We attended the SuperInvestor conference in Amsterdam and hosted a panel on the topic of VC investing in a changing market. A mix of Europe’s best early and growth investors shared their thoughts on key issues faced by entrepreneurs and those backing them.

Valuations in 2022 and beyond

The panel began with a discussion on 2021 prices, the current outlook on valuations, and what exit options remain available. There seems to be a lingering ‘hangover’ for investors who overindulged 2021, and trouble is looming. One panelist observed that several VCs have taken the precautionary approach of applying a 10% write-down across portfolios, whilst another commented that there may be more trouble hidden in portfolios than current figures suggest. All shared the view that whilst valuations will likely continue to experience a healthy correction, the European ecosystem is resilient and the general outlook is optimistic.

The case of Klarna was discussed, perhaps as an indication of what’s to come. The company recently closed funding at a valuation that was roughly 85% down from the prior year. One panelist noted that venture has never been about averages, loss ratios are inevitably due to increase, and it would be blind optimism to hope that things that have been going this well, for this long, would trend upward forever. Those investors overspending in the last few years are soon going to pay for it, whilst another panelist observed that investors new to venture investing tend to also be quicker to drop companies when things get tougher.

How are you thinking about portfolio construction?

Capital loss ratios in the next four years was another key talking point, with most suggesting it’s too early to predict changes so far in advance. There was no forewarning with the war in Ukraine, nor the pandemic. “Some recent rescue rounds are dressed as growth rounds” said one panelist who estimated that “it’s likely that 50% of some manager’s portfolio companies are worth zero”. The question is, which ones?

Discussions turned to how portfolio construction should be approached. Growth investors will double down on stable cashflows, in contrast to early-stage investors. However, one concern highlighted with this approach is the potential for lack of agility. “Reacting fast is key, the companies that will fail are those that have too much cumbersome infrastructure and can’t move quickly when needed to address shifting landscapes.”

Rescue rounds, yay or nay?

When is it prudent to do a rescue round, when is it a bad idea? One panelist offered that if a company needs this to scale, it is probably not worth it. However, it could be appropriate for a company that’s achieved product market fit, has a solid customer base in one core market, and has overextended itself to expand into new geographies. In this case, you can cut the expansion and channel the rescue cash into the core business to survive.

When thinking about extending runways, the key question is what’s at the end of the runway? Looking further in the future, what kind of exit could be on the horizon? One panelist observed that the main buyer profile currently is corporates engaging in M&A; IPO activity has esentially stopped. 2021 was certainly an anomaly, where many funds distributed amounts equal or greater to what they drew down from investors. Despite looming challenges, 2022 has seen a strong year for the birth of unicorns. However as one panelist pointed out, none of the challenges encountered in 2021 and 2022 had the problem of a recession being layered on top, making the outlook for 2023 more uncertain.

Will record dry powder in Europe carry through these choppy waters?

The panel commented on the dramatically reduced pace of deployment, partly because “no one knows how to price anything”. This highlights the importance of identifying the good, the bad, and the great. There is a hope that VCs’ dry powder is used for more opportunity investing in 2023, and fewer rescue operations.

Perhaps even more important than the capital is the need for experience and wisdom. Panelists commented that “if companies are hurting now, it will only get worse”. Younger investors and founders may struggle to get through this downturn as they have become used to freely available capital and consistent growth. Now is a time where new managers and founders need to have around the table “older folks who have lived and operated through multiple market cycles”.

Where are the opportunities in 2023?

Some sectors are much more resistant to the current headwinds. One investor commented that anything related to climate and cybersecurity, for example will continue to do well. And in areas that are more vulnerable, entrepreneurs are finding ways to stay afloat. One speaker mentioned that 25% of their portfolio was consumer-focused businesses, which are holding up well due to inflation and the flexibility in the US market to pass on price increases to customers. But in places like Europe, where regulation is tighter, those companies face challenges.

Meanwhile allocators investing in VC funds are also seeing opportunities in the current market. One confirmed their plan to continue to deploy into funds addressing the energy crisis, as recent geopolitical developments have highlighted the importance of diverse and reliable energy sources. Another allocator rounded the session off by commenting that “we’re in a wonderful buyer’s market, with more time to analyse opportunities, and less competition”.

The general sentiment seems to be that despite some very real challenges, Europe has the right ingredients for a market favourable to investors: great entrepreneurs addressing real problems, and pricing coming back down to a reasonable levels.