Length and severity of the downturn in funding depend on how long the AI bubble lasts
After obtaining his economics PhD from Yale University in 1979, David Swensen was hired by Wall Street investment bank Salomon Brothers and, three years later, moved to Lehman Brothers. Three years after that, at the age of 31, he took an 80% pay cut and returned to Yale to manage the university's endowment.
Swensen later explained that he had accepted the job and pay cut because, "There are a lot of important things in life you don't measure in dollars and cents." For Swensen, some of these things were teaching college students, playing poker with Nobel laureate James Tobin, being on a summer softball team with Yale's then-president, Rick Levin, watching Yale hockey games, and coaching his children's baseball and soccer teams.
When Swensen took over Yale's endowment portfolio, it had a 62% allocation to U.S. stocks, 6% to developed stocks, and the rest mostly fixed income. When Swensen died in 2021, U.S. stocks were just 2% of the Yale portfolio, replaced by venture capital, leveraged buyouts, hedge funds and the like. Swensen's track record was impressive and many other endowments now emulate the "Yale Model."
Yet over past decade, the Yale Model has lagged behind the S&P 500 SPX. One explanation is that there are not enough low-hanging fruit. For example, when the demand for venture capital investments is modest, investors can be picky, but when the demand for venture capital investments far exceeds the supply of good ideas, many investors will be stuck with schemes that should never have been funded.
The consequences of dubious schemes were particularly evident in fiscal 2023, when Yale, Harvard University and many other prominent endowments lost money on their venture capital and private equity investments and their portfolios were trounced by the S&P 500 SPX.
This widely reported dismal performance is, in many ways, a chorus of canaries in a coal mine. Venture capital (VC) investments have always been lottery tickets. On average they disappoint but occasionally they pay off big.
For example, some startups funded between the 1960s and 2000s are now among America's most valuable companies, including Intel (INTC), AMD (AMD), Qualcomm (QCOM), Amazon.com (AMZN) and Alphabet (GOOGL). But recently, disappointments have been far more common than successes. Jay Ritter, a professor at the University of Florida, reports that the percentage of startups profitable at the time of their IPO had fallen to less than 20% in the late 2010s from about 80% in 1980 .
For years, the two of us have been warning of the dangers to America's startup system posed by big startup losses. In 2013, angel investor Aileen Lee coined the term "unicorn" for startups that were valued at $1 billion or more before they went public. We have been documenting the unprofitability of these unicorns along with their huge cumulative losses (see here, here, and here). Furthermore, almost 60% of America's publicly traded unicorns have cumulative losses larger than their revenues - a figure that doesn't include the dozens of publicly traded unicorns which have gone bankrupt or been acquired in the past two years.
Privately traded startups are almost surely doing even worse, because the best will IPO first. Thus, Morgan Stanley's European head of research reported in late 2023 that even the top 25% of privately held startups have an average EBITDA of minus 30%.
The Wall Street Journal, Financial Times and others are now confirming these risks. Scott Stanford, a cofounder and partner at ACME Capital, recently said that, "It's not crazy to think half the VC firms that were actively investing in the last decade will be sidelined and eventually collapse." Sara Ledterman, managing partner of 3+ Ventures, is even more pessimistic. She "estimates 3,200 funds have gone dormant over the past 14 months" while another "analysis found 8,538 VCs stopped investing in the past two years, leading to what some VCs have warned will be a "zombie reckoning in 2024."
Startup shutdowns rose at an accelerated pace in 2023. Pitchbook reports that around 3,200 startups failed in 2023 and more than 2,000 VC firms effectively halted making new investments in startups in the first nine months of 2023. Similarly, Carta reports that among users of its database, startup shutdowns rose to a record high of 264 in the first quarter of 2024 from 72 in the first quarter of 2022 .
For publicly traded unicorns, eight went bankrupt or were acquired for below valuation prices in 2023 (Quotient technology, Coupa, Pear Therapeutics, Qualtrics, Blue Apron, Signify Health, Smile Direct Club, and Lordstown Motors). Several unicorns have followed suit so far this year: 23andme; Invitae; Nanostring Technologies and Fisker). Meanwhile, almost 400 tech companies have laid off workers this year so far, according to layoffs.fyi data - including two publicly traded unicorns (Gingko bioworks and Cue health).
A growing number of limited partners have begun reneging on their commitments.
Endowments, pension funds, trusts and their peers are the limited partners (LPs) that are at the heart of the venture capital system, since they channel funds to venture capital firms. Business Insider recently reported that a growing number of limited partners have begun reneging on their commitments. LPs are legally liable for money they have promised the VCs, but few VCs want the bad press and possible domino effects from suing LPs. Better to pretend that all is for the best in this best of all possible worlds. Keep collecting fees and keep hoping that greater fools will soon appear.
The length and severity of this startup meltdown depends on how long the current AI bubble lasts. Unless companies can figure out a way to make a profit on their AI spending spree, and do so quickly, many startup investors' dreams will dissolve into skepticism, disillusionment and panic. The canaries are warning us.
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