Why Today’s Tech Correction Is Not Likely To Be Another Dot-Com Bomb


To any investor whose experience goes back two decades, the current equity downturn, especially afflicting growth and technology stocks, brings back bad memories of the “dot-com” crash of 2000-01. The tech-heavy NASDAQ Composite index took 15 years to return to its 2000 high and financing for earlier-stage companies slowed to a trickle.

“That implosion stifled funding of innovation for years,” says Kazuki Nohdomi, Portfolio Manager, Private Equity and Venture Capital at Nicola Wealth. But it’s worth considering some of the differences between today’s situation and then.

“While there are parallels, there are some key differences between now and 2000-01,” says Nohdomi, who oversaw last year’s launch of the Nicola Wealth Venture Capital Limited Partnership. Then, the underlying problem was widespread speculation on internet business models that didn’t work and businesses that, in some cases “served no purpose at all.” A large portion of dot-coms — there were important exceptions, like Amazon — could not sustain their early, promotion-driven revenue growth, if they had revenues at all.

The problem today relates to technology valuations, which were driven sky-high in an environment of historic, rock-bottom interest rates coupled with pandemic-related fiscal stimulus. Lower interest rates pushed investors away from bonds and low yielding assets and into growth equities in search of strong returns.  So, when inflation spiked and interest rate expectations took off at the beginning in late 2021, growth company valuations had to come down.

“Today, technology is a tangible added benefit for businesses and digital transformation continues to be a top corporate priority, so the fundamentals in the many parts of the tech sector look strong.  So, while we’ve been experiencing a monetary policy-driven correction in valuations, many businesses have continued to perform well.  The caveat there is the projected economic recession which represents a significant headwind to corporate spend, and we may start to see fundamentals deteriorate in the technology sector as well” says Geoff Taylor, Associate Director, Private Equity and Venture Capital at Nicola Wealth.

While public tech stocks may not reach their 2021 valuation highs in a higher interest-rate / lower growth environment, and certain venture capital (VC) backed companies may find it more difficult to find cheap funding, companies with strong product-market fit with strong cashflows are likely to still secure funding, even in the face of a recession. Indeed, there is an estimated US$230 billion in “dry powder” in the U.S. VC market — cash committed by investors but yet to be deployed.

There was a degree of irrational exuberance in 2020 and 2021 reminiscent of the late 1990s, Nohdomi allows. “High growth companies with little margin improvement were getting funded in this past cycle and we do not think that is going to happen again.”  A big driver of that was the proliferation of new non-traditional VC market participants — crossover hedge funds, pension funds and other institutions attracted by the venture sector’s outsized returns over the preceding decade.  These groups chased late-stage high growth companies, differentiating against traditional VCs with their speed, valuation insensitivity and light governance terms.  High public market valuations and an active IPO market meant that these investors could pay hefty multiples in late-stage private markets and still see strong returns in short order upon exit.

Now, with public stocks deep in correction territory and IPO markets largely frozen to VC-backed issuers, Taylor expects looking for growth stocks to continue to be more selective.

“We’re seeing VCs stepping away from backing high-burn companies without a clear path to profitability. They’re focusing on businesses that are prioritizing building to positive cash flows,” Taylor says. This means hard decisions are ahead for companies that hope to attract financing and survive the impending recession, including cutting headcount and accepting lower growth.

In future posts, we’ll look more closely at the thesis underlying the four target industry verticals in which the Nicola Venture Capital LP has chosen to focus, and we’ll dive into the benefits of our unique portfolio construction and evergreen strategy.

 


 

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