Why Covid-19 will not wreck but strengthen the European technology investment scene.
No one can tell yet what the impact of Covid-19 on our health, our society and our economy will be. Without doubt it will have a tremendous impact on European technology. However, we believe companies and investors will emerge stronger than before.
Covid-19 will likely push the global economy into recession
In order to suppress the virus and to flatten the curve of infection public life in Europe and elsewhere has been paused since mid-March. Large parts of the economy have stopped operating or slowed down substantially which will push the economy into a sharp recession. At this point, it’s not clear how long the recession will last and how quickly the economy will recover. It can be short-lived, but it might well be a recession as severe as the Global Financial Crisis in 2007–08.
Certainly, this recession will have a tremendous impact on the European tech ecosystem. Companies will fail and investors will withdraw or default. But these are the times where lasting businesses are built — in technology and in investment.
Lack of demand and financing
The Covid-19 pandemic will create a demand-side shock on all businesses, including technology companies. Companies in the area of travel or mobility already suffer a direct sharp decline of demand. Other technology companies, such as in the area of enterprise software currently only see slower growth but will likely suffer more with some delay, as their customers tighten budgets, default on payments or go out of business.
The second shock will hit companies from the funding side. Capital will be harder to raise, rounds will be smaller, valuations lower and some existing investors will turn from strong supporters to keen sellers. Down rounds and liquidation preferences will return. During the global financial crisis, annual European VC investment activity declined by 40%. We should expect a similar reduction now. However, not all investors will pull back equally:
· European venture and growth funds are committed to the asset class, have raised more than €30 bn over the last three years and have a reasonable level of dry powder at their disposal. They may privilege existing portfolio companies for a while, but they will continue investing.
However, fund raising will be slower and a few first-time funds with little track record may never raise that second fund. The capital available to the asset class may decline for a couple of years as limited partners rebalance portfolios due to the so called “denominator effect”, the relatively higher decline in value of public assets, or a shift to other asset classes, such as distressed debt or secondaries, which are perceived as attractive in a crisis. However, the pendulum will swing back soon thereafter, and the asset class will continue to grow.
· Corporate investors will take a much bigger hit. Their importance for the technology ecosystem has been growing in the past years and in 2019 they have contributed 45% of the European venture and growth funding. Their investment is heavily skewed towards large and very large funding rounds. This funding will go away, maybe almost completely, in a recession as corporate sponsors shift their priorities from innovation for the future to stability of their core business today. The optics of investing in start-up companies while laying off staff are simply non-manageable.
· Non-traditional investors such as pension funds, mutual funds or hedge funds will also pull back firmly. These investors were critical in recent years as they made the high profile €100+ million rounds for European unicorns possible. But they are not structurally committed to technology companies, prefer more liquid strategies and can allocate across a broad range of asset classes. In the new environment they may view other asset classes as a better fit. As a result, they will temporarily withdraw from private technology companies.
Corporate and non-traditional investors, the so-called “tourists” in technology investment will pull back for a few years. The impact will mostly be felt at the later stage. Companies will find it harder to raise large and very large rounds, but growth funds will benefit seeing lower valuations and less competition. They should now raise larger funds to step into the void.
Survival of the fittest
In 2001 the internet bubble burst and left few survivors behind. This time the European technology ecosystem has a different scale and a lot more substance and maturity.
Yes, in the changed environment, some marginal early stage company will never get funded beyond the seed stage. But venture capital funds will again find Series A opportunities with a more balanced risk-return profile. These companies will have a higher success rate and will earn their founders and investors good returns. In past recessions, early stage investing has proven most resilient. One reason is that we have learned that some of the most successful tech businesses get started in difficult times.
Yes, some later stage companies with less resilient business models and weaker syndicates may not make it through the recession. There will be a flight to quality. The companies that fail weren’t world beaters in the first place and they will free up scarce management and engineering talent for stronger companies that can now scale faster. The ones that make it will emerge stronger, leaner and with less competition.
Yes, some unicorn businesses with marginal economics and unsustainable cash-burn will be pushed into mergers and consolidation. For instance, does a city really need seven micro-mobility businesses? One or two are maybe viable while as many as seven will only clog sidewalks with unused scooters and consume investors’ cash. Consolidation will lead to stronger, more valuable businesses in less fragmented markets.
Meanwhile, the current crisis shows that digital business models are much more resilient than the rest of the economy. Recurring revenue streams based on the delivery of virtual products are not only scalable but also to some degree recession proof. Today, work in most technology companies continues almost unabatedly while many workers in traditional businesses cannot operate outside the physical office.
The digitization and structural change that was already happening in industries such as finance, education, government and health care will only be accelerated by the crisis. Today people are learning to manage their lives and businesses digitally more quickly than ever — because they have to. The change will be permanent and there will be no going back. Remote work, e-learning, e-commerce and e-government are the new normal.
All these factors contribute to the fact that technology companies that do well in the coming year or two are poised to be long-term winners. In other words, excellent investment opportunities.
The worst of times will be the best of times
“As an investor, it is wise to be fearful when others are greedy and greedy when others are fearful.” Warren Buffet
The current environment offers great investment opportunities: Series A rounds will be less competitive and attractively priced again. Growth investors will face less competition and companies will grow faster using capital more efficiently. The economics for growth investments will be stronger. And corporates and non-traditional investors that are now hastily withdrawing to mind their own businesses will provide excellent buying opportunities in secondary transactions.
For tech companies it’s time to close the hatches and weather the storm. The demand-side and funding shock on technology firms will be hard but hopefully short-lived. The surviving companies will be stronger, facing less competition, growing faster and being more valuable at the end of the recession. The European technology industry will not vanish as it did after the internet bubble, but instead lead the economy out of the crisis.
For investors, it’s the time to lean in. Great companies will be raising capital at attractive terms. Investors that keep a cool head and look at the fundamentals will not only do their best deals in years, but also take strong market positions for their own business for years to come. They will raise bigger funds and show stronger performance. These investors will be positioned best in the next up cycle of European technology investing.
by Roland Dennert
 PitchBook 2015 Annual European Venture Industry Report
 PitchBook 2019 Annual European Venture Report