Review of the Macroeconomic Environment for VC

Picture of Idil Azizoglu

Idil Azizoglu

I joined the 212 team around seven months ago. The timing was peculiar considering the U.S. stock market’s worst performance in 40 years, record high inflation, rising interest rates, increasing geopolitical turbulence, residues of an ongoing pandemic, supply-side shocks, and the war in Ukraine.

Being an economics major and a self-proclaimed markets enthusiast, I noticed that the sentiment in the venture capital industry feels somewhat shielded from the global macroeconomic environment. Although history has proved that great companies get built under all economic conditions and the greatest even prevail in a down market, none succeed in a downturn without understanding the underlying economic and social trends. So, although venture capital allocators feel somewhat shielded from market volatility, they must be wary of insulating their choices from reality. Here are my two cents on the macroeconomic headwinds to understand the state of the venture capital industry and where it is heading.

So is it all doom and gloom?

The IMF and the World Bank warn that we are edging toward recession. But determining what counts as a recession and what doesn’t can be a complicated task. A common rule of thumb is that when an economy experiences two consecutive quarters of negative GDP growth, it’s in recession. While substantial, economic growth measured by GDP is only one factor in measuring economic health. Other metrics like unemployment levels and consumer confidence also play a role. As people lose their jobs and cut into their savings, unemployment can be highly disruptive personally, not just for economic reasons but for one’s sense of well-being. This disruption, in turn, would have spillover effects on the future of business and the startup ecosystem.

All the discussions about whether or not we are in a recession completely miss the point. The real question is how severe is the downturn compared to the one of the past? To quantify what’s going on, I pulled U.S. GDP numbers for the past 80 years of recessions, and the results were quite interesting. The U.S. GDP is down 0.6%, the smallest decline heading into a recession since 1947. Historically, most recessions began with a drop of one, two, or three percent.

Taking a look at the employment numbers is also crucial. In recessions, two things happen simultaneously; GDP declines, and unemployment rises. What’s unique this time is that unemployment is decreasing. The unemployment rate in the U.S. dropped to its lowest level in half a century this July, and it has remained exceptionally low ever since. The job market is still recovering from the high employment caused by the pandemic.

The effects of the downturn are hitting the tech sector the most severely. In an American-centric world where tech startups have the ultimate goal of being listed on the NYSE, SPACs have flourished, especially after 2019. Many startups look to the U.S. market as their North Star. The adverse effects of the Nasdaq’s nearly 30% drop year to date and the layoffs of tech giants trickling down into private markets could have severe consequences for entrepreneurs hoping to raise funds in 2023.

It is clear that the public markets have seen the effects of economic distress, and so has the late-stage venture capital. Private companies without a clear path to the public market suffered losses in valuations as IPOs practically froze in the U.S. During the last six months, down rounds were standard, with Instacart cutting its valuation by 40%, citing inflationary pressures and recession fears. Some other notable down rounds were of the cryptocurrency lender BlockFi and payments giant Stripe, who had suffered losses of 67% and 28%, respectively. Fintech Klarna had to raise capital in a down round, which reduced its valuation by over 80% to $6.7 billion from $46 billion a year ago.

So how is the current economic downturn different?

Many in the venture capital industry believe that we have been here before. Veteran G.P.s are old enough to remember at least two of the previous economic downturns, namely the global financial crisis of 2008 and the dot-com bust. Survival through past recessions offers hope for navigating this one, but many significant differences exist between the current and past environments.

The state we are in today poses unique challenges compared to 2008, a protected financial services crisis, or the dot-com era, a protected technology crisis. So if the GDP drop is insignificant and the job market is improving, why do we feel the effects of this recession more heavily? The answer is inflation.

Revisiting the Global Recession of 2008

For many of us, the global recession still invokes images of shamed bankers and people losing their homes. We should revisit what happened during the financial crisis in 2008, which pushed the world’s banking system toward the edge of collapse and left borrowers no longer able to afford their homes. A housing bubble formed in the U.S. where mortgage brokers became greedy, giving out loans to people who could not afford to repay them. Those mortgages were bundled into tradeable derivatives and sold to banks. In the end, the borrowers couldn’t pay their loans, and the House of Cards collapsed, profoundly affecting the banks exposed to that risk.

The first recession hit as the public realized how risky these bundles were, banks became concerned about further exposure, and people questioned whether banks were even solvent. Banks had to be rescued by government bailouts, which caused the crisis to spread beyond the U.S. as European Banks bought many of the troubled mortgages. European countries bailed out these banks, forcing them into a situation where they could no longer repay country debts. Years of austerity caused by squeezed government budgets dramatically affected many Europeans’ lives.

This time, it’s not about the money

Unlike in 2008, there is no capital shortage in 2022. At the moment, banks and capital markets have plenty of money they cannot spend as nothing comes into the E.U. economy. So this time, the world is not short of cash but of almost everything else. When the pandemic struck, the fragility of supply chains became apparent. Global economic conditions deteriorated after factories halted production. As countries eased lockdowns, demand for goods and services outpaced supply. There has been a surge in orders, businesses across the economy had a hard time hiring workers, food and energy prices has risen, and the world’s manufacturing powerhouse, China, has shut down due to strict Covid policy. The supply crunch became more acute after the war in Ukraine awakened Europeans to the fact that Europe depends on a very unreliable partner, Russia, for one of its most essential inputs, energy. An increase in energy and food costs coupled with supply shortages is a dire combination. There is a worldwide inflation crisis, and the U.S., Britain, and the Eurozone are particularly affected. In the E.U., inflation is the highest it has ever been, and the U.S. is at a 40-year high inflation rate. Our day-to-day lives are becoming increasingly expensive worldwide as an excess of money chases too few goods. It’s also what makes this economic downturn unique. Unlike perhaps the financial crisis recession, which essentially crippled the financial markets, individuals feel the current recession more deeply because all of us consume energy at home. We all know that our income and wealth deteriorate when inflation is high. Economic policymakers worldwide are grappling with rapid price rises. Interest rates will rise further as inflation is likely to stay above the target for the near future. It means that we have two problems: low growth and high prices.

In light of these problems, the next year will be defined by real issues:

How is Venture Capital affected?

We know that late-stage investments have a strong relationship with the U.S. public market, which skyrocketing interest rates and geopolitical turmoil this year have hurt. Especially with the post-Covid liquidity (quantitative easing), we witnessed the “search for return” in late-stage private markets by funds and investors who typically invest in the public market. The low-interest rate environment that has persisted for the past ten years has also fed this trend.

As the public market slows and U.S. IPOs hit record lows (on track to drop below $100 billion for the first time since 2016), it’s no surprise that companies at this stage will receive investment at lower valuations than their last rounds.

Likewise, venture capital valuations shift away from “growth at any cost” to “measured growth”. Although revenues are increasing, the fastest-growing software companies are being disproportionately penalized. More than the high growth expectations of the unicorns is needed to transition successfully into the public markets. When we compare the peak performance of the tech market (in November 2020), where there was a +25 percent premium of E.V./Revenue for the >30 percent NTM growth companies to the current market, we see that >30 percent NTM growth companies are now receiving a 40 percent discount. In turn, this translates throughout the venture capital markets but most significantly in the late-stage investments that fell 62 percent in the third quarter of 2022 in the U.S.

What is happening on the homefront?

European Venture Capital:

European venture has been pacing in line with their North American counterparts during the Covid era. Technology investments, which increased with the digitalization experienced, especially during lockdowns, led to the emergence of 100 new unicorns in Europe. We saw Europe outpacing the U.S. in terms of unicorn-making. According to Affinity, there have been 52 percent net new unicorns born in the U.S. year-over-year, half the rate in Europe during the last five years. However, this metric should be taken with a grain of salt as Europe is starting from a lower point compared to the U.S. Nevertheless, as the tides turn, European venture does not seem exempt from macroeconomic headwinds. With the ECB following the FED in monetary tightening and the effects of supply shocks worsened by the neighboring war hitting the European markets, the downward trend for European venture funding has been in line with global and North American trends.

Funding for European venture capital in the third quarter of 2022 fell to $16 billion, down 44 percent from $28 billion a year earlier, as early-stage investment shows clear signs of weakness. Europe’s funding dropped to its lowest level since the fourth quarter of 2020 with an investment of $13.4 billion. The most significant drop year-over-year was in late-stage financing. Early-stage funding continued to remain high in the first half of 2022, despite the slowdown in the economy. However early-stage funding saw the most significant drop quarter-over-quarter, with over 40 percent decline, catching up to the effects in the later stages. Unicorn making also significantly slowed with only four new European unicorns this past quarter, compared with 21 new European unicorns in the second quarter of 2022.

There is a case to be made for European startups, as capital allocators are putting more emphasis on profitability globally. Historically cash has always been more abundant in U.S. markets. During the past 3 years, alternative investments have attracted a greater interest from U.S. capital allocators due to low-interest rates combined with an increase in the Federal Budget. There was no incentive for startups to be financially disciplined. As large hedge funds, unable to fulfill their appetite came trickling down to the private markets, U.S. startups were able to find capital with little concern for profitability.

European startups historically were evaluated on different terms. For this reason, many founders decided to reallocate to the U.S. Fifty percent of American unicorn founders are immigrants, and 66 U.S. headquartered unicorns were founded in Europe. However, as the European Central Bank implemented Covid policies and capital became more abundant in Europe, there emerged a generation of startups that are more likely to stay home and scale. There are obvious advantages to this. European talent is cheaper, easier to obtain, and easier to retain than American talent, where competition is fierce. European unicorns who are doing more with less, since they were always expected to keep a more efficient cost structure, could be the place to turn in this environment. More and more European startups will likely decide to stay home as ecosystems grow.

Turkish Venture Capital:

We can say that we are more protected from the liquidity crunch in Türkiye compared to the U.S. and even Europe. When we look

at the Turkish public market and consider P/E multiples, we know they highly correlate with the late-stage market). Even when the market risk appetite was at its highest, valuations were well below the U.S. and even below the MSCI indices (10-year MSCI EM index P/E is 10x vs. BIST 100 3.8x).

Moreover, Turkish companies, which fall into the emerging markets pockets, did not receive the same capital flow as their American counterparts.

Amazon, one of the most valuable technology companies in the world, stated in its latest quarterly meeting that it would “do more with fewer resources.” Emerging country markets such as Türkiye, with companies not used to hormonal growth (historically, their access to funds was more limited), offer investors unique opportunities.

Early stage trend in Türkiye and the global entrepreneurial ecosystem:

The effect is not confined to the late stage but across the entire ecosystem. In the year’s second quarter, investments in global ventures slowed, while Türkiye achieved the highest number of transactions in its startup ecosystem. The number of seed investments doubled to 61 quarter over quarter, which was instrumental in reaching the record number of transactions in the second quarter. $87 million in 82 transactions comprised the total investment amount during this period.

This dynamic, which shows interest in the earlier stage, is not unique to Türkiye. While we wait for the public market turbulence in the U.S. to pass, we see venture capital funds shifting their focus to earlier-stage companies. The first half, with over 2,900 deals closed, was the most active in seed deal activity.

Final thoughts:

I believe that Türkiye offers good opportunities with its young population, ease of access to global markets, and technology adoption rate. Crises can be opportune times to start a company for founders with solid business plans and access to capital. Access to talent becomes easier for startups as those joining the workforce lower costs. More Turks are completing engineering and computer studies, and the devastating effects of RIFs in U.S. tech, however sad this may sound, increase the willingness of well-trained Turks to reconsider alternatives. Moreover, as the ecosystem developed (there were 0 unicorns five years ago, there are now 6), entrepreneurs fueled by this exit environment began to have substantial capital to start a new startup or to become angel investors and feed into the giveback culture. This culture provides promising opportunities for the development of the ecosystem and feeds our positive sentiment for 212’s upcoming fund.

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