Recession Investing
Are the best companies formed during a recession?
Happy Thursday, 👋
As we look at the current economic environment, it is difficult to ignore the multiple global economic challenges including persistent inflation, rising interest rates, an uncertain consumer, and growing geopolitical tension. The constant stock market volatility is moving into the private markets as we hear more funds nervous regarding partner capital call shortfalls.
Record levels of venture capital investments during the last few years created a company friendly environment for capital raising. We recently discussed how investors rushed into deals with limited due diligence based on a seemingly consistent increase in valuations across most industries.
Markets Are Slowing
Initial third quarter 2022 data from PitchBook indicates recession fears continue to impact startup valuations as investors grow increasingly cautious regarding macroeconomic headwinds. Venture capital deal count for the third quarter declined almost 20% from the first quarter, marking a nine quarter low in terms of venture activity.
Recession Investing = Success?
We hear more venture capital investors discussing a theory that the best companies are founded during a recession. The basis of this idea is an economic slowdown forces companies to operate on a lean budget and grow with a cash conservation mindset. These companies also focus on streamlining operations and closely monitor performance metrics so when economic activity rebounds they tend to be more successful.
Another supportive argument is during recessions larger companies often downsize, providing startups with greater flexibility in hiring and recruiting. The ability to recruit with less competition allows companies to develop stronger teams and accelerate product development.
We have also heard the argument companies which survive a recession often have a stronger story to tell investors during future capital raises or are better prepared to provide detailed operating metrics showing a focus on cost control or performance optimization.
Looking At The Data
We were curious if the theory about recession success holds so decided to review several data points and studies.
A common theory is start-ups focus on capital discipline during a recession. The concept is a good idea but it should not take a recession to convince teams why capital budgeting is important.
Hiring from larger companies during a downturn can provide access to a greater talent pool but may also be disruptive. Startup teams are small and should be careful about maintaining the culture as part of the hiring process instead of only hiring based on a skill set.
Research conducted by Touchdown VC evaluated companies in the Fortune 500 list to identify those founded during recessions. The analysis found no strong correlation between companies performing better or worse depending on when in the economic cycle they were launched.
Startups reaching unicorn status or those valuated at more than $1 billion are a good indicator of success in the venture capital world. Pitchbook performed an analysis of unicorns in a study looking at data going back to 2001. During the period there were 95 startups founded during recessions reaching the $1 billion+ valuation level, but these made up only 12% of the total unicorns during the period.
Economy Independent
If we do a high level analysis, according to the Federal Reserve the US has only encountered three recessions since 2000. The PitchBook study indicates each year 5% of the companies are unicorns, so if the US had three recessions (assuming each last about a year) that would equal 15% of the unicorn population. So we get to about the same 12% number for unicorns founded during a recession.
Although the data does not point to strong support for the idea of companies being more successful if launched during a recession, it does show that companies are capable of succeeding regardless of the macroeconomic environment. Venture investing involves longer time horizons so it often helps to evaluate some of the data behind various investment theories.
What We Are Reading:Â Cheetos and People
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🌎 In November the world is expected to reach the 8 billion level in terms of global population. For those of us living in the US, it means we now comprise less than 5% of the global population.
âš¾ With the start of baseball playoffs, MLB recently reported the number of 100+ mile-per-hour pitches is now at an all time record.
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Wishing everyone a great weekend.
-Â The Caymont Team.