In June 2020, the National Bureau of Economic Research (NBER) determined that the US economy had peaked in February 2020, and subsequently had entered a recession for the first time in over a decade.  US GDP fell by a record 32% in the second quarter of 2020 as the strain of COVID-19 lockdowns affected all sectors in the economy.  Venture capital is a business with a ten-year time horizon, so it is less affected by market sentiment and short-term economic turns than other areas of the capital markets.  Nonetheless, the experienced investor knows that timing is everything, and so we looked at venture capital returns before and after the last recession to gauge when might be the best time for venture capital investors to deploy capital. 

The record drop in GDP in the second quarter affected venture capital funding.  Overall VC investments fell only by -2% in 2Q2020, according to Crunchbase.  However, the funding was heavily skewed to larger startups doing follow-on funding rounds to shore up their balance sheets going into the recession.  In 2Q2020, Global Seed and Angel round investments fell by -38% in dollar terms and -58% in the number of deals closing, while late-stage VC investments fell by only 8.7% in the second quarter, and growth stage investments, those made in the latest funding stages, were up over 4x.

While the financial markets have enjoyed a healthy rebound since their lows in March, the data on Main Street is less sanguine. On our own estimate, over 50M privately employed Americans were being paid by the US government in the form of paycheck protection program (PPP) funds.  This is coming to any end as the third-quarter wraps up, and presumable many of these employees will face termination once their private employers are responsible for their salaries again.  This, combined with a significant hit to local and state revenues and further lockdowns in some areas, makes the economic outlook cloudy at best.

While the dust has yet to settle, the data is clear about one thing; the United States is facing its first recession in over a decade. Therefore, JC venture capital took a look at VC returns at different points during the economic cycle, and there is cause for optimism for investors. In addition to famous success stories of start-ups beginning during the Great Recession, we found the data points for venture capital as an asset class to do well at the time of, and after, a recession. Aside for the inherent advantage of the long-term time horizons, we found average venture capital investments held up better in the thick of the last two recessions than its public market peers.

Entrepreneurs know that downturns are inevitable in the economic cycle. Recessions should not sink a strong business, nor should they impede one from starting. This was demonstrated through the Great Recession as many unicorns began operations in the heart of the downturn. To name a few – Instagram, Uber, Venmo, Square, Slack and WhatsApp – thrived despite starting in an uncertain time.

In addition to the lucky few firms who invested early in the above household names, market conditions were favorable to the entire venture capital industry. According to data compiled by Pitchbook, the average venture capitalist was still able to produce strong returns during the Early 2000s Recession as well as the Great Recession (Exhibit 1 below).

Venture capitalists were also able to post better returns in the worst part of recent recessions compared to their counterparts in the public markets (Exhibit 1 below). Typical venture firms are priced quarterly, while public equities are priced anytime there is a transaction. However, the resilience in recent recessions was not simply due to the illiquidity of the venture capitalists’ investment vehicles. Rather, the average firm counted the short-term pain within their portfolios and positioned themselves for long-term success.

The resilience in recent recessions along with the overall returns makes venture capital a very attractive home for investors. Despite historic bull runs of the early 2000s and 2010s, venture capital still outpaces the S&P 500 and NASDAQ’s average annual return. Per data compiled by Pitchbook, the average venture capital firm returned 14.16% from 1996 to 2017, while the S&P 500 and NASDAQ indices returned 8.49% and 12.93% respectively.  And the illiquid nature of venture investments result in less volatility than experienced in public markets (see Exhibit 1 below).

The last trend we identified is perhaps the most powerful. The average venture capitalist actually did better in the midst of the Great Recession than during the economic boom that proceeded it (Exhibit 2 below).

For these reasons, we see venture capital in this environment as an opportunity for superior returns. As capital becomes scarce in economic downturns, the best ideas stand out. We work with entrepreneurs that stand out and view this short-term stress as a fantastic opportunity.

Jason Teitelbaum contributed to this article.