Early-Stage VC Is ‘Highly’ Sensitive to Downturns — Including This One

The “low correlation” to public markets claimed by venture capital managers may not exist, according to an NBER study.

(David Paul Morris/Bloomberg)

(David Paul Morris/Bloomberg)

Venture capital, like other alternative asset classes, is often viewed by institutional investors as a way to diversify their portfolios and achieve returns that are uncorrelated to public markets. But venture capital activity may not actually be so uncorrelated to stocks — at least in the earliest stages, according to a new working paper from the National Bureau of Economic Research.

In the first two months after the Covid-19 pandemic struck the U.S., early-stage venture capital activity dropped by 38 percent relative to the previous four months, reported the paper’s authors Sabrina Howell (New York University), Josh Lerner (Harvard University), Ramana Nanda (Harvard), and Richard Townsend (University of California, San Diego).

This sharp drop is not unique to the current crisis: deal volume, capital invested, and deal size have historically declined “substantially” during recessions, they said. This is in contrast with later-stage venture capital, which has so far “remained much more robust” in 2020.

“This higher sensitivity in early-stage VC is noteworthy, as the 10-year fund structure and the private, long-term nature of venture investments might suggest that VC deal activity — particularly at the early stages — is relatively insulated from downturns,” the authors wrote. “Indeed, a low correlation with public markets has been an important justification for institutional asset allocation to this sector, and a frequent claim of VC fund managers.”

[II Deep Dive: Private Markets ‘Not Immune’ to Downturn]


In reality, the authors said they found “systematic evidence that investors who specialize in early-stage deals are significantly more responsive to business cycles than later-stage investors.” Using data from PitchBook, they recorded a “marked decline” in all VC deals since the arrival of the pandemic in the U.S., falling from 112.3 deals per week before the crisis to an average of 69.7 deals per week in the two months after it started. This drop was primarily driven by a sharp decline in early-stage deals, they found, describing the effect on later-stage deals as “muted.”

They found similar patterns during previous recessions, with early-stage venture activity falling off sharply, while later-stage activity was not affected much.

In addition to deal activity, the authors looked at patents acquired by venture-backed firms to determine the possible consequences of subdued financing. Here, too, economic downturns had “pronounced” effects for early-stage venture capital funds, with startups backed by these funds applying for fewer patents during recessions. The patents that were filed during these periods tended to be “less highly cited, less original, less general, and less closely related to fundamental science,” according to the paper.

“The particular sensitivity of early-stage VC investment to market conditions… raises questions about the pro-cyclicality of VC and its implications for innovation, especially in light of the common narrative that VC is relatively insulated from public markets,” the authors concluded.