Opinion: The Black Swan is Not All Black - Venture Capital Startup Funding and COVID-19
- Sequoia Capital issued a black-swan warning following the global outbreak of COVID-19
- Our analysis of historical data adds a new perspective: showing that the stock markets and Venture Capitalist firms have very different responses to pandemic outbreaks.
- The 2009 H1N1 outbreak and COVID-19 are appropriate parallels.
- The stock market crash during H1N1 wasn’t as bad as it was during the 2008 recession.
- Data on VC seed and total funding reveals an increase during and following the H1N1 outbreak.
- Conclusion: The current situation promises short term turbulence in stock markets, and positive or zero effect on VC investment trends, especially seed funding stages, proven by the comparison with the historical data of past H1N1 pandemic outbreak.
Financial markets’ sensitivity to pandemic events is self-evident. Such sensitivity is often painfully visible in market breadth indicators, such as stock market indices. The VC market, however, has different dynamics. VC investment is based on a promise that new opportunities change the dynamics of current markets, while stock investment is based on the capacity of the investor to predict the future.
VC investors, therefore, spend most of their efforts and resources scouting for new opportunities, while stock market investors dive into stock forecast analysis of targeted companies and stocks. Deal flow in VC is sequential while in stock markets the deal flow is continuous. These differences in particular, as well as others, put VC investment in a different spot than other financial market sectors when it comes to sensitivity to global pandemics.
Sequoia Capital issued a black-swan warning last week following the global outbreak of COVID-19 in 100 countries, leading to the fifth-worst week in the history of the US stock market. To the VC market, this warning could be taken as a sign urging immediate caution against new commitments as well as slowdown of funding deployment. However, the COVID-19 outbreak is not the first pandemic in the 21st century, and the 2020 black-swan warning can be better understood by looking at similar events in the past two decades. In this piece, we discuss the VC investment statistics from the OECD (Organization for Economic Cooperation and Development) in comparison with MSCI historical data and the WHO pandemic records to explore the possible connections between VC investment potential and the ongoing COVID-19 outbreak.
The available data on VC investment in OECD countries covers the period from 2006 to 2018. In terms of geographical scale and pandemic nature, COVID-19 is similar to the H1N1 pandemic. The outcome of H1N1 turned out to be milder than initially feared. H1N1 is now commonplace and generally viewed as part of the seasonal flus that come and go every year around the globe. Early estimates on the fatality rate for H1N1 were much higher than the roughly 0.01 to 0.03% it turned out to be. H1N1 is a particularly good parallel, epidemiologists say, because while it had a lower fatality rate than SARS or MERS, it was deadlier because of how infectious and widespread it became. Table 1 compares COVID-19 and H1N1 key statistics.
Despite hard crashes, stock markets recover quickly after disease outbreaks. The MSCI returns recovered by 10% after the H1N1 outbreak and by 40% after six months. The time-series correlation between VIX index jumps that precede stock market crashes during pandemics suggest a strong causal relation. This has been explained in relevant behavioural psychology research. This also explains the quick recovery of stock markets, as witnessed during the H1N1 pandemic. Moreover, despite nearly a half-million deaths in less than 10 months, the H1N1 outbreak had little impact on stock markets compared to the 2008 crisis or the 2011 economic recession. Graph 1 shows historical data of the MSCI world index that compares the impact of H1N1 to other events in terms of influence on stock markets.
Graph 1. Historical data of MSCI world index high, low, and percentage change from January 2016 to January 2020, with shaded periods representing (a) the 2008 economic recession (b) H1N1 outbreak (c) 2011 recession and (d) 2016 micro-recession.
While the impact of economic recession is more evident than the H1N1 impact on stock markets, as indicated in graph 1, the response of VC funding to the same events is different. Seed and total VC funding recorded 13.1% and 12.9% increases in OECD countries, respectively, following the H1N1 outbreak. Almost a year earlier, seed and total funding recorded 12% and 29% declines during the 2008 economic crisis, with seed funding increasing by 30% and 12.3% during the subsequent financial recessions in 2011 and 2016. (See graph 2.) The total VC funding, however, declined by 12.9% and 4.9% during the 2011 and 2016 recessions.
Graph 2. Seed and total VC investment in startups of the OECD countries with major economic recessions and pandemic events from 2006-2020. The bottom row shows the percentage change in seed and total VC investment funding in the shaded events shown in the top row: (a) 2008 crisis (b) H1N1 outbreak (c) 2011 recession, and (d) 2016 recession.
As of today, scientists identified two strains of COVID19 with the more aggressive one prevalent in early reported cases of China. The number of active cases in China is decreasing. Human trials for a COVID-19 vaccine could begin within a few weeks, with the animal studies on transgenic animals having progressed during the past few weeks.
We think it is safe to argue that despite the ongoing short-term turbulence in stock markets, the COVID-19 outbreak will yield similar losses on the long run to that of the H1N1 outbreak. This should be much less than the losses of the 2008 economic crisis. Further, it is interesting to note that the VC trends are drastically different from that of the stock market, yielding different dynamics in the long run. There is a correlation between the H1N1 pandemic and the increase in VC seed and total funding in OECD countries, while economic recessions involving the collapse of financial institutions can be correlated to a reduction in total VC funding.
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