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Talk to UsJuly 13, 2022 | 6 Minute Read
Darren CohenGlobal Co-Head of Growth Equity Darren Cohen |
Juliana HadasVice President for Alternatives Capital Markets & Strategy Juliana Hadas |
The COVID-19 pandemic pulled forward demand for technology, accelerating both the trajectories of and investor interest in technology-enabled growth companies. This led to a massive valuation re-rating, especially among the fastest-growing companies. From a nadir in Q1 2020 to November 2021, publicly listed hyper-growth1 software companies, for instance, saw multiple expansion of over 3 times, from 10.7x to 33.7x.
But in November 2021, investor sentiment turned dramatically, a culmination of concerns over macroeconomic headwinds and the prospect of rising interest rates. Public growth equities have since given back gains of the prior 18-24 months, the Nasdaq composite is down 31% since its November highs, and the Russell 2000 Growth Index is down 37% as of June2. However, headline figures disguise significant dispersion across individual names and sectors. Just like in the prior regime, changing investor sentiment has had its most profound impact on the fastest-growing companies. Hyper-growth software companies have seen their valuations decline by two-thirds from their November highs to the end of June 2022. They are trading at an average valuation of 11.6x next-twelve-month revenues – at the lower end of the range seen in 2015-2020. Companies with more moderate growth, on the other hand, experienced valuation re-ratings on a significantly smaller scale, both upwards and, subsequently, downwards.
Source: Guggenheim Securities; Company filings and FactSet as of June 30, 2022.
Note: Growth buckets defined based on CY21 revenue growth rate. Hyper Growth Software (>40%) includes ASAN, BIGC, BILL, BRZE,CFLT, CRWD, DARK, DCBO, DDOG, DOCU, ESTC, FIVN, FRSH, GTLB, HCP, HUBS, IOT, KNBE, LAW, MDB, MNDY, NET, OKTA, PATH, PLTR, S, SHOP, SMAR, SNOW, SPT, TTD, TWLO, U, USER, XM, ZI, ZM, ZS. High Growth Soft-ware (20% –40%) includes ADBE, AI, ALRM, AMZN, ANET, API, APPN, AVLR, BL, BLZE, BSY, BTRS, CDAY, CNSWF, COUP, CRM, CXM, DCT, DOCN, DOMO, DSGX, DT, EVBG, FORG, FROG, FSLY, FTNT, INST, INTU, JAMF, KLTR, LPSN, LRN, MNDT, NCNO, NOW, PANW, PAYC, PCOR, PCTY, PD, PING, PLAN, PRGS, PSTG, QTWO, RNG, RPD, SAIL, SPSC, SQSP, SUMO, TEAM, TENB, TWOU, VEEV, VRNS, WIX, WK, XRO, ZEN. Moderate Growth Software (10% –20%) includes ADSK, ALTR, ANSS, APPF, AVGO, AZPN, BASE, BOX, CDNS, DBX, DELL, ECOM, EGAN, ETWO, EVCM, GOOGL, INTA, KXSCF, MANH, MIME, MODN, MSFT, MSP, NABL, NEWR, NICE, NTNX, PEGA, PTC, QLYS, RDWR, SNPS, SPLK, SUSE,TYL, VERX, WDAY, YEXT, ZUO. Mature Growth Software (<10%) includes AKAM, ALMFF, AVV, AYX, BLKB, BNFT, CHKP, CSCO, CTXS, CVLT, CYBR, DSY, FFIV, GWRE, HPE, IBM, INFA, MCRO, NLOK, NTAP, NTCT, ORCL, OSPN, OTEX, PRO, SAP, SCWX, SGE, SWI, TDC, UPLD, VMW, VRNT, VRSN.
Some of the public market dynamics have begun to impact private market strategies as well. Q4 2021 performance was flat for the median venture and growth equity manager.3 However, the full impact of changing sentiment on growth equity and venture capital-backed companies will likely take several quarters to be determined, due to the lagging and smoothing inherent in private market valuations and reporting.
In the meantime, a number of metrics offer clues to evolving investor sentiment in private markets. In late-stage venture capital, the median deal size declined in Q1 2022. Deal counts and median valuations continued to trend up, but these figures include deals agreed to in Q4 2021 and announced in 2022. In growth equity, both the deal count and the average deal size declined in Q1 (-18% and -14%, respectively) – although these figures still represent some of the highest on record4. After peaking in 2021, private market funding, average deal sizes, and valuations are set to decline.
As is the case in public markets, however, headline figures disguise dispersion underneath. Industry-wide statistics have been driven by the largest deals – so much so that the average reported late-stage venture deal size was in line with the top-quartile deal, while the average reported valuation has exceeded the top quartile figure. And it’s the largest deals that have seen the largest impact in Q1 2022 – while the median late-stage VC valuation increased in Q1, the largest deals saw lower valuation5.
Source: Pitchbook, NVCA Venture Monitor. As of March 31, 2022.
Source: Pitchbook, NVCA Venture Monitor. As of March 31, 2022.
Source: Pitchbook/Geography: U.S. As of December 31, 2021.
Also in line with public market dynamics, 2021 serves as a particularly challenging comparison, having brought significant deviation from long-term trends in venture capital and growth equity markets. Deal activity, deal sizes, valuations, valuation step-ups, and number of mega-deals all grew sharply last year.
Some of this deviation reflected public market valuation dynamics. Another important factor was the influence of non-traditional investors – corporate venture arms, crossover investors, buyout investors expanding into the venture and growth equity space, and others. Non-traditional investors participated in 78% of total U.S. venture capital deal value in 2021 and were especially active in the late-stage market.
Ironically, the large amount of capital raised in 2021 may have near-term mitigating implications for private equity marks. General Partners are typically less likely to change marks on deals less than a year old, so to the extent that a meaningful proportion of marks is based on transactions completed within the past year, markdowns may be shallower than would have been the case had portfolios been older, on average. Robust fundraising may also mean that down-valuation rounds remain limited in the near term. Many companies are now well capitalized; some have sufficient runway to fund operations for as long as several years without needing to return to capital markets, especially if that means accepting a down round. Other companies may avoid the appearance of down rounds by structuring terms with greater protections for new investors (e.g., greater liquidation preferences, ratchet provisions, convertible structures) while nominally maintaining a flat valuation. Structured equity transactions are likely to increase significantly in volume and capital committed, as management teams try to avoid the negative optics of a down round and the related negative implications for employee morale, retention, and recruiting. In the battle for talent, those companies that did not optimize for maximizing valuation at the top of the cycle should benefit, as they continue to fund in-line with or at a premium to their last round.
However, a prolonged period of macroeconomic challenges and uncertainty would mean that an adjustment is merely postponed, rather than avoided. As such, investors should look beyond the upcoming quarters and evaluate what these dynamics mean for their portfolios in the long run.
Source: Pitchbook, NVCA Venture Monitor. As of March 31, 2022.
Source: Pitchbook/Geography; U.S. As of December 31, 2021.
With the extremes of 2021 in the rear view mirror, today’s investments are being made at valuations that appear more reasonable, relative to both historical levels and companies’ underlying fundamentals. Many growth equity-stage companies have sound business models with compelling unit economics, in our view – and are scaling quickly and efficiently. The broader theme of digital transformation of the economy and society should have multiple more years to play out. However, given the multiple macroeconomic headwinds and great uncertainty in the near- to medium-term, we expect dispersion to increase across company, sector, and performance going forward.
In certain sectors demand may prove more resilient than in others. For instance, software has become so deeply embedded in consumers’ lives and companies’ operations that customer retention should hold up better than in past recessions. Demand from new clients is generally more elastic (with an attendant impact on revenue growth), but certain areas (such as cybersecurity, supply chain solutions, and workflow automation) are seeing structurally-driven demand that may have less cyclical sensitivity. The end customer matters too. Companies catering to large, established companies are better positioned to retain their customers and revenues through a prolonged downturn than are companies catering primarily to smaller, emerging companies that may themselves be less resilient.
Operational and financial discipline, including cash management, should also become an increasingly important differentiator. The funding market will likely be more challenging going forward, especially as some of the players that drove the high velocity of 2021 (e.g., crossover funds) have pulled back. As a result, we believe companies without scalable, sustainable business models and sufficient cash to finance operations through a downturn may fail more often. Stronger companies, on the other hand, should do well and grow into their 2021 valuations over time. (For instance, a company funded at 20x revenues experiencing 60% annual revenue growth would have an implied valuation of 12.5x revenues one year hence). Hyper growth companies remain actively pursued and may continue to raise capital at healthy premiums.
Fund performance dispersion will be a function of both differences in the outcomes of underlying portfolio companies and of the timing and discipline of capital deployment. In aggregate, funds deploying the majority of their capital in more disciplined environments may fare better than those that deploy significant capital in more exuberant markets. We believe Funds that maintain valuation discipline through exuberant markets has the potential to outperform
Examining the health of underlying portfolio companies, the consistency of focus and discipline of investment strategy of GPs, and the pace of capital deployment are all important as asset owners assess the state of their venture and growth equity portfolios and plan for the future.
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Beyond the Headline: Examining Recent Dispersion in Growth Equity
How have investments in technology transformed the private equity landscape in recent years? Darren Cohen and Luke Flemmer share their views in a new report in Private Equity International (PEI).
Read MorePrior to the COVID-19 global pandemic, broad trends were pushing forward growth investing themes across four specific sectors – healthcare, financial technology, consumer and enterprise technology.
The pandemic has further propelled these themes, pulling forward technology adoption through the acceleration of e-commerce penetration, the embracing of virtual environments and remote interactions, and the increased value proposition of workplace automation and cloud environments.
Read MoreCommitted to providing you with the insights you need to build your practice.
Sources:
1Defined as companies with annual revenue growth >40%
2GS Marquee, as of the close on 5/31/2022.
3Cambridge Associates, as of 5/19/2022.
4Pitchbook, as of 3/31/2022. Deal counts in late-stage venture include both recorded deals and estimated deals, based on historical patterns of deals reported with a lag beyond the data release period.
5PitchBook, as of 3/31/2022
6PitchBook, as of 3/31/2022
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