A partner at a billion-dollar venture firm breaks down the 'psychology-driven reason' why a downturn in the public markets makes it harder for startups to raise money

Alex Niehenke

The public markets have taken a beating in recent weeks, and some investors are comparing the plunge to the early days of the dot-com bust.
Alex Niehenke, a partner at Scale Venture Partners, explains how a downturn in the public markets can affect the venture-capital industry.
Much of this trickle-down effect is psychological, Niehenke says, and can inspire both general and limited partners to make more conservative bets.

The public markets have taken a beating in recent weeks, and some investors are comparing the plunge to early days of the dot-com bust.

In a recent interview with Business Insider, Alex Niehenke, a partner at enterprise-focused venture fund Scale Venture Partners — which made early bets on companies like Docusign, Box, and Hubspot — broke down the "psychology-driven" effect that a plunge in the public markets can play on venture capital.

In short, he says, a downturn in the markets means investors are more scared to place big bets on startups, because there's less assurance that you'll get a strong return on your investment.

Here's a passage from that interview, edited and condensed for clarity, quoted from Niehenke:

"If you think about the value proposition of venture, it's fundamentally borderline ludicrous ... The business of venture is all based on near-term belief. Any time this belief becomes a question mark, or an insecurity, it can be troubling.

"Let’s put you in the seat of a general partner. If you're a pretty successful general partner at a standard fund, you're maybe on the board of five or six companies. A third are hopefully knock-out-of-the-park good, a third are in the middle, and another third are going to have some trouble. When things are in a positive environment, your top performers will take care of themselves, the middle third might need a little help along the way, and the bottom third will require more work.

"You can generally manage this bottom third in two outcomes: When the market turns (for instance, I'm thinking back to 2009 here), the bottom third of companies are unfinanceable. No one will touch them. And then, the middle third will have trouble finding financing. So that’s two-thirds of your portfolio. Then you start focusing on the top third of your portfolio, which are performing really well.

"But by then, everyone starts worrying. It's a terrible metaphor but, when your house is burning, you're not thinking about how to build out your deck because you're too concerned with putting out the fire.

"Everyone starts worrying, and the belief becomes the reality. This often starts with the limited partners who manage large positions. They start seeing a certain amount of their wealth decrease from the public markets, and seeing their market cap decrease overall, which drives more conservative behavior.

"This business is so psychology-driven. In 2009, if you were trying to raise a venture fund, it was incredibly difficult. Everyone with money had problems. People weren’t talking about how to grow a business, they were trying to survive the economy. If you do decide to raise that capital, you become more cautious and thoughtful in your capital deployment. Venture operates in 10-year fund cycles.

"Psychology really matters in this industry because so much of venture is based on believing.

"So, this goes back to entrepreneurs. If I’m going to a set of investors and saying, 'Hey, I think that the taxi industry is backwards and that should change,' then I have to postulate that I should change it. ... Still, many entrepreneurs start companies during downturns because there's a definite reason to change the status quo.

"I've been very excited about the M&A markets this year. Acquirers have such large balance sheets, and there's been a string of fantastic M&A deals. I think this is healthy for the ecosystem and something that we anticipated and hoped for.

"But if we see a 15 to 20% slide in the public markets, you'll see less that this tends to be the behavior among acquirers, and this would be a shame for the venture industry.

"M&A can drive good venture returns, it's a great way for investors to clear out our portfolios. What inevitably happens when that goes away is that one of our options to see a realization for returns disappears. I'd like to say that at Scale all of our companies will go public, but that's just not true. You need the ability to exit for a good return.

"If you can't execute on returns, then at some point, LPs stop giving you money. You have to have reality checks when these markets change."

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