Today’s Age of Alpha and what Startups Should Know

Précis: For the foreseeable future – at least until mid-2023 – VCs are going to get pickier and there will be fewer but more consequential investments in startups in select sectors. This trend will parallel portfolio management strategy in the public markets.

Larger Picture:

Since March 2022 the Federal Reserve Bank has been increasing interest rates in response to rising inflation and they are likely to continue to raise interest rates for the foreseeable future. In fact, we haven’t seen such rapid interest rate increases in 40+ years. (All other cycles of interest rate increases have been much more gradual: 2015-19, 2004-06, 1998-2000, 1993-95, and 1987-89.)

In response, we have also seen the economy in flux and likely tip into a recession while unemployment fluctuates. The Ukraine war, erratic oil and commodity prices, and the global supply chain are likely to be persistent problems. The Chinese economy is currently not doing well but we know it will eventually improve. Covid is temporarily under control but who knows? Finally, there’s been a dramatic retreat in the stock market (approximately 30-35% by various estimates) – but especially in the equity valuations of leading technology and growth companies.

In other words, risk is back in a big way.

Clearly, we’ve passed beyond the period of low interest rates and the perceived low risk climate which brought about the sustained bull market. That tide brought about a long-term increase in the valuations of public equity portfolios, in part, because it was easy to choose stocks that win. Just throw a dart at any listing of technology stocks plastered to a wall and you came out a winner.

We’ve now entered the age of “alpha” valuations in both the public equity and VC markets. This will have a profound influence on entrepreneurship, that is starting-up the startups.

VC funds make most of their money from exits or sales of their shares in startups being bought from them. VC funds have a high-risk profile – especially relative to Growth Equity or Private Equity (PE). Growth Equity and PE have holding periods of 3 to 7 years compared to VC funds that have a holding period of between 5 to 10 years. This means that VC is riskier but possesses a longer-time to realize returns for fund investors.

But VC use public companies as relative comparisons (“comp’s”) for startup valuations, industry trends, scaling patterns and issues, and for other reasons. Public financial markets are equally gauged for their receptivity to technology trends (e.g., adoption of AI), valuation ranges, the health of the IPO pipe, retail investor interests, and other factors.

So, when the equity markets are more based on alpha, so goes VC funds and partners’ views of investments.

In the near term, this means the following:

• VC will invest more selectively in companies that have or are close to having current or imminent earnings potential or EBITDA and other operational and financial advantages.

• VC will not only offer terms sheets with lower valuations but also investor-friendly terms (such as, minimally 1x liquidity preference. This is standard now),

• As a consequence, VCs will take more time to make an investment, and

• VCs will make fewer investments and more major commitments of capital – so the average round size may trend lower relative to the last decade but generally there will still be many large investment rounds putting their capital to work.

This is what the Age of Alpha will look like in the VC funded startup world.

Regardless of whether it is private or public, an investment’s risk is driven by its underlying economic fundamentals. The impact of the heightened incidence of risk factors today has to be taken into account by startups seeking funding. Getting these fundamentals right will enable you to see the current alpha funding environment for VC and see the turn back to beta when risk diminishes and things change.

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Thank you, Eric Henderson, Chief Investment Officer of East Horizon Investments, for your review and additional comments.