History is Rhyming, Do You Hear It?
It is hard to believe that COVID-19 sparked an economic crisis that is only a few weeks old. Less than 2 months ago everything seemed to be going great, markets were going up almost every day and investor enthusiasm was running high. What a difference just a few weeks make… Markets are down more than 30% from their highs, economic activity has basically stopped and the media is full of stories of businesses struggling and investors suffering.
Before I go any further, I want to say that I am an optimist and I believe we will get through this current rough patch. I personally do not subscribe to the “doom and gloom” perspectives that pop up during difficult times. It is hard to be an optimist during difficult times, but I always remind myself that it is darkest before the dawn. After all, this is my fourth major economic and financial crisis in 25 years, and we got through the previous three. The economy will recover, markets will rise, and life will get back to normal.
However, I also think that a sudden disruption in the markets and economy are triggers to reflect and see whether there are similarities between our current crisis and prior crises. These similarities may provide lessons for us to learn. History does not repeat itself, but it often rhymes.
Particularly, I wanted to reflect on the state of funding for private companies today and compare it to the dot-com era bubble and burst.
20 years ago, on March 10, 2000, the NASDAQ stock market index peaked at 5,048.62 points. It took 13 years for NASDAQ to recover back to that same level.
In the 3 years preceding the dot-com bubble, the media was full of stories about Internet companies that were reshaping the world. Investors were caught up in the frenzy, chasing after these companies with little regard for business models, revenues or profitability.
Typical metrics such as Price/Earnings, Price/Sales and other similar ratios that served investors faithfully for decades were discarded in favor of hope and dreams expressed as “price/eyeballs”
IPO statistics between 1997 and 2000 paint a telling picture. In 3 years over 1,200 companies went public, many of them being Internet companies. I was working on the trading floor of a large Swiss bank at the time and recall the excitement of an IPO every day. Bankers were chasing every company they could find that wanted to do an IPO.
Meanwhile, salespeople and traders excitedly called their institutional clients because everyone wanted to “get in on the deal”. Receiving an allocation in a hot IPO was a sign that you were part of the inner circle of finance, but that all ended when the bubble burst.
At this point you may be asking – where are the parallels and why am I looking at the dot-com bubble. On the surface of it, the world of investing is very different. The number of IPOs has fallen dramatically over the past 10 years and today is less than 1/3 of the volume it was in the late 1990s.
Technology companies remain in private hands a lot longer and IPO when they are mature businesses. Furthermore, companies such as Apple, Facebook, Google, and many other large-cap technology companies are generating record profits and sitting on trillions of dollars in cash.
However, a more detailed analysis will quickly find uncanny similarities to the pre-dot-com era. The 1990’s IPO has been replaced by large rounds of raising capital. Rather than tapping public markets for growth capital, many tech companies today choose to tap into private markets through Venture Capital firms.
If we compare the amount of mega-VC rounds, which are rounds over $50m, to the amount of IPO’s in the 1990s, starting from around 2016 the deal-flow start to look very similar to the IPO’s after 1996. In fact, since 2016 in the US alone there were over 1,300 VC rounds of more than $50m with median capital invested per round of $80m and median valuations of over $450m (analysis based on Pitchbook data). Many companies doubled valuations in less than 12 months between these rounds.
Market dynamics looked very similar as well, at least before COVID-19. There were almost daily news reports of some company raising large sums of money from VCs, deals being completed in record times, reduced due diligence, and investors were clamoring to get an allocation.
As in any frothy market, caution and risk management seemed to have disappeared. As JP Morgan Asset Management’s Michael Cembalest writes in Eye On the Market, “The prophets of the venture capital ecosystem (startup CEOs and venture funds that finance them) have reached new cycle peaks regarding private companies with no profits”
We are very early into the crisis created by COVID-19 and it is hard to forecast how everything will play out. Maybe the economy will experience a sharp rebound and things will go back to the way they were. Maybe the rebound will be more gradual. But times of crisis should be used to evaluate strategy and see if fundamental changes are needed. Every entrepreneur who is thinking today about their product and services strategy must also think about their funding strategy.
There is plenty of liquidity in the system and some Venture Capital and Private Equity firms are sitting on record piles of dry powder (cash to allocate.) I suspect these firms will not be in a hurry to deploy all of their capital quickly as their own investors’ attitudes toward risk will change.
Only select companies will likely continue to receive funding from VC firms and many will need to consider how to position themselves to be more attractive to a broader audience of investors. Valuations may have to come down and focus may need to switch to profitability a lot sooner. But that is a good thing because it will still enable innovation to continue.
The cover on Barron’s magazine in March 2000 closed with this quote: “The Internet investing game has been kept alive in large part by a massive flow of money out of Old Economy stocks and into New Economy stocks. Last week’s steep slide in the Nasdaq and the sharp recovery of the Dow Jones Industrial Average may mark a reversal of this trend.
As illustrated last week, once psychology changes, cash-poor Internet issues tend to fall farthest, fastest.” Every entrepreneur should listen to the rhymes of history and be prepared for every eventuality.