Today we find ourselves in an unprecedented situation and a frightening time for many people. Much has been written about the impact of COVID-19 on healthcare, the economy, and the state of our society. Interestingly, the beginning of this year started very differently and continued a theme that we saw emerge in 2019— the acceleration of FinTech exits at historically large scale. It is remarkable that less than a month ago, Intuit announced the acquisition of Credit Karma — the largest venture-backed FinTech acquisition to-date. Since then, we have seen shocks in the financial and labor markets not experienced since the darkest days of the Financial Crisis. These are fundamentally resetting market expectations and are likely a harbinger of what is still yet to come.
Part I — An Explosion of FinTech Acquisitions
In a four-month period starting November 2019 and ending in February 2020, the FinTech market saw the highest level of M&A of the past decade. Five deals worth a combined $55B were announced, including the acquisitions of Plaid by Visa ($5.4B), Honey by PayPal ($4B), Credit Karma by Intuit ($7B), Ameritrade by Schwab ($26B) and E*TRADE by Morgan Stanley ($13B). These five acquisitions spanned our entire ecosystem — including commerce, payments, banking, investing and wealth management.
As illustrated in Figure 1, these acquisitions reset market expectations with higher prices and increased valuations — particularly in the cases of Plaid (55x revenue) and Honey (44x revenue).
Figure 1: Major FinTech Acquisitions ($B size, Multiple EV/Rev)
The common theme across these acquisitions is a recognition that the “challenger” threats and opportunities are real. Large incumbents have begun to recognize the need to acquire and integrate new capabilities in order to go after new segments and compete head-on against existing and emerging competitors. Moreover, it revealed that these capabilities are critical to an incumbent’s ability to extend and consolidate along the value chain — whether Intuit’s ability to reinforce it’s personal finance offering through Credit Karma, Visa’s relevance to FinTech by integrating Plaid’s APIs or Morgan Stanley’s recognition that E*TRADE’s deposit base can power the new economics of online brokerage.
Part II — A Black Swan Takes Flight
As the FinTech world was experiencing a wave of M&A, the rise of COVID-19 in China began to form a storm cloud on the horizon. Over the last 3 weeks, the situation has escalated rapidly and given flight to the Black Swan of 2020.
As illustrated in Figure 2, the growing threat of a global pandemic and its related economic fallout have led to a 30% drop in the S&P 500 since its peak less than a month ago and the greatest daily decline since Black Monday in October 1987. The market has erased 3 years of gains in just 3 weeks of trading. We believe that this is just the beginning.
Figure 2: Dow Jones Industrial Average (12-month performance)
Today, we find ourselves in an environment of increasing volatility and uncertainty. We are just beginning to see the impact on global markets, with year-on-year factory activity in China down 13.5% in February and the American crude oil benchmark at the lowest level since 2002. However, we are in the early innings of what will likely be a fundamental reset of the market.
The immediate economic shock will be heavily felt in transportation, entertainment & recreation, and food services & accommodation. In the United States, these sectors represented $2.1T and 14% of total consumer spending in 2019 — including $478B on transportation, $586B on recreation services (e.g., sport events), and $1.02T on food services and accommodation (not including grocery).
The shock in these sectors has already begun to ripple through the U.S. labor market. On March 19, the Labor Department reported a 33% increase in week-to-week unemployment claims. As noted by the New York Times, this “rise in initial claims is larger than any week-to-week move that occurred during (or since) the 2008 financial crisis.” Most economists expect these numbers to increase dramatically as individual states report updated numbers in the coming weeks.
In total, hospitality, entertainment, and transportation made up $574B in employee compensation — roughly 10% of the total market. The potential impact on small and mid-sized businesses (SMBs) is particularly severe — with SMB employment representing 47.5% of total private sector employment — and could trigger contagion risks for the broader economy.
As illustrated in Figure 3, high risk SMBs in these sectors employ 12% of the total workforce. The majority (86%) of these businesses have less than 20 employees, making them particularly vulnerable to labor shocks created by business closures and severe reductions in consumer demand. Recognizing the potential danger, Treasury Secretary Steve Mnuchin warned on March 17th that without corrective action, the U.S. “could see 20% unemployment rate due to coronavirus.”
Figure 3: Employment in high risk SMB categories (M)
We are still in early stages of the pandemic and we anticipate that domestic as well as global markets will continue to experience significant turbulence over the next 8–10 weeks. The response in Asia (China, South Korea) suggests that the societal impact of the virus can be contained — albeit at great cost to personal freedom, labor productivity, and economic activity. The coming weeks will be telling as U.S. and European authorities navigate options and implement policies — including fiscal, monetary, security and health — to contain the escalating consequences of the disease.
This turbulence will impact all categories across the Commerce Continuum. The impact of supply chain shock and decline in consumer spending will be particularly acute in the retail (“Shop”) as well as payments (“Spend”) categories. Already, we are hearing numerous large entities adjust projected earnings and shift core business priorities for 2020. Similarly, we are seeing increasing pressure on banking and investment (“Save”). The declining interest rate environment coupled with unclear implications on underlying debt (commercial & consumer) is placing financial stocks under the most significant pressure since the 2008 housing crisis. Importantly, the FinTech exit valuations that we saw at the beginning of the year are unlikely to be sustainable in the near-term and it is possible that individual deals may be renegotiated.
Scenarios Going Forward: Quick Recovery or End of the Good Times?
While it is too early to understand or predict the long-term implications of the current economic situation, we believe there are three potential scenarios:
1. Short-term stabilization and correction: Aggressive response by governments and global health organizations rapidly isolates and stabilizes the impact of COVID-19. Accompanying economic stimulus plans — through a combination of monetary and fiscal levers — will minimize long term structural impact and will likely halt the current slide into global recession. Global GDP growth will slow and stabilize towards the end of 2020.
2. Near-term containment, long-term correction: The health impact of COVID-19 will stabilize within the next 6 months through a variety of aggressive public health policies. However, markets will struggle as labor dynamics fundamentally shift and consumer sentiment declines. Global GDP growth will be anemic for the foreseeable future, with many markets entering into recession.
3. Long-term structural shift: Despite best efforts, the impact of COVID-19 continues to escalate as countries close borders, global travel grinds to a halt, and governments order an unprecedented lock-down. Supply chains and labor markets suffer significant, lasting shocks as larger businesses look to cut expenses in a deteriorating credit environment and many small businesses shut down in the face of plummeting demand. Major industries fundamentally reevaluate existing supply networks, especially in emerging markets. Productivity and consumer sentiment decrease substantially — particularly in the face of significantly increasing unemployment and business closures — severely reducing discretionary spend across key categories. Long-term financial forecasts have to be rebuilt from the ground-up as demand and supply recalibrate to a new normal. Global GDP contracts as most markets face major recession.
It is unclear which of these scenarios will play out. We expect that the most acute health implications of COVID-19 will be largely resolved by the end of the year but the magnitude of the impact of the virus on long-term supply chains, consumer sentiment, labor markets and consumer balance sheets remain unclear. At the very least, we anticipate that it will take longer for the economy to recover.
Our Response: A Steady Hand for Uncertain Times
We anticipate that overall investment from funds will slow as investors try to make their current funds last. Raising capital for new funds will face headwinds in the next 12 months, especially as allocations to venture funds look overweight as more liquid public market portfolio values fall.
Irrespective of which scenario will ultimately play out, we believe in a pragmatic approach to managing the downside risk, including:
· Working with companies that have low cash positions to ensure they can weather the storm
· Ensuring that capital from new rounds last for 12 months or more
· Opportunistically look to deploy double-down capital at prices that would have seemed incredibly low in the past
Generally, we plan to stay the course. Our investment theses are grounded in secular trends that aren’t changing despite the economy. We haven’t chased high-priced, momentum deals, which are going to be the most at risk in this environment. Most of our companies have sufficient cash to last more than 12 months. We also recognize that some of the largest technology companies were built in the hearts of recession: Cisco in the Crash of ’87, Google during the Dot.com Bust, and Facebook in the Great Recession. We believe our portfolio is well-positioned for the current market — with real capabilities, real clients and partners, and real revenue.
While this piece isn’t meant as a prescription for what anyone else should do, we do hope our friends and colleagues will receive it as an open invitation to contact us with any questions or comments they’d like to discuss. Meanwhile, we hope you are all safe and staying healthy!
Sources: U.S. Bureau of Labor Statistics; U.S. Small Business Administration (2018 Small Business Profile); U.S. Bureau of Economic Analysis; Company filings; The New York Times; TD Ameritrade