Staying the Course: The Future of Nontraditional Investors in Venture Capital

In the era of COVID-19, experts pondered the reality of returning to pre-pandemic normalcy. How long would it take for people to feel comfortable going maskless on public transportation? Would job interviews remain virtual, or would candidates be expected to come into the office? Would people continue to favour e-commerce, or would brick-and-mortar stores have a reawakening? We are now seeing these questions answered. Few people wear masks on public transport, the degree to which employers require job candidates to be present in-office varies by industry and company, and e-commerce remains king despite a boost in bricks-and-mortar traffic due to pre-pandemic nostalgia. Questions concerning reversions to pre-pandemic norms are especially relevant in the business world. Stay-at-home orders and a stalled global economy brought about many changes across industries – new market leaders emerged, novel products and services were created, and certain business lines exploded with profitability while others faltered. A sector that saw a great deal of change was the venture capital (VC) industry, especially as the number of nontraditional investors (NTIs) multiplied along with their influence over deal terms and trends. NTIs can be categorized as all investors that do not fall into the categories of traditional VCs, angel investors, or accelerators. A common question that is raised concerning NTIs is if they will be permanent fixtures in the VC market, or if they will retreat in the face of economic volatility.

During the height of the 2021 VC boom, it seemed the good times would continue to roll for investors and their portfolio companies; however, experienced players in the industry expected the market to ultimately correct itself. Money would not always be cheap and company growth would not be sustained by the abnormal human and economic conditions brought about by the pandemic. However, what was initially expected to be a healthy reversion to the mean became a much more complex picture. In combination, geopolitical uncertainty and a precarious economic situation brought about by record levels of inflation, coupled with the increased interest rates put in place as a remedy,  added several layers to the equation. Given the compounding effect that economic and geopolitical instability was projected to have on the VC market correction, traditional VCs expected NTIs to pull back from the venture markets. 

NTIs are colloquially known as “tourist investors”, as historically, they have increased their presence in VC markets when times are good and have pulled back when times get tough. At the time of the 2008 Financial Crisis, private equity firms, investment banks, and hedge funds made up the second-largest investment class in private tech companies. The top 50 firms that fell into one of these categories cut back their VC investment by 29% in 2008 and another 36% in 2009, compared to 15% and 21% cutbacks made by traditional VCs. While it seems as though NTIs have set out to prove “this time will be different,” track records underscore the unlikeliness. 

What we have observed in the markets since the start of 2022 has been much more nuanced than in past downturns. In Q1 2022, the VC market appeared to be cooling and metrics across the board were reflective of that. A slight pullback in VC market participation by NTIs was perceived to be more a reflection of a greater market correction than a tactical retreat. Notably, mega-deals (funding rounds of $100M or more), which were a fixture of most NTI’s VC strategies, began to face troubles in closing, as growth in NTI deal participation stalled. Q2 2022 came with a more pronounced pullback from NTIs, with all investor groups except for corporate venture capitalists (CVCs) posting declining deal counts and deal value rates. As public tech market volatility began to trickle into the private markets and the IPO market dried up, large NTIs that typically invested in the growth stage found themselves with fewer places to put their money to work. Q3 2022 deal activity from NTIs reflected a pullback most akin to NTI retreats of the past. While deal counts remained above pre-pandemic levels, they fell faster than the broader venture market – a trend that is important to take note of. Deal value participation saw an even more noticeable decline than deal count. As of Q3, private equity firms participated in 48.3% of deal value, compared to 58.5% in 2021. Similarly, asset managers participated in 34.9% of deal value in 2022, compared to 43.6% in 2021. The only bright spot of Q3 was CVCs, which continued to invest in venture deals at a record pace.

NTIs make up a diverse group of firms that pursue different investing strategies and as such, the degree to which NTIs have pulled back from the venture ecosystem can only really be observed on a group-by-group basis. For example, CVC participation in venture markets has remained strong despite a noticeable pullback from other NTI types. This can be attributed to the fact that CVCs earn non-cash returns from VC investing due to the technology to which they are exposed and the relationships they forge. Furthermore, as most CVCs operate out of evergreen funds, they do not answer to Limited Partners and have the freedom to reinvest the profits they realized in 2021 as they see fit. While this group has remained the most resilient so far, an imminent recession means that they may become more risk-averse. The line of business that a CVCs’ parent companies operates in and the degree to which the profitability of such businesses will be impacted by a recession will dictate the amount of activity we see from different CVCs moving forward.

Another NTI investor group that has had a nuanced reaction to the VC market slowdown is Sovereign Wealth Funds (SWFs). SWFs typically manage hundreds of billions of dollars so they require massive deals to make investments worthwhile. In the height of the VC funding boom of 2021, this group faced an abundance of choice in terms of where they could deploy capital as the number of unicorn companies, so mega-deals skyrocketed. These late-stage growth deals also typically came with a clear path to a billion-dollar exit, as long as the IPO market remained hot. With the value and attractiveness of these growth-stage deals declining and the IPO market closed, it is not surprising that we have seen SWFs pull back from VCs substantially. It is clear that the investment opportunities that are currently available in the VC market are not in line with the general strategy or financial needs of SWFs. 

Crossover investors, NTIs that hold portfolios in both public and private markets, are another group that has had a unique reaction to the VC market slowdown. Investors in this group were some of the most prominent during the pandemic, with names like Tiger Global and Coatue Management pushing top-line trends across the VC industry. These investors were in trouble as soon as the public markets dipped, as their portfolios became at risk of being overweight in private assets. Due to the expectation that these investors would retreat from VCs to rebalance their portfolios, initial pullbacks did not come as a surprise. More recently, though, it became apparent that the VC investing strategy that crossovers had employed during the pandemic – outsourcing due diligence, investing quickly, and deploying large cheques – is not conducive to rougher economic times. When valuations are choppy and venture investments carry more risk, capital needs to be deployed more thoughtfully. Furthermore, in times of market uncertainty, founders are looking for guidance from their investors, not only money. While traditional VCs offer this kind of support, crossovers are notorious for being ATMs rather than involved participants in a founder’s journey. Despite the headwinds they face, the most prominent crossover investors appear to be adamant on maintaining a footprint in the industry. As such, many have announced intentions to raise new funds to invest in earlier-stage opportunities, as they have not yet been impacted by public market volatility. 

The behaviour of different NTI investors suggests that, while many groups desire to stay active in the venture market, they are constrained in doing so given their other lines of business. The mismatch in desire and action makes sense, as each type of investor has a responsibility to their primary business. If public tech market volatility persists, we are likely to see a matched pullback from these NTI groups; however, the retreat is likely to be measured and not to the degree of previous downturns. In times of uncertainty for the VC market, it is beneficial to have traditional VCs back at the helm of the industry, helping founders navigate through ups and downs and setting standards for fundraising to ensure that the industry does not sink too far into a downturn.