July 13, 2023

The Role of Market Cyclicality in Venture Capital Investments

I have been studying the history of venture investments. I’ve been fascinated by how the cyclicality of the markets impacts the failures and successes in venture capital investments. Like how the public markets go through cycles of over-optimism (i.e., greed) and over-pessimism (i.e., fear), venture capitalists also go through these cycles. They are very highly correlated, and there is some lag between them. I’m not concerned about how to time these cycles to become a better investor; I wanted to learn how to identify these cycles and assess my position.

My goal is to enhance my decision-making prowess as an investor significantly. Understanding past investment trends, sectoral performance, and how VCs have navigated market cycles can help you identify opportunities when everybody is just running in the opposite direction. I wanted to collect enough data and stories to analyze successful and unsuccessful investments to reveal the key factors influencing a startup’s success or failure, providing a more nuanced understanding of due diligence. Furthermore, the history of exits has been a great guide so far in setting my expectations for exit timelines and valuation multiples.

Venture fundraising, investing, and exits come in cycles. Understanding those market cycles makes VCs better risk managers and decision-makers. If you can see more than others the odds of a crash or recovery at a certain point, you can adjust and calibrate your investment between offensive vs. defensive.

As the cycle progresses, the odds fluctuate. Failing to adjust our investment strategy accordingly means passively disregarding the opportunity to tip the scales in our favor. However, by gaining insight into these cycles, we can seize the moment to increase bets on more aggressive investments when the odds are in our favor and reduce risk when the odds turn against us. It’s all about leveraging these fluctuations to our advantage and optimizing our portfolio strategy.

My writing aims not to predict any cycles or try to time your fundraising and investments accordingly; it is impossible, given the long-term nature of venture capital. A great venture investor would focus on these three core areas:

Understand the fundamentals and dynamics of the industry, startups, and building zero-to-one ventures.
Build strong discipline in finding good deals, performing proper due diligence, and reasonable investment terms, i.e., ruling out greed and fear as much as possible in your investment decision-making process.
Understand your investment environment and decide how to position your portfolios for it strategically.

What Impact Do Market Cycles Have on Venture Funding?

Market cycles, directly and indirectly, affect venture capital activity, including fundraising, investing, portfolio management, and exit strategy. Here are some of my thoughts on why that matters.

The Ability to Fundraise

VCs raise funds primarily from institutional investors and wealthy individuals, known as limited partners (LPs), which include pension funds, endowments, and wealthy individuals. The fundraising environment can significantly influence broader economic and financial market cycles.

In bullish markets or during economic expansion, LPs generally have more capital available to invest. They are more likely to allocate some of that to riskier, illiquid assets like venture capital. In contrast, during bearish markets or economic downturns, LPs might become more risk-averse, making it harder for VCs to raise new funds.

It is counterintuitive since these are the best times to invest since competition on startups is at its lowest with humble valuations, which maximize the returns. Savvy investors and LPs know this is the time to get aggressive. On the other hand, novice investors and LPs get caught by the FOMO effect at the peak of the markets and throw money at over-valued startups, which puts the funds at far more significant risks of losing value and corroding their returns.

The Ability to Find the Best Startups and Invest in Them

Economic and industry-specific cycles can affect the number and quality of startups seeking funding. In boom periods, entrepreneurship often surges, leading to more startups and potentially higher valuations and competition among VCs. While the number of startups might decrease during downturns, those that launch are often more resilient and resourceful, and valuations may be more reasonable.

Additionally, specific sectors might be more attractive at different points in a cycle. For instance, fintech companies often thrive during financial disruptions, while direct-to-consumer businesses might struggle in a recession but flourish in a recovery. By understanding these cycles, VCs can more effectively identify promising investment opportunities and negotiate better terms.

The challenge is that fund managers must be aggressive when most are not, including the LPs. That leaves a lot of fund managers needing more resources to invest in cost-effective and promising startups. Savvy investors bring their LPs to the right mindset during these downturns to aggressively invest in funds looking for medium and long-term high returns.

To optimize the positioning of a portfolio at any given time, it’s crucial to determine the right balance between aggression and defensiveness. This balancing act should be periodically adjusted in response to changes in the investment landscape and the phases of various elements.

The Ability to Support Startups to Grow and Achieve the Highest Returns

As active investors, VCs often take on advisory roles in their portfolio companies. Understanding market cycles can help VCs provide better strategic advice. For example, during a downturn, VCs might advise startups to focus on cost control and survival, whereas, during an upturn, the focus might be on growth and expansion.

Understanding cycles can also aid in financial planning. VCs can help startups plan their future funding rounds according to capital market cycles to ensure they can secure capital when needed and on favorable terms.

The Ability to Generate Great Fund Returns with Successful Exits

Exit opportunities, either through acquisitions or initial public offerings (IPOs), are strongly influenced by market cycles. During bullish markets, IPO windows are more likely to be open, and corporates are more likely to make acquisitions, often leading to higher exit valuations.

Understanding these cycles can help VCs advise on the right timing for exits to maximize returns. It also helps VCs manage the lifecycle of their fund, as the timing of exits can affect the fund’s internal rate of return (IRR) and, ultimately, the VC’s ability to raise subsequent funds.

Understand How Key Cycles Impact Your Investments

The first step is understanding the nature of the market cycles and their impact on venture funding and investments. These cycles affect companies at different stages of development, but early-stage startups may be more sensitive to these shifts. Therefore, understanding the cycle at any point (expansion, peak, contraction, or trough) can help you make better decisions on the types of companies or industries you invest in.

Venture capitalists (VCs) invest in startups expecting high returns, even though many of these ventures fail. While VC investments are generally considered less sensitive to economic cycles, they are not immune to them. The next set of articles will expand on understanding these cycles’ impact on venture funding and investments. I will discuss three main cycles that impact venture funding in one way or another. These are:

The Economic Cycles comprise expansions and recessions in general economic activities.
The Credit Cycles reflect changes in the availability and cost of borrowed capital.
The Technology Cycles refer to technology creation, adoption, maturity, and replacement.

Closing Remarks

My following few articles will dive into each of these cycles. I will define each cycle, how it impacts different venture capital investment parties, and how early-stage fund managers or angel investors can use these cycles to improve their investment positions and maximize their returns significantly.