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Getting Over the Hangover: The COVID-19 Pandemic and its Impact on Venture Capital

The pandemic was an event that reshaped the world in profound ways. While its effects on public health and the global economy were immediate and visible, the ripple effects on specific investment sectors, like venture capital, were similarly transformative.

By Geoff Taylor, Principal, Private Equity and Venture Capital
September 4, 2024|7 min read
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Venture Capital’s Pandemic Journey

Sometimes, indulging too much in a good thing leaves you with a headache once the euphoria fades. In this case, the hangover was from capital—too much of it, too fast, with a strong dose of regret when the party ended.

The COVID-19 pandemic was an event that reshaped the world in profound ways. While its effects on public health and the global economy were immediate and visible, the ripple effects on specific investment sectors, like venture capital, were similarly transformative. The pandemic distorted consumer behaviour, upended traditional business models, and accelerated technological adoption. These effects were compounded by unprecedented monetary policy and fiscal stimulus, driving record-breaking venture capital investment and valuations. Amid lockdowns and uncertainty, it was difficult for investors to determine which impacts were lasting and which were temporary.

The rapid shift in customer behaviour and record-low interest rates fueled a wave of investment activity in both private and public technology markets. IPO and M&A activity increased, and investors eagerly reinvested their gains into the expansionary environment. These distortions changed the complexion of the venture capital asset class. The accelerated pace of investment and rising valuations prompted VC fund managers to raise increasingly larger funds. Investors who traditionally focused on early-stage ventures sought to capture more value in late-stage investments, further fueling the trend. Easy access to capital, coupled with an investor focus on revenue growth, incentivized technology companies to pursue unsustainable levels of operating expenses under the “growth at all costs” mantra. Bill Gurley, a partner at VC firm Benchmark Capital, noted that the influx of capital led to “a complete lack of discipline and disregard for traditional valuation metrics,” creating unsustainable business models heavily reliant on continuous funding rounds1.

Then, all at once, the music stopped and the lights came on. As inflation spiked and governments began tightening monetary policy, a widespread correction ensued. This shift led to a contraction in venture capital supply and a renewed focus on sustainable business models, catching many investors and companies off guard, with many continuing to feel the effects today.

Despite these challenges, investor optimism is building. The rise of generative AI is ushering in a new wave of innovation, significantly impacting the entire technology space and the global economy. As the market stabilizes and investment activity resumes, investors are cautiously optimistic, looking to capitalize on the next generation of technological advancements while applying the hard-learned lessons from the pandemic era.

Our team had a front-row seat to the disruptive impact of the pandemic and its fallout on the sector. In this article, we will share our perspectives on the seismic shifts in the venture capital space during the COVID-19 pandemic, how we believe the industry is coping with the aftermath, and the optimism we see around current tailwinds. We’ll share our firsthand observations and implications for our investment strategy today.

The Pandemic's Digital Legacy: Enduring Changes vs. Fading Fads

Pandemic lockdowns forced rapid changes in consumer behaviour, fundamentally altering how people purchased products and accessed services. Venture capital dollars poured into companies looking to capitalize on these themes.

  • E-Commerce and Retail: Retail giants like Amazon and Walmart quickly adapted to the surge in online shopping, scaling their e-commerce capabilities and expanding their delivery and logistics networks. Smaller retailers also scrambled to establish an online presence, leading to heavy investment in e-commerce enablement tools like Shopify and last-mile delivery providers like GoPuff.
  • Remote Work and Communications: The shift to remote work was one of the pandemic’s most significant changes, with companies like Zoom and Slack becoming essential tools for businesses and employees.
  • Telemedicine: Healthcare underwent a significant shift as telemedicine became a necessity during lockdowns. Companies like Teladoc and Doctor on Demand experienced rapid growth as patients sought virtual consultations, especially as the pandemic negatively impacted mental health worldwide.

Not all pandemic-induced technology changes have persisted. For example, the early lockdown surge in home fitness equipment saw companies like Peloton thrive as people looked for ways to stay fit at home. However, as gyms reopened, demand for these products dropped, revealing a trend that was more temporary than many investors anticipated. Some got caught up in the excitement, paying high prices for growth that never fully materialized. Even trends that have proven more durable—like the rise of e-commerce, remote work, and digital tools in education and healthcare—often didn’t live up to the sky-high projections set during the pandemic. One key takeaway for investors: spotting a lasting trend is one thing, but overpaying during a market frenzy can lead to disappointing returns, even in sectors that continue to grow.

Easy Money: Monetary Policy and the Venture Investment Bubble

The spread of the COVID-19 pandemic and ensuing global lockdowns sent major stock indices into a tailspin in March 2020, with the Nasdaq cratering approximately 30% from its December 2019 level. Over 20 million jobs were rapidly lost in the U.S., and many feared a lasting recession. The U.S. Congress and the Federal Reserve took immediate action, cutting already depressed interest rates to near zero (the benchmark rate went from a target of 1.0-1.25% to 0-0.25%) and launching the Coronavirus Aid, Relief, and Economic Security (CARES) Act, a $5 trillion fiscal rescue package providing financial support to businesses, households, and local governments. Aggressive government action and progress in vaccine development gave investors enough comfort to wade back into financial markets, and it became clear that technology was broadly benefiting from the pandemic. By mid-May 2020, the Nasdaq Index had recovered above its pre-COVID levels.

There is no doubt that the CARES Act was a necessary initiative and that it prevented millions of citizens from falling into poverty. As employment continued to regain ground and stimulus payments increased personal income, the average American found themselves with more disposable income. Millions of Americans increased their spending on durable goods (household spend on durable goods rose 25% in 2021 vs. 20192) and many poured their stimulus cheques into the stock market. According to CNBC3, Americans earning between $35,000 and $75,000 increased stock trading by 90% in 2020. This investment activity focused largely on companies with a strong pandemic value proposition. Institutional investors chased these names as well—Peloton stock increased over 500% from December 31, 2019, to its pandemic high. Zoom increased 765% during the same period. In private markets, healthy demand for new public listings and strong public comparable performance pushed VC deal activity and valuations to record levels.

Through a mathematical lens, it is easy to see why growth stocks were outsized beneficiaries of easy monetary policy. The present value of a business is the value of its future cash flows, discounted at a rate closely tied to interest rates. When discount rates are low, growth companies with no current cash flows but lofty expectations for future cash flows become much more valuable. Bonds and low-yielding assets are less competitive, and investors look to riskier assets to earn returns. The Nasdaq index peaked in November 2021, 130% higher than the lows seen during the early days of the pandemic.

2021 was the most active year on record for venture capital, with investment activity nearly doubling year-over-year to approximately $240 billion. VC valuations soared, especially at the later stages, where median pre-money valuations nearly doubled from 2020 to $120 million in Q1 20224. The environment led to the rise of mega-rounds (financings over $100 million), often led by large investors new to the venture capital space, such as Sovereign Wealth Funds, corporate VCs, and hedge funds, who were looking to deploy significant capital quickly. For startups, this meant access to more funding than ever before, but it also came with increasingly unrealistic expectations for growth.

These distortions perverted the behaviour of traditional venture capital funds. A lot of capital chasing late-stage growth companies resulted in rising paper valuations for their existing funds, performance which they marketed to investors to raise larger and larger funds and expand into later-stage investing. Sam Lessin, a General Partner at Slow Ventures, critiqued what he called the model of “factory farmed unicorns” (companies with a valuation over $1 billion), where startups were pushed to achieve rapid growth and high valuations, often at the expense of sustainable business practices. He argued that this approach led to inflated valuations and a focus on metrics that appealed to public markets but didn’t necessarily reflect the true health or potential of the companies. In summary, easy access to capital masked fundamental flaws in business models which would soon be revealed.

Rate Hikes and a Return to Reality

The Federal Reserve’s decision to raise interest rates in 2022 marked a significant shift from the stimulatory monetary policies that had been in place during the pandemic. This move aimed to curb inflation but also had profound effects on financial markets. As interest rates rose, the cost of capital increased, leading to a reevaluation of investment strategies across various asset classes, including venture capital.

The stock market experienced significant declines in 2022, with the S&P 500 closing the year down 19% and the Nasdaq experiencing similar losses as investors flocked to yield instruments that were paying high interest rates with comparatively low risk. These declines in public market valuations had a trickle-down effect on private markets. Late-stage venture-backed companies, which often rely on public market comparables for their valuations, were particularly affected.

The downturn in public markets effectively shut down the IPO window for many companies, and the window remains largely closed today. Growth-stage investment activity slowed, and the impact cascaded down to valuations and activity at earlier stages. The macroeconomic environment also led to elongating software sales cycles and a slowdown in corporate spending. Many software companies faced a one-two punch, with declining IT spend impacting demand and an end to easy access to capital.

In response to these challenges, a renewed investor focus on financial metrics and unit economics emerged. Investors became more cautious, prioritizing companies with strong financial fundamentals and sustainable business models. Technology companies pursued mass layoffs to get bloated cost structures under control, as they were no longer sustainable without access to cheap capital. Many businesses had no choice but to raise capital in this environment at lower valuations than they had previously. VC investment activity slowed dramatically in 2022 and 2023, with managers focusing on stabilizing companies in their existing portfolios and shying away from new investments.

Despite these challenges, the changes in the venture capital landscape had some positive outcomes. Venture capital firms today are more focused on funding sustainable business models, with founders now operating in a more capital-constrained environment. We’re hopeful this shift will give rise to the next generation of companies with sustainable, long-term compounding potential, much like Oracle and Microsoft—today’s tech giants that emerged during periods of high interest rates and inflation. Investors now have the breathing room to conduct thorough due diligence and spend quality time with founders—something that was sorely lacking during the frenzied days of 2021, when underwriting standards took a backseat as traditional VCs competed aggressively with large, non-traditional venture investors. While some pandemic-era bets turned out to be tied to short-lived behavioural shifts, many of the technologies invested in, like telehealth, have had a lasting and positive impact on society, offering scalable solutions for overwhelmed health systems. Lastly, the hyperactive IPO and M&A market of 2021 led to some very profitable exits for venture firms—those who timed it right certainly reaped huge rewards.

Looking Ahead: Balancing Challenges and Opportunities

Some of the industry’s challenges persist. Venture-backed IPO market activity remains very depressed and is likely to remain ahead of the U.S. federal election cycle and in the face of current geopolitical instability. Many software companies valued at over $1 billion have experienced slower growth as business spending on traditional software remains light, compounded by uncertainty around how AI will impact incumbent software businesses. 2019-2021 vintage venture funds are likely to be poor long-term performers given the frothy environment into which the capital was deployed. Fundraising for VC firms remains difficult, particularly for those without well-established names and long performance track records.

That said, we have observed renewed optimism and a pickup in venture financing activity in 2024, likely driven partly by expectations for lower interest rates but more directly by growing investor interest in generative AI. Many experts predict that AI could have an even greater impact on the global economy and society than the internet boom. Marc Benioff, CEO of Salesforce, has described AI as “the most important technology of any lifetime,” highlighting the transformative potential of generative AI and its ability to revolutionize business operations and customer interactions. Indeed, interest in AI is expected to unlock a massive amount of corporate IT spending. A survey by Battery Ventures found that 84% of enterprise technology buyers plan to increase spending on AI tools. According to a report by Ernst & Young, 30% of U.S. companies plan to invest at least $10 million in AI in 2025, up from 16% in 2024.

As we stand on the brink of what many are calling the “next big thing”—AI—it’s hard not to see the familiar signs of a new bubble forming. However, it is worth noting that a huge portion of dollars chasing AI has been targeting capital-intensive infrastructure companies—large language model platforms and chip companies that believe they are in a winner-take-all race. These financings take up the bulk of the headlines as they raise huge amounts of capital at high valuations. We remain unconvinced that these companies will ever generate enough profit to result in strong returns on so much invested capital. At the other end of the market, incumbent software companies are enhancing existing software products with AI, and new companies are leveraging AI to tackle yet unsolved problems—we believe there are reasonably priced opportunities in both of these categories.

All of this has implications for the Nicola Venture Capital Limited Partnership. We look to balance our portfolio with exposure to both early-stage investments (which have higher upside but longer timelines to liquidity) and later-stage secondary investments (which comprise more established businesses that are closer to liquidity). We continue to see attractive opportunities in secondary markets as the lack of IPO activity forces investors to seek other liquidity avenues. We also aim to invest steadily through market cycles. History tells us that investing after a pullback is one of the best opportunities to generate strong long-term returns. When we assess potential VC fund managers, we look to see whether they were able to take advantage of the attractive exit environment in 2021 and return capital to investors.

The frenzied pandemic environment and its aftermath was a stark reminder to investors to “stick to their knitting.” At a high level, our strategy remains unchanged—we continue to focus on partnering with high-quality, experienced VC managers who have learned from different market environments. We prioritize diversification to mitigate risk and maximize long-term returns in a market where there are many losers and just a few, very large winners. While there’s no doubt that AI will drive the creation of some truly transformative and sustainable businesses, driving strong returns for patient venture capital investors, history tells us that there will also be plenty of companies that don’t make it past the hype. We believe our diversification will serve us well, especially as we invest amidst this exciting AI platform shift.


  1. 1

    Tim Ferriss, “The Tim Ferriss Show Transcripts: Legendary Investor Bill Gurley on Investing Rules, Finding Outliers, Insights From Jeff Bezos and Howard Marks, Must-Read Books, Creating True Competitive Advantages, Open-Source Strategies, Adapting Mental Models to New Realities, and More (#651),” Tim Ferriss, January 26, 2023, https://tim.blog/2023/01/25/bill-gurley-transcript/.

  2. 2

    Dan Jones, “An End to the US Goods Boom? Economic Week Ahead – 22-26 July,” Specialist, July 19, 2024, https://www.investorschronicle.co.uk/content/81e06f15-170e-5d3c-9120-42c97e729a8d.

  3. 3

    Lorie Konish, “Many Americans Invested Their $1,200 Stimulus Checks. What the Pros Say You Should Know before You Trade,” CNBC, August 25, 2020, https://www.cnbc.com/2020/08/24/many-people-invested-their-stimulus-cash-what-to-know-before-you-do.html.

Disclaimer

This material contains the current opinions of the author, and such opinions are subject to change without notice. This material is distributed for informational purposes only and is not intended to provide legal or specific investment advice. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. This investment is intended for tax residents of Canada who are accredited investors. Residency restrictions apply. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. At the time of recording, the following securities are held by Nicola Wealth: * Amazon (AMZN) * Walmart (WMT) * Microsoft (MSFT) Mention of these securities is not a recommendation to buy or to sell. Nicola Wealth Management Ltd. (Nicola Wealth) is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required securities commissions.


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