'Zombie' Venture Capitalists haunt tech investors amidst plunging valuations

In the eyes of some venture capitalists, we are rapidly approaching the night of the living dead as we speak.

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Investors in startups are increasingly warning that the VC sector is facing an apocalyptic scenario - that is, the emergence of "zombie" VC firms that are having difficulty raising funds for their next round.

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It is expected that within a few years, there will be hundreds of companies that become zombies as a result of an increasing interest rate environment and fears of an oncoming recession.

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“The number of zombie VCs is expected to increase in the coming years as a result of the need to manage the investments they have made from their previous fund but are not able to raise their next fund.” Maelle Gavet, CEO of the global entrepreneur network Techstars, told Trade Algo that the number of zombie VCs are expected to increase in the coming years.

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“ There is a possibility that it could be as high as 50% of investors in the coming few years who are not going to be able to raise their next round of funding,” she said.

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What’s a zombie?

It is important to understand that a zombie in the corporate world isn't just a dead person brought back to life. It is actually a business that is so heavily indebted that, while it is still generating cash, it can barely pay off the interest on its debts, let alone the principal, which makes it difficult for it to pay off its fixed costs.

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Zombie firms find it harder to survive in an environment with higher interest rates, as their borrowing costs increase as a result. At the beginning of this month, the Federal Reserve, the European Central Bank, and the Bank of England all raised interest rates again.

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The idea of a zombie in the VC industry is that it is an investment firm that no longer raises money to back new companies. They still operate in the sense that they manage an investment portfolio that they have accumulated over the years. Despite this, they cease to write new checks to founders during tough times as they struggle to generate profits for the company.

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In today's gloomy economic backdrop, investors anticipate that a horde of zombie funds will emerge that no longer produce returns, but instead focus on managing their portfolios while preparing to wind down their operations at some point in the future.

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It is without a doubt that there are zombie VC firms out there. "It happens during every downturn," says Michael Jackson, a Paris-based VC who invests in both startups and venture funds, in an interview with Trade Algo.

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“There has been a significant cooling in the fundraising climate for venture capital firms, so many firms won’t be able to raise their next fund.”

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Why VCs are struggling

Venture capitalists (VCs) take money from institutional investors or LPs, or limited partners, and transfer small amounts of the money to startups in exchange for equity stakes in those startups. The majority of these LPs are pension funds, endowments, and family offices, among others.

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In the event that everything goes well and the startup goes public or is acquired, a venture capital firm is able to recoup the money it invested or, better yet, make a profit from its investment. However, now that startups are seeing their valuations slashed in the current environment, LPs are becoming pickier about where they park their money because they are seeing their valuations slashed.

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“Zombie venture capital firms will become more prevalent this year,” said Steve Saraccino, founder of Activant Capital.

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The VC industry has been hit hard by a sharp decline in the valuations of technologies over the past few years. With investor sentiment on high-growth areas of the market souring amid souring sentiment on publically-listed tech stocks, Nasdaq shares have fallen nearly 26% from their peak in November 2021, with the stock market down nearly 26% from its peak.

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Private valuations are now playing catch-up with stock valuations, which means that venture-backed startups are also feeling the chill.

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Since reaching a peak of $95 billion in March 2021, Stripe, the online payments giant, has seen its internal market value drop 40% to $63 billion, from a peak of $95 billion in March 2021. In contrast, Klarna, which offers a buy-now, pay-later service, recently raised funds at a valuation of $6.7 billion, which is a hefty 85% discount over the previous fundraising.

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Cryptocurrencies are the most extreme example of the reversal in technology in the last few years. The FTX crypto exchange filed for bankruptcy in November, with its private backers valuing the company at a staggering $32 billion at the time of its launch.

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A number of top players in venture capital and private equity, including Sequoia Capital, Tiger Global, and SoftBank, invested in FTX, raising questions about the level of due diligence - or lack of it - that went into the deal negotiations.

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Since most of the companies, they back are privately held, any profits that VCs make from their bets are paper gains - in other words, they won't be realized until their portfolio company goes public, or sells to another entity. As an increasing number of tech companies are opting to stall their listings until market conditions improve, it appears that the IPO window for the most part has been shut. There has also been a slowdown in merger and acquisition activity over the past few months.

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New VC funds face a tougher time

Due to the prolonged period of low-interest rates, a flood of new venture funds has emerged over the last two to three years as a result of a prolonged period of low-interest rates. As per the data provided by the data platform Dealroom, in 2022, VCs raised a total of 274 venture capital funds, more than in any previous year. This is an increase of 73% from the 158 funds raised in 2019.

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Some LPs may be less inclined than others to hand cash over to newly established funds with fewer years of experience under their belts in comparison to names with a proven track record.

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“The private equity firms are pulling back after being overexposed in the private markets, leaving less capital to go around a number of VC firms that have been started over the last few years,” Saraccino explained.

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“ Many new venture capital firms lack experience and haven't been able to return capital to their limited partners, meaning they are going to struggle mightily to raise new funds.”

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When will zombie VCs emerge?

VC firms are likely to take three to four years before they begin showing signs of distress, according to Frank Demmler, who teaches entrepreneurship at Carnegie Mellon University's Tepper School of Business.

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“As with zombie firms in other industries, the behavior won't be as obvious as it is with zombie firms in other industries. However, the tell-tale signs are they have not made big investments in the last three or four years, they have not raised a new fund.”

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“The last couple of years were buoyant enough to fund a lot of first-time funds,” Demmler said.

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“These funds will probably get stuck somewhere in the middle, where they haven't had much liquidity yet and are mostly invested if they were invented in 2019, 2020.”

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It is then that they are in a position where they will no longer be able to make the type of returns that they expect from their limited partners. It's at that point when the zombie dynamic really kicks in."

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There is a consensus among industry insiders that venture capitalists will not lay off their employees in droves, unlike the tech firms that have laid off thousands. In the long run, the company would rather shed staff through attrition, rather than filling vacancies left by partners leaving as it prepares to eventually wind down its operations.

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As Hussein Kanji, partner at Hoxton Ventures, explained, a venture wind-down is very different from a company wind-down. “The process of closing down funds usually takes between 10 and 12 years. Thus, they are not raising money and their management fees are declining as a result."

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“It is common for people to leave the firm and you end up with a skeleton crew taking care of the portfolio until it all exits in the decade allotted. As you can see, this is what happened in 2001."