Rise of zombie VCs haunts tech investors as startup valuations plunge

For some venture capitalists, night of the living dead is on the horizon.

Startup investors are increasingly warning of an apocalyptic scenario in the VC world: the emergence of “zombie” VC firms struggling to raise their next round of funding.

With interest rates rising and fears of a looming recession, VCs expect hundreds of companies to become zombies over the next few years.

“We expect the number of zombie VCs to increase. VCs that still exist but cannot raise the next fund because they need to manage investments made from previous funds,” says global entrepreneur Maelle Gavet, CEO of House Network Techstars, told CNBC.

“That number could reach up to 50% of VCs in the next few years, and they may not be able to raise their next round of funding,” she added.

In the corporate world, zombies are not the reanimated dead. Rather, it is a business that, while still generating cash, has so much debt that it can almost pay off the fixed costs and interest on the debt, rather than the debt itself.

A high interest rate environment makes life more difficult for zombie companies as borrowing costs increase. The Federal Reserve, European Central Bank and Bank of England all raised interest rates again earlier this month.

In the VC market, zombies are investment firms that don’t raise money to back new companies. They still work in the sense of managing a portfolio of investments. But as they struggled to make a profit, they stopped writing new checks to the founders.

Investors expect this pessimistic economic situation to spawn hordes of zombie funds that no longer generate returns and instead concentrate on managing their existing portfolios, preparing to eventually wind down. increase.

“There are definitely zombie VC firms out there, and they happen every recession,” Paris-based VC Michael Jackson, who invests in both startups and venture funds, told CNBC.

“The VC fundraising environment has cooled considerably, and many companies will not be able to raise their next round of funding.”

VCs receive funding from institutional investors, known as LPs or limited partners, and give small amounts of cash to startups in exchange for equity. These LPs are typically pension funds, endowments and family offices.

If all goes well and the startup goes public or is acquired successfully, the VC will either recoup the money or, even better, make a profit on the investment. However, in the current environment where start-up valuations have plummeted, LPs are becoming more cautious about where they keep their money.

The companies they back are privately held, so the profits VCs make on their bets are just paper profits. The IPO window was all but closed as several technology companies opted to suspend their listings until market conditions improved.

“We will see more zombie venture capital firms this year,” Steve Saraccino, founder of VC firm Activant Capital, told CNBC.

A sharp drop in technology valuations has hit the VC industry. Listed tech stocks have stumbled amid deteriorating investor sentiment for high-growth segments of the market. Nasdaq It’s down nearly 26% from its peak in November 2021.

Venture-backed startups are feeling the chill as private valuations catch up with equities.

Online payments giant Stripe’s market value has fallen 40% to $63 billion since peaking at $95 billion in March 2021. Meanwhile, his Klarna, a buy-now-pay-later lender, last time he was valued at $6.7 billion. His 85% discount on previous funding.

Cryptocurrency was the most extreme example of a technology reversal. November, virtual currency exchange FTX filing for bankruptcythe stunning downfall of a company once valued at $32 billion by private backers.

FTX’s investors include Sequoia Capital, Tiger Global, and Softbankquestion the level of due diligence, or lack thereof.

The last couple of years have seen a flood of venture funds due to prolonged low interest rates. A total of 274 deals were raised by VCs in 2022, according to figures from data platform Dealroom. That’s more than any other year and a 73% increase from 158 in 2019.

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LPs may be less inclined to hand over cash to newly established funds with less experience than names with strong track records.

“LPs are exiting after being overexposed in the private market, and lack the funds to move around the numerous VC firms that have been established in the last few years,” Saracino said.

“Many of these new VC firms are unproven and have failed to return capital to LPs, which means they will have a very hard time raising new money.”

Frank Demmler, who teaches entrepreneurship at Carnegie Mellon University’s Tepper School of Business, said it would take three to four years for ailing VC firms to show signs of trouble.

“It may not be as obvious a move as zombie companies in other industries, but it’s a telltale sign that they haven’t invested heavily and haven’t raised money over the last three or four years,” he said. new fund. ”

“Many first-time funds have been funded in the last few years in a strong period,” Demler said.

“These funds will probably get caught in the middle of the situation where they have not yet had the opportunity to secure sufficient liquidity and are only on the investment side if they are invented in 2019 or 2020.”

“Then they get into situations where their ability to generate the type of profit that LPs want is close to zero. That’s when the zombie dynamic really kicks in.”

VCs won’t lay off staff in large numbers, according to industry insiders. Thousands laid offInstead, they will gradually reduce headcount, avoiding filling vacancies left by partner exits as they prepare to eventually downsize.

Hussein Kanji, partner at Hoxton Ventures, explains: “It will take 10 to 12 years for the fund to close. Basically the fund will not raise money and management fees will decrease.”

“People leave and end up with a bare bones crew managing the portfolio until it’s all done in the 10 years allowed. This is what happened in 2001.”