Gaming’s Investment Climate
This week, we are sharing our views on how the macro environment in the capital markets is impacting the investment landscape of early-stage gaming VC.
Here is a brief summary of what we are covering:
- Global Macro Environment: rising interest rates and geopolitical tension are putting significant pressure on virtually every asset class after a 12+ year bull market
- Slowdown in Venture Capital: slower capital raises and lower valuations are being seen across the industry, but the pullback in funding is particularly notable at late-stage venture
- Gaming’s Resilience: the highest growth industries (gaming is in the top five globally) are less likely to be meaningfully impacted by macro disruptions, especially in early-stage venture
1) Setting the Stage: Global Macro
When we first started Konvoy in late 2018, we were already over 8 years into a strong bull market. Less than two years later, the entire world experienced the beginning of COVID-19 which caused the key public market indices to see some of their largest single day drops in history (CNBC) before returning to pre-pandemic levels just a few months later. Since then, low interest rates and significant consumer and corporate cash balance sheets have continued fueling a market boom across asset classes. Financial charts showing lines moving “up and to the right” has almost become an expectation.
Although the degree may vary significantly, macroeconomic sentiment impacts all asset classes, sectors, and stages of investing. Over the last few years, it has become challenging not to correlate risk-on strategies with high chances of success. This is not only reflected in the rapid influx of capital into asset classes such as crypto and venture capital, but also in the broader equity market through a rush towards riskier instruments such as leveraged ETFs (Wall Street Journal).
However, after more than a decade of overwhelmingly bullish market behavior, we are now witnessing signs of a slowdown. Rapid inflation is squeezing interest rates (CNN) and geopolitical conflicts (most recently Russia’s invasion of Ukraine) are creating widespread uncertainty. Even in the context of relatively strong corporate earnings (buoyed by inflated consumer spending), these macro factors are finally putting downward pressure on assets.
2) Impact on Venture Capital
Given Konvoy’s position as a venture capital fund, we are primarily concerned with how macro considerations will flow into the venture capital asset class. Despite the record breaking capital being raised by venture capital funds ($128.3b in 2021, up 47.6% over 2020), Q1 2022 showed a 19% decrease in allocated capital compared to the prior quarter (CB Insights). This pullback from Q4 to Q1 is particularly noteworthy given that the venture asset class is seeing a compression in fundraising cycles and a shortening of investment periods. With that in mind, the fixed allocation period and deployment mandates means that VC funds have to allocate. If everyone is pausing/slowing right now, that just means they will need to either 1) extend their investment periods or 2) accelerate their deployment later on (leading to artificial inflation of valuations).
This current slowdown in venture capital is not only impacting the total amount of capital readily available for founders but also round dynamics. Over the course of 2021 we simultaneously saw the timeline of capital raises shorten as valuations inflated. This dynamic is fading quickly at the late-stage and is slowing slightly at the early-stage. Growing caution amongst asset managers is leading to a rather quick regression to the status quo: rounds are taking longer and valuations are cooling. Essentially, a heavily founder-friendly market in 2021 is pulling back in 2022.
That being said, the speed of this reaction is not uniform across the entire asset class. In particular, we are seeing early-stage venture capital operate on a 6-9 month lag to late-stage. The total value of funding rounds at Series C or later is declining significantly faster than Series B and earlier (-17.8% vs -11.1%) between Q4 2021 and Q1 2022 (CB Insights). This makes sense as growth stage businesses are more reliant on fundamentals than their early-stage counterparts that can initially rely on promising product-market fit and growth theories.
This will be healthy for the ecosystem as the best founders find the funding they deserve. We also think this will make it more competitive on the investor side as it will force investors to showcase their value-add even more than before in those hyper competitive rounds.
3) What Does This Mean for Early-Stage Venture Capital?
Given our focus on early-stage investing here at Konvoy, we have taken a more granular view of how we believe this will play out in Pre-Seed / Seed, Series A, and Series B rounds over the next 12 months:
- Pre-Seed / Seed: These rounds will be impacted the least and will generally continue to be filled and oversubscribed. Investing at this stage is primarily focused on founders, market tailwinds, and underlying product/strategy (in that order). Additionally, given the valuation entry points, the return upside remains quite substantial regardless of macro conditions. As a result, they are less susceptible to immediate changes in the market environment.
- Series A: This is the first stage where demonstrating results will be absolutely critical to capturing investors’ attention over the next 12 months. While “pitching the vision” was often sufficient in 2021, there will be heightened scrutiny on early execution in a less frothy market. A critical consequence of this will be the need for faster feedback loops at the company level that require more bridge rounds to keep companies alive until they can show sufficient results to raise. We may see many VC funds increase their reserves strategies to triage their portfolio through this high-bar Series A environment.
- Series B: Since this is generally the round where growth investors will start to enter the picture, the underwriting will be more meticulous in a tightening market. Beyond growth momentum and compelling KPIs, this is where investors will search for true strategic differentiation and a path to profitability.
While these early rounds are certainly not immune to market headwinds, high quality long-term visions will continue to receive funding. However, the pressure to show results is increasingly prevalent at each advancing stage in a market like the one we are entering.
4) Gaming: Resilient and Accelerating
The success of any company is heavily reliant on whether the sector they are in is actively growing, stagnant, or declining. This has a significant impact in determining how susceptible an investment is to macroeconomic pressures. We believe that the highest growth industries (i.e., biotech, gaming, blockchain, fintech) will be more resilient to adverse market conditions.
For gaming specifically, this industry has already demonstrated recession resilience three times over at this point in 1999 (dot com bubble), 2008 (financial crisis), and 2020 (pandemic). We fully expect this sector to continue to thrive in bull markets and grow in tough markets, which is why we exclusively focused on the category.
Taking a look at gaming in particular, the last couple weeks are proof of a continued risk-on approach from many investors. Three deals stand out in particular:
- One More Games raises $22m Series A (Source)
- Probably Monsters raises a $200m Series A (Source)
- Playable Worlds Raises $25m Series B (Source)
Even as pessimistic market sentiment leads many investors to seek safety, we expect more early-stage deals like these to continue coming out of the gaming space. Long-term bets on strong founders with visionary ideas and the ability to execute will be compelling in any environment.
Takeaway: key macroeconomic headwinds such as rising interest rates and geopolitical tension are negatively impacting every asset class. For venture capital in particular, this is driving a more cautious approach to investing that includes more meticulous diligence, heightened expectations on metrics, and more risk adjusted valuations. As a result, the industry as a whole saw a significant slowdown in allocations during Q1 2022. While this paints a generally negative outlook, we remain confident that early-stage venture investments in high growth sectors like gaming will continue to remain resilient.