Advice: Preparedness in the wake of market course corrections

31 December, 2019

Both the private and public equity markets have been on a bull run for the last 11 years. The technology and the fintech market, in particular, show early signs of overheating.

The combination of markets ripe for disruption, a radical platform shift to mobile, and vulnerable incumbents be they banks, wealth managers, or insurers, have attracted billions of dollars of investment over the last decade.

With funds flowing freely and venture capitalists (VCs) armed with billions in their pockets, investors have been hunting for promising start-ups. With so much money looking for deployment, funding rounds have gotten increasingly bigger, and valuations continuously higher. Some critics even believe start-ups are getting too much money resulting in a loss of focus, overspending, and burning a perceived never-ending pile of cash.

The WeWork wakeup call

Nowhere was this as acute as with the IPO of WeWork. Once the most valuable US start-up, the company pulled its public offering after analysts baulked at the annual losses and lofty promises from the former CEO Adam Neumann. The company went from being valued at $48 billion to bankruptcy talks in just six weeks. The poster boy of the VC investment boom is now a totem of the potential outcome for over-inflated companies.

Fast forward to now. This year’s (2019) IPO class is the least profitable since the tech bubble, and the marketing used by tech start-ups isn’t drawing capital like it used to. Andre Haddad, the CEO of the car-sharing startup, Turo, is quoted as saying, “I think the markets have been very unforgiving with the companies that are burning a lot of cash and are not showing material changes in their profit margins. If you’re a start-up and you’re in that camp, then you’ve got to change.”

The path to profitability

There has been a shift from growth to margin, which means investors are more interested in profitable businesses than those boasting rapid growth and a high burn of cash. Before WeWork, only the number of customers and its month-on-month growth counted, and investors were less worried about profitability.

This still may hold true for private companies, but once these companies are preparing for IPO, private companies are forced to put much more focus on the path to profitability. The shift reflects a change in risk appetite, and investors are less inclined than ever to give money to cash-burning firms.

Recent disappointing IPO stories are sending investors back to the drawing board, looking for companies to prove their staying power instead of boasting rapid expansion. This is leading companies to shift growth, expansion, and sales strategies accordingly.

Growth solves many problems at start-ups, but unit economics is not one of them. As a tech start-up, it’s not enough to have a high growth rate. If a company is buying customers with VC money and then losing this when customers buy the product, that’s not good business. Instead, starting small and allowing a market-informed strategy to take root, as well as time to focus on developing the right “product” will create a solid foundation upon which to build a venture-enabled growth strategy that persists and drives value over the long term. This is how investors are now appraising valuations.

A recession is looming

The global economy is now in its 11 straight years of expansion. History and sound financial logic tell us that this trajectory is unsustainable. Periods of economic growth end because of assets bubble bursting or entering in recession cycles, as happened with the tech bubble burst of 2000-2001 or the Lehman crisis in 2008.

This means the likelihood of a downturn is increasing, a potential recession looming at the horizon, but we do not know when it will happen and what it will trigger at the end. Just recently, the US experienced a Flash Crash at the repo market; as we remember, the restricted access to the re-financing opportunities of the repo market led to the Lehman decline in 2008. Since the situation of the repo market is seen as an early warning sign. We can also observe the re-emergence of the collateral loan obligations (CLOs), which is deja vu with 2008.

We are currently in a situation of various asset bubbles: bond, equities, real estate, private equity, and venture prices are close to an all-time high, which begs the question, ‘how long it will be able to sustain’?

In the last financial crisis, the central banks served well their role of lender of last resort, this time around the situation looks bleak. Interests are at an all-time low, in eurozone mostly negative, billions of dollars have been invested in buying government and corporate bonds on both sides of the Atlantic as part of the quantitative easing resulting in the alarming situation that there is no dry powder left. So, what does this mean for the tech industry in general: be prepared for tougher times ahead.

TempoCap is a signatory to the United Nations-supported Principles for Responsible Investment (PRI).

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