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Investment Ideas Who wants a market downturn? These investors actually do

Vini Letteri, a managing director at KKR who invests in tech companies, had a slow 2018.

The venture capitalist, who manages a US$714-million fund, tried to put some of that money into 12 tech startups this past year – but failed when they demanded too rich a price. In some cases, he said, his offers to invest were outbid by as much as 40 per cent. The only investment he led in 2018 was a US$360-million deal in OutSystems, a software company in Atlanta.

So here’s what Mr. Letteri is not-so-secretly hoping for in 2019: a downturn in the private startup market.

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“When the market turns, we’re prepared to be more aggressive,” he said. He added that he had sketched out a “downturn list” of 150 targets – including financial tech, cybersecurity and consumer internet companies – in case they become cheaper.

Mr. Letteri is one of a growing number of venture capitalists rooting for a market dip to calm the overheated startup scene. For the past few years, Silicon Valley tech startups have been awash in a stream of cash that has allowed them to expand quickly and sell or go public at high valuations. Yet that drove up the costs of deal-making for venture capitalists, who often prefer to invest in young companies at lower prices in the hopes of making a bigger return later.

Now some of these investors may get their wish for a market decline. Stocks tumbled late last year, led by tech giants such as Facebook and Apple, amid fears of slowing economic growth and a trade war with China. And so far this year, the stock market has swung wildly, whipsawed by confusing signals including Apple’s disappointing iPhone sales in China and American employers adding more jobs than expected last month.

While it takes time for choppiness in the stock market to ripple out into the startup market, many venture investors are already preparing for a downturn. Some are setting aside money to pounce on investments and are preparing to write bigger checks with the expectation that new investors who flooded in in recent years will flee. And they are keeping closer tabs on companies that were too expensive to invest in last year.

“We definitely want to take advantage of a market downturn,” said Sandy Miller, a venture capitalist at IVP who projects that startup valuations will fall 10 per cent to 40 per cent this year. He said his Silicon Valley venture firm has set aside “meaningful reserves” to do more deals and to put more money into companies it has already invested in, although he declined to specify an amount.

Silicon Valley investors have long complained that startup valuations have gotten too expensive, given that the startup ecosystem has been on a bull run since at least 2015. That has minted an unprecedented number of “unicorn” startups, which are valued at more than US$1-billion, including now-giant companies such as Uber and Airbnb.

But the rising valuations have only continued to climb in the past year. In 2018, the median company valuation for one category of mature startups more than doubled to US$420-million, up from US$183-million in 2017, according to Carta, a provider of valuation software and services. And, in a 2017 National Bureau of Economic Research study of 135 unicorn startups, researchers concluded the companies were overvalued by an average of 50 per cent.

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“There’s too much heat around good, not necessarily great, companies” that are older, said Mamoon Hamid, a partner at the venture firm Kleiner Perkins. Even one “good, not great” company he recently met with had 13 investment offers, he said. The upshot: Mr. Kleiner did not invest.

Greg Sands, a managing partner at Costanoa Ventures, said his venture firm walked away from three investments in 2018 where the price was 30 per cent higher than he was willing to pay, an increase from past years. He also screened out numerous companies that were asking for more money than seemed reasonable – yet some of those companies then went on to raise triple that amount from other investors.

“What’s happening right now isn’t sustainable and it won’t go on forever. It can’t,” he said. Costanoa raised a US$75-million “opportunity fund,” which Mr. Sands said would give it the ability to do more deals when the market cools down.

Many other venture-capital firms are also in a position to become more aggressive in case of a market downturn. Venture funds raised US$30.2-billion in the first three quarters of this past year, on track to surpass 2017’s total of US$35.3-billion, according to PitchBook, a data provider.

Startup founders also appear to be preparing for a potential shift in fortunes. In a survey conducted late last year by First Round Capital, a venture-capital firm, just less than half of 529 entrepreneurs surveyed said they expected fundraising to become more difficult in 2019. A third said they believed the tech bubble was close to popping, a 10-point increase over 2017.

Some startups are raising more money to weather the uncertainty, according to Kirsten Green, a managing partner at Forerunner Ventures. Others are creating backup plans to cut costs so their survival won’t depend on new funding.

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Not all venture capitalists want a downturn, especially if it will throw a wrench into the plans of some of the biggest unicorns – such as Uber, Lyft, Pinterest and Slack – to go public. Many investors are eager to cash out of those companies when they stage an initial public offering.

“You always want a better market,” said Micah Rosenbloom, a managing partner at Founder Collective, which was an early investor in Uber. “In a crisis, everything gets hard. You’d rather have your companies in good times for everything from hiring to sales.”

Still, Mr. Rosenbloom said he also saw opportunity in a downturn. His firm’s two most successful investments – Uber and the Trade Desk, a digital advertising company – were created in the aftermath of the 2008 financial crisis.

In previous downturns, the less-serious entrepreneurs disappeared, leaving the most committed ones, said David Pakman, a partner at venture firm Venrock. “During those periods, some incredible companies were founded by highly determined entrepreneurs,” he said. “The cream rose to the top.”

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