Crisis Resilience in VC: How the Industry Responds to Economic Challenges

e often talk about how startups and founders can make it through tough times, but venture capitalists face just as many unforeseen crises and challenges. Economic downturns, market volatility, and unexpected changes often lead to decreased valuations, slow funding rounds, and liquidity problems, challenging even the most seasoned investors. 

The 2007–2009 period saw a reduction in the deal value of VC investments by approximately 25% in late and growth-stage deals and 35% in early-stage deals. The recent market downturn in 2020 was characterized by a roughly 40% decline, signaling the end of a decade-long period of phenomenal growth.

Historical patterns indicate that markets take at least four years to recover from similar crashes, with certain crises, such as the 2008 market crash and the 1973 oil crisis, requiring even more extended recovery periods. But, through resilience and adaptability, the top VC firms have survived for decades and overcome many cycles of economic turbulence.

Below, we're looking at the strategies that the best VC firms in the world have used to make it through the toughest of times.

‍Problems That VCs Face During an Economic Downturn

Economic downturns can severely affect the venture capital ecosystem, changing the dynamics of investment, valuation, and liquidity. During such periods, VC firms face a host of challenges, with decreased valuations, tightened funding rounds, and liquidity constraints being the biggest issues.

Decreased Valuations

During economic downturns, the valuations of startups and growth-stage companies tend to decline. This leads to increased investor risk aversion and a recalibration of growth expectations.

This devaluation can impact VC firms' existing portfolios, affecting the portfolio's overall performance. For example, during the 2008 financial crisis, many firms saw their portfolios' value significantly decrease, prompting a reevaluation of investment strategies and portfolio company support. On the flip side, it can also create opportunities to invest in promising companies at lower valuations, potentially leading to higher returns in the long term.

Generally speaking, though, the most experienced investors understand the market dynamics and will often have a robust valuation methodology to avoid the pitfalls of market pessimism.

Challenges in Funding Rounds

For startups, raising new funds becomes increasingly challenging during economic downturns. But VCs are often left with a lot of dry powder at hand (unused capital) that they need to very carefully deploy, which can be problematic because, with this contraction, there is a reduction in the number of viable investment opportunities, and deals for promising startups become highly competitive.

Additionally, VC firms may find it challenging to raise new funds from limited partners (LPs) who also feel the economic pinch and may hesitate to commit capital to higher-risk asset classes.

Liquidity Constraints

In an economic downturn, the exit landscape, comprising IPOs and acquisitions, becomes less favorable, delaying the realization of investment returns. This liquidity crunch can strain relationships with LPs who expect timely returns on their capital. 

Furthermore, it complicates the fundraising process for new VC funds, as potential investors may be wary of committing capital in an uncertain market environment.

Strategies That Venture Capital Firms Use to Thrive in Tough Times

Now that we've covered the main challenges that VCs face in harsh economic conditions, let's examine the strategies they employ to address these issues. Tough times often present possibilities for development and innovation. 

The best venture capital businesses have prospered even in difficult times, in addition to having systems in place to withstand economic obstacles.

‍Diversification and Risk Management

Diversification and risk management are essential to the success of VC firms. Investments are spread across various industries, stages, and geographies to mitigate the impact of market downturns.

By avoiding over-concentration in any single sector or company, VC firms can weather sector-specific downturns and capitalize on emerging opportunities elsewhere.

Strong LP Networks and Relationships

Having a strong network is at the heart of venture capital. Venture capitalists rely heavily on their networks and relationships, which can provide valuable insights, deal flow, and support not only during upticks but also during challenging periods.

By nurturing relationships with LPs, entrepreneurs, other investors, and industry experts, VCs have a bunch of resources to turn to.

Long-Term Vision

While short-term fluctuations are stressful, venture capitalists maintain a long-term perspective, with the understanding that innovation and disruption are not constrained by economic cycles and that downturns often present unique investment opportunities. 

By focusing on innovative startups' fundamental value and potential rather than short-term market trends, VCs can identify promising opportunities even in tough times.

Active Portfolio Management

A hallmark of experienced VCs during turbulent times is the intensive focus on portfolio companies. For example, during a recession, the primary objective is to prepare portfolio companies through strategic measures, including 'tightening the belt' via reductions in burn rate (layoffs, furloughs, pay cuts, etc.).

VCs will also advise companies with adequate cash reserves - those poised to sustain operations for the next 18 to 24 months (quite rare among startups) - to halt new hires and optimize expenses optimally. Oftentimes though, the capacity of a VC firm to manage its current portfolio is significantly influenced by the number of companies it supports and the bandwidth of its managing partners.

Despite the challenges, firms in the early or mid-stage of their investment period will continue to seek new opportunities, albeit at a significantly reduced pace and volume.

Flexibility and Adaptability

VC firms are often ready to pivot their investment strategies if necessary, reassess their assumptions, and adjust their tactics in response to changing market conditions. They might initiate internal financing rounds for companies in urgent need.

Down-rounds and complex recapitalizations might also be necessary, especially during an anticipated prolonged recession. It is critical for companies to adopt more realistic valuations and terms, thereby enhancing their preparedness for future investment rounds.

Flexibility is key, whether it's shifting focus to different sectors, reevaluating investment criteria, or exploring new geographies.

Case Studies of VC Firms That Survived Economic Crises

We've covered some of the main strategies VCs use to survive an economic crisis, so let's look at some examples of how the top VC firms in the world dealt with the challenges highlighted above.

Sequoia Capital

Sequoia Capital, arguably the most renowned VC firm with $85 billion worth of assets under management, has survived a few economic downturns, notably the dot-com crash in the early 2000s and the global financial crisis of 2008-2009.

During these downturns, Sequoia Capital proactively engaged with its portfolio companies, providing strategic guidance, operational support, and additional funding to help them out. The firm also adjusted its investment focus towards more resilient sectors and emerging opportunities, adapting to changing market conditions.

Takeaways: Sequoia's hands-on approach to portfolio management, long-term orientation, and willingness to pivot investment strategies have been crucial to its long-standing success. The firm's knack for building strong relationships with entrepreneurs and collaborative partnerships within the ecosystem has also been crucial to its resilience.

Andreessen Horowitz (a16z)

Andreessen Horowitz, also known as a16z, has established itself as a leading venture capital firm with a track record of successful investments across various sectors. It was actually founded during the downturn in 2009 and is probably one of the best examples of VC firms surviving a challenging economic climate.

During adverse times, a16z maintains a disciplined investment approach, focusing on sectors with long-term growth potential, such as technology, healthcare, and consumer internet. The firm leverages its extensive network and expertise to identify promising investment opportunities and support portfolio companies through difficult periods.

Takeaways: a16z's emphasis on deep sector expertise, rigorous due diligence, and active portfolio management has made it a top-tier VC firm. The firm's commitment to long-term value creation and ability to adapt to changing market dynamics have contributed to its sustained success in volatile environments.

Bessemer Venture Partners

During the 2020 COVID crisis, Bessemer Venture Partners quickly moved to virtual deal-making, leveraging technology to maintain its investment pace and support for portfolio companies. Bessemer also provided guidance on transitioning to digital-first business models, helping startups capture new opportunities in a rapidly changing environment.

Takeaways: Their proactive approach not only safeguarded their investments but also positioned them for growth as the world adapted to the realities of the pandemic.

Market Downturns Are a Great Time for Investing

Echoing Warren Buffett's advice to "Be greedy when others are fearful," economic downturns present unique investment opportunities. Startup valuations tend to decrease in such climates, allowing investors to enter at more favorable valuations. 

In fact, the 2007 recession resulted in some of the best venture capital vintage years in modern history. Many of the world's most respected VCs earned their reputation from their investments during that time. Iconic tech giants like Venmo, WhatsApp, and Uber were all founded during the 2007 recession.

Given the long-term nature of these investments, the potential for enhanced returns upon exit, post-economic recovery, is significant. Historical data supports the notion that investments made during economic downturns can yield exceptionally high returns.

Venture capitalists can survive and thrive in the face of adversity by leveraging diversification, strong networks, a long-term vision, active portfolio management, flexibility, and resilience.