COVID-19: The Future of Early Stage Business Investment
Covid-19 has changed everything, fast, and put us into yet another period of uncertainty. Consequently, this has impacted the investment decision process and the M&A sector more widely. Here we take a closer look at what the impact has been so far to try to understand the future outlook of the sector.
Early stage business investment is a high intensity, fast-paced industry. The risks involved in operating in this sector are significant, but so are the potential returns. Timing is always key as micro and macro landscapes can change quickly, impacting deals. In mid-March, we were aware of several deals that were due to imminently close. Within days, these deals were put on hold indefinitely.
There are myriad factors that influence the investment market; some of the more salient include investor confidence, general business health, and economic and political conditions. These factors can be considered within two naturally critical aspects of the market – demand and supply.
Demand refers to the capital that is available to be invested and is linked to investor confidence. If investors are confident about the future, they will be more willing to part with their liquid assets. Conversely, a lack of investor confidence will reduce the pool of investable capital.
It is no surprise that COVID-19 has reduced investor confidence, and therefore the supply of capital has reduced. This has been seen through live deals being put indefinitely ‘on hold’ and investment managers shifting into ‘portfolio mode’ (focusing only on limiting value erosion of existing investments).
Supply refers to the number of quality investment opportunities in the market and is affected by business owners’ willingness to divest their control interests.
Ideally, shareholders should only look to raise funds or exit an enterprise when their business is in the best health as this will encourage a strong valuation. Consequently, many owners are currently holding off selling or delaying entering fundraising or M&A processes during the COVID-19 pandemic while their business is not in optimal health.
However, as businesses have finite capital reserves, they may not be able to hold off indefinitely and will require funding as the effects of COVID-19 persist. We therefore expect an uplift in accelerated and potentially distressed investment and M&A activity in the coming months, but the number of deals completing may remain limited by demand.
To summarise, the likely impacts of changing supply and demand in the market: economic uncertainty combined with increasing supply and limited demand will, in theory, lead to a general reduction in business valuations. For the braver investor the market is likely to present an opportunity – particularly as lack of demand drives down the valuation of potential investments – to invest in businesses at a relative discount.
Opportunities for the Angel Investor (and the companies they already work with)
Despite the challenges, there are opportunities for investors, including but not limited to:
- Investors with sufficient liquid assets will have the opportunity to invest in businesses at a relative discount;
- Accelerated fundraise processes will increase as businesses continue to suffer from the crisis;
- Value expectations on the sell side (including on equity funding rounds) should become more realistic, improving the chances of successful transactions and enhancing process efficiency;
- The market can bounce back strongly within a short amount of time, given the general reserves held by investors. This is a great time for business owners to get their companies ready for a future fund raise or sale process, and M&A professionals can assist with this; and
- The Future Fund recently announced by the UK government is in essence a match funding initiative. Businesses will be able to receive a convertible loan from the government where they have an equivalent capital commitment from an external investor. This should help to drive activity in the debt and equity capital markets.
Looking to the future
It is difficult to predict what the future holds for the investment sector. In the aftermath of both the Dot Com and the Sub-Prime Mortgage crises, heightened cautiousness was exhibited by investors which led to increased scrutiny during the investment process. There has already been a change in the attitude of VC and other early stage investors, with some putting deals on hold, others being more cautious, and a small amount deciding not to explore new opportunities altogether.
Taking a longer-term view, well documented historic macroeconomic cycles may provide insight into what the future could hold. These cycles often exhibit specific stages, such as growth, peak, decline, and crash. Recent cycles have lasted for approximately 10 to 12 years each as indicated by the decline/crash phases – 1987 stock market crash, 2000 Dot Com crash, 2008 Sub-Prime Mortgage crisis, and now the 2020 COVID-19 crisis. If history is anything to go by, it could reasonably be expected that the next six to twelve months to will be a decline/crash phase, followed by three to four years of regrowth, followed by three to four years of acceleration, and finally a peak phase.
Though the initial phase can be rather grim for the investment and M&A markets, the other phases are generally more amiable, with sophisticated investors re-entering the market in the regrowth phase. This phase also attracts new investors as confidence grows and uncertainty reduces. We therefore expect the market to return to a rational equilibrium state, however, the main unknown factor is time. As famed economist John Keynes once said, “the market can remain irrational longer than you can remain solvent”.