The term “funding winter” has not been in our lexicon until very recently. Frankly, not many people used it until last year, when, suddenly, talk that venture capital (VC) funding was drying up began to spread.

Anecdotally, we understand that many start-ups found it hard to raise capital last year. It was indeed a bad year for funding, but was it just a one-off bad year or is this expected to persist for some time?

Venture capitalists have loads of money

The first question we need to ask is whether VCs have sufficient “dry powder” — VC lingo for capital waiting to be invested or deployed — to invest or whether they themselves have been unable to raise enough funds. The Asia-Pacific Private Equity Report 2022 by Bain & Co states that over the last decade, assets under management focused on Asia-Pacific “grew 2.4 times faster than for North America and 3.0 times faster than for Europe”, making Asia-Pacific the second-biggest private equity and VC market in the world after North America. In 2022, funds in this region reached a record level of US$650 billion.

In Malaysia, the Securities Commission Malaysia (SC), the body that administers the VC industry, reported in the SC Annual Report 2021 that total committed funds in private equity and VC rose 26.75% to RM14.83 billion in 2021, from RM11.7 billion in 2020. Of this, RM5.18 billion was for VC. This rise in funding in Malaysia as well as the region clearly indicates there is a lot of money sitting in VC bank accounts. The funding winter, therefore, is not due to a lack of funds.

Macro causes of funding winter

Speak to VCs and they will tell you they are still seeking deals. No one is shutting down their funds. Everyone is operating as normal, albeit a bit more cautiously than before. But they do have several concerns.

First is the uncertainty in the global economy due to rising interest rates and oil prices, possible recessions in the major economies and a slowdown in global trade due to the Ukraine war and global supply chains. Some of these concerns seem to be settling down as interest rate rises are reaching their peaks and central banks may even start cutting rates towards the end of the year.

The fear of recession, in Asia at least, seems unfounded and, even in the West, inflation is moderating amid slower growth, and they may yet avoid a recession. Supply chain woes are also abating with the opening up of China and global trade is starting to normalise. Even oil prices are now off their peak. The only remaining uncertainty is the Ukraine war, but there is now more talk about a peace settlement, which seemed impossible six months ago. While it is difficult to ascertain how this will go, at least the impact of the war on the rest of the world is lessening.

In Malaysia and the rest of Asia, economies are continuing to grow at a steady pace with strong growth in industries such as travel and tourism. This will help Asia return to normal growth rates and thereby avoid any recession.

With a reduction in uncertainty, some confidence is returning to VC investing. While it may still take another six to 12 months before it returns to some form of normalcy, the stage is set for recovery in VC investing, especially in Asia.

Survivability issues affect VC confidence levels

Besides the macro issues, VCs are also concerned about survivability, both of their own portfolios as well as prospective investment targets.

Over the last few years, VCs made big bets on some companies, with several receiving tens and even hundreds of millions of dollars in investments. Many of these companies have been affected by the uncertainty that has resulted in slower growth and, in some cases, higher losses. E-commerce and logistics businesses, which were big beneficiaries during the pandemic, have been particularly affected, with revenues dropping more than 50%, following the end of pandemic measures and the opening up of the traditional retail sector. To ensure they survive for a longer period of time, many of these companies had to cut costs and staff and strive for cash flow breakeven or profitability.

Some VCs have been reserving some cash to support their portfolio companies, especially the bigger investments, as they have become too big to fail. They have had to also spend more time helping these companies through these tough times.

Owing to the macro uncertainties, VCs are cautious about making new investments as they are also concerned that many of these companies may not survive the economic uncertainties. That is why 2022 was a tough year for companies. VCs would rather wait it out till 2023/24 to see which companies survive and which do not. Risk is the main criterion for VCs. If the risk is too high, then they would rather wait it out until the target company’s performance and survivability improve before they consider an investment.

Start-ups that have made it through bad times and shown strength in growth as well as business models that can generate strong gross and net margins will be favoured in 2023 and 2024 before we return to the go-go days of pushing growth at all costs (and, trust me, those days will return as they have through every downturn, from the 2000s dotcom bust to the global financial crisis of 2008 and now this current cycle).

Good news for start-ups

It is therefore not all bad news for start-ups. The important thing to know is that VCs need to invest their funds and they usually have a time frame to make investments. Most VC funds are structured as seven- or 10-year funds. This means they have to return the funds to their fund investors (known as limited partners or LPs) within this time frame.

Assuming it is a seven-year fund, as most of them are, VCs would spend the first three years investing the money, the next two managing the portfolio and the final two divesting their portfolio. Even with an extension of one or two years, they would normally use the last few years to find ways to divest and exit the investments.

This essentially means the first three years are critical. VCs need to find, evaluate and make the investments within these three years. Considering many of the VCs may have raised funds in 2020 to 2021, they have to now speed up their deal sourcing and investments to ensure they do not miss the divestment deadlines and promises they made to their LPs. This is likely to mean that 2023 and 2024 will be big years for them to make investments.

Start-ups need to prepare for this. Make sure you have a good business, a scalable product and business model and the ability to scale the business while also ensuring the model is sustainable to allow for growth without sacrificing cash flows and profits. Tough times create tough entrepreneurs, and VCs know that smart founders who have used these tough times to build strong and sustainable businesses will make great investments. Some of the best companies were born during tough times.

My advice to start-up founders is to focus on building a great business. Show VCs you have a highly investable business with solid prospects to capture customers and revenues as markets normalise in the next few years and you stand a good chance of getting an investment. VCs need to invest; they have the money and they are running out of time. This makes 2023 and 2024 very interesting years for start-up entrepreneurs.

Dr Sivapalan Vivekarajah, who has a PhD in venture capital from University of Edinburgh, Scotland, is co-founder and senior partner of ScaleUp Malaysia Accelerator (www.scaleup.my) and adjunct professor at the School of Science and Technology, Sunway University. He is the author of the book Supercharge Your Startup Valuation.