was bound to be more impressionable and sensitive to gloomy projections.  But some of the insights provided by Martin Wolf in today’s FT would still have made me nervous had I taken the 07:09 train:

  • US real interest rates are remarkably low, yet the world seems to want ever more US assets, deepening an already imbalanced current account deficit.
  • The US has financed this through a mixture of public and more importantly private borrowing, driven in large part by household indebtedness.
  • The housing led consumption boom may be coming to an end, fuelled by the sharp switch in real estate market sentiment.

This matters because countries like China have not done enough to reinvest their huge surpluses in domestic demand and infrastructure.  Europe is still in a mess.  So there is no relay in global growth and no real counterweight to the anticipated "exported slowdown" of the US economy.  In other words, the unprecendented period of growth we have been enjyoing might be drawing to a close.  And if the downturn is led by a real estate readjustment, the hard landing some have been predicting might finally be materialising: the real estate market rarely adjusts through anything other than a crash.

This analysis is the basis of three thoughts I would like to put to my readers:

1. Don’t assume a strong refinancing market, and manage cash accordingly

As VC’s it is very important to carefully think about the timing of downturns.  We typically fund our companies through ~18 months cycles and rely on exits (ideally), credibly-led uprounds (second best) or revenue momentum to demonstrate to our LP’s that we are doing a great job.  This also means we are particularly exposed to public market downturns regardless of how our companies are doing on the business front.  My personal belief is that many boards would do well to manage cash carefully and ensure they have sufficient runway to execute meaningfully on the business side, rather than rely on a strong refinancing market.

2. Take more cash now (but only as required by your business model)

Some of our portfolio companies, such as Icera, have taken advantage of strong market conditions to reinforce their balance sheet and make sure they are adequately funded to the finish line.  This makes plenty of sense.

What I do not find sensible however is that companies bump up the cash they raise for the sake of it.  Entrepreneurs may be lured by massive rounds but have to remember that these come with seniority and the attached liquidation preferences and anti-dilution provisions.  If the market downturn is bad, a heavy weight of capital almost guarantees significant dilution.  Raising too much cash is also a guarantee of lower ROE.  I, as other observers of  the market, have been struck by how much supposedly capital efficient Web2 companies have raised in the past few quarters.

3. Consider investing more slowly

It is hard to resist the momentum of the market as we all spend our time chasing the hottest deals.  But I would bet that many funds are ahead of their deployment plans at present.  Just as funds that invested heavily in 2002 are now doing great (in particular those who picked up cheap internet assets), it may be wise to consider slowing the pace of investment and consider keeping some powder dry for quieter days when valuations become more reasonable.

Having said that, we have two term-sheets out and a bunch of highly exciting irons in the fire, so I will get back to being a headless chicken and pursue these with abandon!  Happy hunting to all of you from car 12 of the Eurostar…

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