Look Beyond Prices and Indices, and Into Liquidity to Understand the Current Risks
The recent mega growth cycle for tech stocks, fuelled by the Fed, the impact of global digitalization, and the growth of the Chinese economy, delivered a sustained bull run. Add to that a COVID-inspired need to do everything online, and you had the recipe for a massive spike in all things tech. So when the pandemic hit, a huge number of second and third tier tech stocks lifted off.
But the story today is very different, and it seems that the laws of economic gravity remain. From their pandemic peak to today, share price falls of 70-80% aren’t just common, they’re the norm. Even the established Big Tech stocks like Alphabet, Meta, Microsoft and Amazon are down an average of 30% from their peaks.
While much of the current focus is on share prices and indices, evidence suggests that there is much to be gained by entrepreneurs and investors studying the impact of liquidity.
In the Asian financial crisis (which started in 1997) for instance, it was the liquidity drought, not just massive price falls, which led to the most visible after-effect of the crisis for many years: rusting, partially-built tower blocks as far as the eye could see in cities such as Jakarta and Bangkok. That is, liquidity shortages lead inevitably to business failures.
And the same may well prove true for the current generation of technology scale-ups, and for a cohort of high-growth, people-intensive, cash hungry start-ups operating in hyper-competitive environments.
That may not seem obvious right now, if you only assess the contemporary data – which can provide a disarmingly gimlet-eyed view. Often in the aftermath of a price correction, the data initially suggests that liquidity actually increases. The problem is that this may simply reflect investors heading for the door, rather than any new money suddenly rushing to fill the gaps in a world of lower valuations.
After that initial burst of liquidity, there is likely to be a sustained period where funding is either hard to secure, or is only available on tough terms. Put simply, after a massive run-up, the balance of power has shifted from the founder to the investor.
Our review of previous downturns suggests that any liquidity crunch is likely to be sustained for a couple of years – it is typically two to two and a half years. You might say, “but there’s so much money on the sidelines!”. True, but it often takes issuers quite a while to realise that prices aren’t bouncing back any time soon, and that surviving the downturn is more important than picking the market. Running out of money waiting for valuations to trend upwards again just doesn’t work!
Keep an eye on deal flows in the IPO, SPAC and VC markets – all will offer signals of a potential liquidity crunch across different stages of the investment lifecycle to provide a solid holistic view of the overall environment.
All of these observable facts stem from the public markets. Like it or not, the public markets do have a bearing on the pricing for private assets.
Private markets are opaque, lacking the continuous price feed available in the public markets. One-off data is available for discrete transactions, as opposed to all transactions – so looking at average deal sizes from one quarter to another, for example, provides an apples with oranges comparison.
However, there is already evidence of both price changes and a reduction in liquidity, with lower deal volumes, down rounds and deals increasingly pulled as expectations adjust. Over the next few months we expect the picture to become increasingly clearer - and probably more bearish - while economics and geopolitics do their darndest to wreck the party. You can be certain that liquidity will dry up as interest rates increase, and that private market valuations will be negatively affected.
At North Ridge Partners, we’re already seeing the phenomenon in action across multiple deals. There’s a gap between issuer and investor value expectations, and that gap needs to be bridged for deals to close. Carta data, cited by TechCrunch, suggests that across series A, B and C funding rounds, the number of deals completed declined by between 20 and 30 per cent in Q1 this year compared to Q4 last year, with series A numbers most affected.
At face value venture capitalists have been enjoying a brief moment in the sun, investing nearly US$20bn in Q1 – down slightly but still close to record highs. However, many, if not most, of these deals will have started during those headier days of 2021.
Exit data also suggests a slowdown in the most recent quarter, after six consecutive quarters of unusually healthy returns. To add a little more weight to the argument, the last quarter saw a retreat by non-traditional VC investors like Tiger, who announced a tactical reweighting from private markets in order to take opportunity of bombed-out public market pricing.
Right now, there are deals to be done for cashed-up investors at much lower prices than last year. Increasingly, investors are going to encounter companies with immediate and pressing needs, with their demands likely accompanied by less hubris and more fear, motivating quicker outcomes.
Where this will all get really interesting is when VCs need to hit their LPs for more cash for their next funds. Some may well be doing so off the back of a drought in exits and potentially marked down portfolios chock full of underperforming assets. Timing, as they say, is everything…
Teachable Moments
A final note – and first the bad news. Some of the worst investments we ever made took place in the aftermath of a meltdown. We now see our errors as “teachable moments”.
How to avoid such teachable moments? Be very sure of your business model when you take the plunge. Don’t be fooled by the illusion of “cheap” prices relative to last year – make sure “cheap” isn’t masking a broken business model or other structural issues. Focus on recurring revenues, scalable growth that delivers positive margins, and selling cycles that are measured in weeks – not months or years.
Now the good news.
Some of the best investments we ever made were also in the aftermath of a tech meltdown. Our sense is that soon will be the time to once again secure the deal of a lifetime!