One topic of conversation among VC’s over the last few months is how their portfolios are faring during the Covid pandemic. It occurred to me that the message I’m hearing has been pretty consistent but perhaps non-obvious to those outside of the industry. So I thought I’d share my observations, informed by what’s going on in our portfolio and from what I can gather from others in the ecosystem.

 

1. Vintage year differences

VC’s invest in dozens of companies in any given fund, and so the impact of the pandemic gets spread out across that portfolio. VC’s also manage multiple funds that get deployed over 10+ years, with new investments happening over the first 2-3 years of a fund’s life. For example, a 2015 vintage fund is adding new portfolio companies in 2015, 2016, and perhaps 2017. If that fund targets series A investments, then those companies are likely to be a few years old when the initial investment is made, and thus about 5-7 years old at the time of the pandemic.

This pandemic has affected portfolios unevenly depending on the maturity of the companies. Generally speaking, companies that are very early have been able to weather the storm pretty well. Their burns are quite low, and they can probably extend runway without requiring a huge amount of additional capital. Companies that are largely in R&D phase can operate business as usual, assuming there is capital to fund the company for 18-24 more months. Some early stage businesses may even be able to get to CFBE fairly quickly.

Mid-stage portfolios can be more acutely impacted if many companies have fat cost structures and were investing heavily in growth that is not materializing. These companies are probably burning a lot of cash, seeing headwinds in demand, and have funding needs that are substantial. Many of these companies are probably valued at their last financing round, which probably occurred in a very frothy funding environment. So investors are probably nervous that they’ll be forced to mark down these positions if/when these companies are forced to raise their next rounds.

Very late stage portfolios may have companies that have less existential risk, but are now facing an exit environment that isn’t very friendly. VC’s may have been expecting significant liquidity from some companies in 2020 and early 2021, but will need to put that off for some time even if the companies are doing ok. This may not hurt the ultimate exit value of these companies, but the passage of time will hurt the fund’s ultimate IRR.

 

2. Reshuffling the deck

Most VC’s typically have some mental ranking of the return potential of their portfolio companies. These tend to vacillate a lot early on, but converge as portfolios mature. However, this pandemic is like an earthquake that throws everything in the air and reshuffles the deck.

Some companies that were looking great may now be facing existential risk because of the industry in which they operate. These companies are ones where demand has fallen by 80% or more, causing their underlying viability to be in question. I think every investor has some of these.

Some companies are seeing a massive acceleration event because of Covid. Certain sectors are seeing remarkable tailwinds, such as ecommerce (especially household consumables), digital entertainment, collaboration software, and health and fitness. There is a question of whether this recent surge in demand will be a momentary spike or will represent a new baseline as customer preferences radically shift in a permanent way. Most VC’s have some of these companies in their portfolio as well, and some might be companies that were fighting for survival just a few quarters before.

Other companies are great businesses, but are effectively encountering a dilution event. These businesses are not under existential threat, but have unfortunately hit the funding market at a bad time. There will be need for additional capital to the fund the business, and probably at mediocre terms. The business will ultimately emerge on the other end in good shape, but everyone will be more diluted as a result. Perhaps it will work out though, because weaker competitors will be cleared out allowing for even greater market share and market power down the road. But that remains to be seen.

 

3. Unevenly distributed, but broadly optimistic

As you can tell from my first two points, the effects of Covid have been quite unevenly distributed within a VC portfolio. Some companies are sucking wind, some are thriving. This is in contrast to prior downturns where almost every company faced significant challenges.

What’s interesting in this case is that if there is a general trend for VC portfolios, it’s probably in the positive direction. While the pandemic has been extremely painful for main street businesses and anything that relies on in-person interactions, it has broadly increased the demand for software and accelerated the move to the cloud. The majority of most tech VC portfolios benefit from this acceleration in some way, and so business results in the first half of the year have been fairly good.

Also, most VC portfolio companies have been able to transition to WFH relatively seamlessly after some initial disruption, and so operationally it seems that most companies are hitting a decent stride. Finally, public technology companies have largely been on a tear, creating optimism about the long-term prospects for the tech industry overall.

Personally, I am quite optimistic about the prospects for my industry when we get through this pandemic. But for a couple reasons, I think we are in a bit of a head-fake situation at the moment where things seem a bit better than they really are. First, although we’ve heard that many software companies have hit their plans in Q1 and Q2, I think it will take a few quarters for the full economic effects of the pandemic to work its way through the market. I’d expect a much softer second half of the year, and I think when budgets are assessed for next year, most companies will be looking to trim, not expand their spending in all but the most critical areas.

Second, I think there will be real costs to being unable to meet in person. I think it’s tough to truly pull off building a distributed team, and it needs to be done with a lot of intention. Companies that have a distributed model thrust upon them may function well for a period, but there will be real costs to cultural cohesion, collaboration, alignment, motivation, and speed & efficiency that will be a drag on startups for longer than we realize.