July 25, 2023

The Impact of the Credit Cycles on Venture Funding

The credit cycle reflects changes in the availability and cost of borrowed capital. These cycles reflect the ease or difficulty with which businesses and consumers can borrow money, and they can directly affect a startup’s ability to access debt financing, manage cash flow, and weather periods of financial instability. Therefore, credit cycles significantly affect the entire economy, including venture capital firms and startups. Credit cycles create a domino effect in the venture funding and startup world, from sources of venture funds (aka LPs) to startups and employees.

A tight credit cycle is only sometimes destructive. A favorable credit cycle is also only sometimes a good thing.

A tight credit cycle is only sometimes destructive. A favorable credit cycle is also only sometimes a good thing. As I mentioned in my previous article, the market always swings between over-optimism and over-pessimism. Credit tightening and loosening, which create the credit cycles, are one of the government tools to cool down an overheated economy or catalyze an economy to get out of a recession. Let’s examine the credit cycles’ impact on LPs, venture capitalists, and startups.

Limited Partners (LPs) have complex cash flow and capital investment calculations significantly impacted by the credit cycles.

Reduced Liquidity. LPs, often including institutional investors such as pension funds, endowments, and insurance companies, might face reduced liquidity during a tight credit cycle. This can result from lower returns from their broad investment portfolio, potentially reducing the capital they can allocate to VC funds.

Risk-Aversion. LPs could become more risk-averse during a tight credit cycle. Given VC investments’ illiquid and high-risk nature, they may choose to allocate less to VC funds in favor of safer assets.

Cash Flow Considerations. Due to the uncertainty and financial stress during a tight credit cycle, LPs might need to hold a larger portion of their assets in liquid form for potential obligations, further limiting their ability to commit to VC funds.

The impact of the credit cycle on limited partners, or LPs, trickles down very quickly to Venture Capital Fund Managers.

Fundraising Challenges. A tight credit cycle can make raising new funds harder for VC fund managers. LPs may commit less capital to VC funds, or fundraising may take longer.

Stricter Due Diligence. LPs who commit capital might conduct more rigorous due diligence and demand more stringent terms, such as lower management fees or better hurdle rates.

A shift in Investment Strategy. Given the likely reduction in available capital, VC fund managers might need to shift their investment strategy. This could involve focusing more on supporting existing portfolio companies rather than making new investments or seeking out startups that require less capital or have a clear path to profitability.

Longer Fund Lifecycle. With a potential decrease in exit opportunities due to market conditions during a tight credit cycle, the fund’s lifecycle could extend, impacting the fund’s Internal Rate of Return (IRR) and, ultimately, the VC’s ability to raise subsequent funds.

How Can You Still Raise in a Tight Credit Cycle?

As a fund manager, especially first-time fund managers, there are several ways to pitch your fund to LPs, using changes in the credit cycle to your advantage.

Emphasize Resilience. In a tight credit environment, highlight your fund’s resilience and ability to navigate economic downturns. Show evidence from past investment cycles where you’ve delivered consistent returns. If you don’t have that, show access to promising deals!

Focus on Opportunities. During a tight credit cycle, there may be opportunities to invest in undervalued startups due to less competition and lower valuations. Convey to your LPs that your fund is well-positioned to capitalize on these opportunities.

Highlight Prudent Use of Debt. If your fund or portfolio companies use debt wisely and sparingly, this could be a selling point in loose and tight credit environments. In a loose environment, it shows you’re not being reckless despite the availability of cheap credit. In a tight environment, it shows you’re less likely to be affected by increased borrowing costs.

Long-term Strategy. Remind LPs that venture capital is a long-term investment. Even if the credit cycle is tight now, investments you make today could yield significant returns when the cycle turns.

Diversification. Depending on your fund’s thesis, this can be a selling point if you’re diversified across sectors, stages, and geographies. It shows you’re not putting all your eggs in one basket and that you’re less likely to be severely affected by a downturn in any area.

Impact of Technology Cycles on Venture Funds

Now, for venture capitalists, the technology cycle can also impact their ability to raise and invest funds. As much as VCs feel the hype and FOMO investing in startups, LPs feel the same. They don’t want to miss investing in hot technology, as well as they don’t want to appear as the dump investors who are investing in a losing section. Therefore, you need to be aware that the technology cycle can affect your fund cycle in these ways.

As much as VCs feel the hype and FOMO investing in startups, LPs feel the same.

Fundraising. When a new technology is in the innovation or syndication stage, there’s a lot of excitement and potential for high returns, which can attract LPs, as what’s happening with AI at the time of this writing. However, this stage also comes with high risk, which some LPs may be wary of. The risk may be lower in the diffusion or substitution stage, but so is the potential for outsized returns.

Investing. VCs want to invest in startups in the early stages of the technology cycle, with the highest growth potential. However, they also need to consider the risk that the technology may not achieve widespread adoption or that the startup may be unable to outcompete others in the same space.

Exit Opportunities. The stage of the technology cycle also impacts exit opportunities. If the technology is nearing the end of its cycle by the time the startup is ready to exit, it may be more challenging to find a buyer or go public.

Closing Remarks

The credit cycles are the most volatile and most impactful on LPs and, consequently, on VCs. Show discipline during loose credit cycles, and resilience and preparedness for tight credit cycles is inevitable.

My last article in this series on market cycles’ impact on venture funding will discuss the impact of technology cycles. Stay tuned!