Rise of zombie VCs haunts tech investors as startup valuations plunge

For some enterprise capitalists, we’re approaching an evening of the living dead.

Startup investors are increasingly warning of an apocalyptic scenario within the VC world — namely, the emergence of “zombie” VC firms which are struggling to lift their next fund.

Faced with a backdrop of upper rates of interest and fears of an oncoming recession, VCs expect there shall be a whole bunch of firms that gain zombie status in the following few years.

“We expect there’s going to be an increasing variety of zombie VCs; VCs which are still existing because they should manage the investment they did from their previous fund but are incapable of raising their next fund,” Maelle Gavet, CEO of the worldwide entrepreneur network Techstars, told CNBC.

“That number might be as high as as much as 50% of VCs in the following few years, which are just not going to have the opportunity to lift their next fund,” she added.

In the company world, a zombie is not a dead person brought back to life. Moderately, it is a business that, while still generating money, is so heavily indebted it may possibly nearly repay its fixed costs and interest on debts, not the debt itself.

Life becomes harder for zombie firms in a better rate of interest environment, because it increases their borrowing costs. The Federal Reserve, European Central Bank and Bank of England all raised rates of interest again earlier this month.

Within the VC market, a zombie is an investment firm that not raises money to back recent firms. They still operate within the sense that they manage a portfolio of investments. But they stop to put in writing founders recent checks amid struggles to generate returns.

Investors expect this gloomy economic backdrop to create a horde of zombie funds that, not producing returns, as an alternative give attention to managing their existing portfolios — while preparing to eventually wind down.

“There are definitely zombie VC firms on the market. It happens during every downturn,” Michael Jackson, a Paris-based VC who invests in each startups and enterprise funds, told CNBC.

“The fundraising climate for VCs has cooled considerably, so many firms won’t have the opportunity to lift their next fund.”

VCs take funds from institutional backers referred to as LPs, or limited partners, and hand small amounts of the money to startups in exchange for equity. These LPs are typically pension funds, endowments, and family offices.

If all goes easily and that startup successfully goes public or gets acquired, a VC recoups the funds or, higher yet, generates a profit on their investment. But in the present environment, where startups are seeing their valuations slashed, LPs have gotten more picky about where they park their money.

For the reason that firms they back are privately-held, any gains VCs make from their bets are paper gains — that’s, they will not be realized until a portfolio company goes public, or sells to a different firm. The IPO window has for probably the most part been shut as several tech firms opt to stall their listings until market conditions improve.

“We’ll see rather a lot more zombie enterprise capital firms this 12 months,” Steve Saraccino, founding father of VC firm Activant Capital, told CNBC.

A pointy slide in technology valuations has taken its toll on the VC industry. Publicly-listed tech stocks have stumbled amid souring investor sentiment on high-growth areas of the market, with the Nasdaq down nearly 26% from its peak in November 2021.

With private valuations playing catch-up with stocks, venture-backed startups are feeling the coolness as well.

Stripe, the web payments giant, has seen its market value drop 40% to $63 billion since reaching a peak of $95 billion in March 2021. Buy now, pay later lender Klarna, meanwhile, last raised funds at a $6.7 billion valuation, a whopping 85% discount to its prior fundraise.

Crypto was probably the most extreme example of the reversal in tech. In November, crypto exchange FTX filed for bankruptcy, in a shocking flameout for an organization once valued by its private backers at $32 billion.

Investors in FTX included among the most notable names in VC and personal equity, including Sequoia Capital, Tiger Global, and SoftBank, raising questions on the extent of due diligence — or lack thereof — put into deal negotiations.

Previously two to a few years, a flood of recent enterprise funds have emerged as a result of a chronic period of low rates of interest. A complete of 274 funds were raised by VCs in 2022, greater than in any previous 12 months and up 73% from 158 in 2019, in response to numbers from the info platform Dealroom.

LPs could also be less inclined handy money to newly established funds with less experience under their belt than names with strong track records. 

“LPs are pulling back after being overexposed within the private markets, leaving less capital to go around the massive variety of VC firms began over the past few years,” Saraccino said.

“Lots of these recent VC firms are unproven and haven’t been in a position to return capital to their LPs, meaning they will struggle mightily to lift recent funds.”

Frank Demmler, who teaches entrepreneurship at Carnegie Mellon University’s Tepper School of Business, said it might likely take three to 4 years before ailing VC firms show signs of distress.

“The behavior won’t be as obvious” because it is with zombie firms in other industries, he said, “however the tell-tale signs are they have not made big investments over the past three or 4 years, they have not raised a recent fund.”

“There have been plenty of first-time funds that got funded throughout the buoyant last couple of years,” Demmler said.

“Those funds are probably going to get caught midway through where they have not had a possibility to have an excessive amount of liquidity yet and only been on the investing side of things in the event that they were invented in 2019, 2020.”

“They then have a situation where their ability to make the sort of returns that LPs want goes to be near nil. That is when the zombie dynamic really comes into play.”

In accordance with industry insiders, VCs won’t lay off their staff in droves, unlike tech firms which have laid off hundreds. As an alternative, they’ll shed staff over time through attrition, avoiding filling vacancies left by partner exits as they prepare to eventually wind down.

“A enterprise wind down is different from an organization wind down,” Hussein Kanji, partner at Hoxton Ventures, explained. “It takes 10-12 years for funds to shut down. So principally they do not raise and management fees decline.”

“People leave and you find yourself with a skeleton crew managing the portfolio until all of it exits in the last decade allowed. That is what happened in 2001.”