Venture capital (VC) investors are among a long list of market participants who are feeling the pinch in the new norm of higher levels of interest rates, inflation and volatility. Falling valuations, subdued fundraising activities and headline risks have dampened investment sentiment over the past year or so for VC as an asset class.
Rather than run for cover, however, now might be a good time for asset owners in Asia to start eyeing opportunities in new growth areas and assessing how to build early-stage VC exposure in their portfolios.
“Having more of a contrarian view can be effective in this market. We think it is better to invest now in certain VC strategies, especially given the valuation environment,” said Steven Yang, head of global venture investments at Schroders Capital.
Being somewhat bullish about VC opportunities while many investors remain cautious is counter to the typical pro-cyclical investment mindset for allocations to these assets.
Yet with certain strategies, such as growth-stage investments, there is much less reason to be influenced by a six-month market view. “It is important to invest with a forward-looking perspective since it involves allocating across several vintage years,” added Yang.
Ripe for a market reset
Being vigilant is an understandable approach amid the many headwinds across economies, banking and geopolitics. In response, investors are mostly displaying elevated levels of caution when assessing VC and growth capital strategies.
Data from Crunchbase, for example, highlights the extent to which VC investors have scaled back their interest in private companies in the first quarter of 2023. Global funding during this time was US$76 billion, a 53% decline year-over-year from the US$162 billion in the first three months of 20221.
In Asia, total venture funding fell to US$15.2 billion in the first quarter of 2023, its lowest in at least the past three years, based on Crunchbase data. A year ago, first-quarter funding in Asia hit $35.5 billion2.
With 2023 looking set for a challenging year on the whole as far as VC goes, Yang also expects the IPO window to remain shut for most of the year, possibly into 2024.
“We are seeing a valuation reset, especially across tech and biotech, and in both public and private markets,” he explained. “However, this is healthy for the market, as many companies are extending their cash runways to ensure they can withstand near-term market disruptions.”
Profiting with patient capital
Some of the most attractive bright spots can be found in early-stage investments. “This segment has been the most resilient across all market cycles,” says Yang. In these areas, valuations remain relatively low and stable, due to a minimal dependence on finding exits or raising debt, given that many growth-oriented companies are in their early revenue generating phase.
Crunchbase data supports this, showing the biggest drop in venture funding in Asia among all rounds year-to-year being in late-stage and growth rounds, both in terms of dollars and percentage.
Meanwhile, Yang is starting to see a more significant flow of venture secondaries, where investors are looking for liquidity to ensure they are in a position to use “dry powder” to access new opportunities as they emerge.
From a thematic perspective, Yang favours investing across megatrends, to ensure a potential payout across several decades and sectors of growing importance, such as tech and biotech, plus energy transition. Cybersecurity is also a core theme which, in his view, won’t go away. He is more cautious and selective at the moment to generative artificial intelligence, AI and machine learning algorithms, given vast capital inflows already, plus sizeable valuations.
In the healthcare space, drug discovery and oncology-focused remedies are enticing, with investors looking for companies that find treatments to diseases where there are currently no options.
Such opportunities offer the type of multi-year exposure that’s able to ride out today’s down markets. They are also proving increasingly attractive in terms of performance. “The data points over the past 10 years make a case that the risk profile of venture capital is similar to that of buyouts, and with half the volatility,” explained Yang.
Experienced in getting the right exposure
Inevitably, the challenging market landscape has sharpened the spotlight on due diligence and risk controls as investors seek exposure to VC and growth capital investments.
This is where a tried-and-tested process shows its value. At Schroders, for example, a 25-plus year heritage in venture investing across market cycles has enabled the firm to calibrate its internal assessment framework as a more systematic way to evaluate managers across multiple investment criteria.
The focus is on key characteristics across leading VC players. “We look for firms with a strong brand positioning, experience across market cycles and with leaders who can scale them,” explained Yang.
A consistent track record is also key. “We are advising clients to be critical in how they assess opportunities,” he added. “They shouldn’t just look at face value, but need to understand what is driving performance and whether valuations are sustainable.”
Other important factors include the fund’s team and the team continuity, particularly in challenging market cycles. There needs to be a balance in incentives, with generational and transition issues addressed.
Adapting to changing realities
For Schroders Capital, it further differentiates itself by taking a global approach rather than honing-in on niche segments or a specific region – in turn enabling it to shift attention to those sectors or geographies that are more attractive at certain times in relation to valuations and fundraising dynamics. That means Asia for the time being.
In line with this, the firm’s fund commitments have largely been in early-stage ventures, concentrating capital where there is a proven track record. It has also channeled its investments consistently into healthcare over the past 25 years.
More recently, Schroders Capital has emphasised sustainability and impact in driving its VC exposure. “We added an ESG assessment framework into our investment process across our venture platform,” said Yang. “This is playing a more important roll in the buyout and venture space as more venture firms develop their ESG policy.”
Click here to learn more about venture capital investing at Schroders Capital.
Investment involves risks. This material is issued by Schroder Investment Management (Hong Kong) Limited and has not been reviewed by the SFC.