The Outsourced Tech Economist: The slippery slope involved in ‘valuation hunting’ (3/4)

John is a member of RBCx’s banking team, where he predominantly supports early-stage clients across capital fundraising and strategic growth. In addition to this role, John works alongside RBCx’s capital team on both direct, indirect (fund-of-funds), and strategic investment opportunities.

Introduction

There is a fascinating phenomenon in venture capital whereby cyclical collapses are built into its structure – meaning you have funds with 10-year life cycles who are more likely than not to experience a downturn during that time frame. As we have seen through 2022, when that is triggered, it completely disrupts capital allocation, valuation methodology, and market pricing. This cyclical nature is not evenly distributed with ups-and-downs, but rather, consists of a gradual build over a long period of time followed by a sharp and abrupt decline. This gradual build is known as risk-on – where investors experience macro tailwinds, invest LP capital freely, and move further along their investing risk curve. The risk-off period is an abrupt shock to the market, which occurs during an economic downturn, as investors swing all the way back in the opposite direction and see mass value destruction across public portfolios, initially.

Our venture ecosystem’s own risk-on period happened between 2009 and 2022, where rates remained near-zero, inflation was predictable, and the asset class earned greater institutional allocations (from pension funds, sovereign wealth funds, endowments, etc.). The risk-off period was triggered at the start of 2022, driven by our current macroeconomic environment. As the black-swan bull of the past two years was the concluding chapter to our peak risk-on period, it was also the point where VCs were furthest along their risk curves:

• Seed rounds were normalized at $10-20M vs. the traditional $1-2M
• Series A rounds were getting completed at pre-revenue and pre-product-market-fit
• Private and public software valuations were getting recorded at over 200x and 50x annual run-rate (ARR), respectively
• Infant businesses with minimal use cases, and big aspirations, got funnelled with capital (think Web3, NFTs, and alternative coins)
• Investment priorities shifted to speed and valuation over diligence and fundamentals, to get deals done

Now, with consecutive quarters of negative or declining GDP growth across both Canada and the U.S., companies that took advantage of this market cycle and received seismic valuations over the past two years are in a difficult position. They have been hit the hardest from their valuation peak, have been forced to abruptly cut costs, and now have a severe uphill battle to climb into what seems like a daunting valuation. Furthermore, the period between 2009 and 2022 has been the longest time between any two major downturns on record[1] – meaning the peak of this risk-on period for investors was the furthest they have ever been on their risk curve.

In thinking through the main macroeconomic and market drivers that took us from a decade long risk-on run, to an abrupt period of risk-off for public and private technology valuations, a few factors come to surface:

• Rising interest rates damaging valuation entry and exit multiples
• Crossover investors distorting valuation integrity and abruptly leaving
• The outbreak of large cap funds all hunting for large cap returns
• An overarching structural dis-incentive that exists for down-rounds across private equities

Macroeconomic factors impacting on valuation

Interest rates, inflation, and outlook

In February 2021, the median public software EV (enterprise value) / NTM (next twelve months) valuation multiple was 17.0x, while for high-growth companies (i.e. those growing top-line revenue above 30% YoY), it was 28.1x. As of October 2022, those two valuation multiples are now trading at 5.7x and 8.1x respectively, meaning the terminal exit valuation for software companies has dropped roughly 70% across the board (see below). Rising interest rates have played a lead role in this massive shift.

As the iron law of investing and valuation setting, a 1% increase in interest rates generally leads to a 15-20% decrease in valuation[2]. As we have managed to go from a comfortable near-zero interest rate environment to one now at 3.75% in under a year, tech companies as an asset class have been hit the hardest. Why? As discussed earlier in the series, tech companies have historically been cash-burning enterprises who primarily prioritized top-line revenue growth at the sacrifice of bottom-line profitability. Knowing this and given the exponential nature of discount rates used in typical discounted cash flow analysis, cash flows generated in the outer years are highly vulnerable to rate fluctuations and have a greater overall valuation impact (especially for those that are pre-profit). $1 today is worth a lot more than $1 promised eight years from now – especially as discount rates rise.

The other key macro factor to consider in determining the market outlook is expectations about inflation. With a 40-year record inflation print in June and at the risk of putting our economy in a recession, central banks have been utilizing interest rate hikes to suppress consumer demand – making mortgages, car loans, personal credit, and overall living costs more expensive. With a Fed destined to tame inflation, rate hikes will continue to be utilized, and as a result, continue to damage public technology valuations which will have a downstream ripple-effect on private equities all together.

Crossover investors – bull in a china shop

During the past 10 years, public and private technology investors managed a universally aligned and predictable process for setting valuations – driven from stable macroeconomic factors, extensive comparable and multiples analysis, and an overall understanding for what an investment-ready company looked like across every stage of the venture ecosystem. During the black-swan bull, as crossover investors brought their troves of capital over to the venture ecosystem – with the goal of arbitraging the late-stage private to public value spread – valuation predictability got blown up.

Following the initial March 2020 market downturn, public tech stocks struck lighting, driven off a few factors: the Federal Reserve/Bank of Canada abruptly slashing rates to near-zero, the government’s unprecedented quantitative easing campaign, investors pouring capital into growth-assets in search for yield, and technology being the asset class everyone turned to establish ‘the new normal’. As that happened, public tech companies were funnelled with new investor and retail capital, accelerated strong top-line metrics (revenue growth, customer count, etc.) and were granted with valuations that were 10x the previous 5-year mean. This glorified, artificial valuation distortion led many late-stage private tech companies to get tunnel vision on ‘going public’ – and with incentives aligned across companies, investors, and bankers – reduced all public barriers to entry.

With the inherent time-lag that exists for public valuations to hit private markets, sophisticated hedge fund (crossover) investors noticed that the spread between late-stage private and public became a lucrative market opportunity worth pursuing. More acutely, their thesis was one around an index strategy – whereby if they could invest their capital at speed and scale, across the most prominent IPO-destined technology companies, then their portfolio would capture sizable gains from the spread. In the spirit of playing to your strengths, crossover investors had two that they doubled down on through the past two years: the sheer amount of capital at their disposal and their ability to fundraise more of it.

As crossover investors infiltrated the late-stage (and afterwards early-stage) private market, they came in like a bull in a china shop. In under a year, they managed to deploy a record amount of capital, across a record number of companies, at record pace – to a point where in Q4 of 2021, Tiger Global, a leading crossover and hedge fund investor, averaged over 1 completed deal a day[3]. As venture investors noticed some of the most sophisticated investors enter their arena and deploy large sums of capital on huge valuations – and see it initially paying off – confirmation bias set in. Venture investors began to break their own records across both capital deployment and fundraising, and the entire private market valuation methodology became pegged to one of an index strategy – based on fast capital deployment on huge valuations. A previous clean and universally understood private valuation methodology now became predicated on “if I buy for x, someone will buy for x+y” and that ripple-effect made its way through the entire spectrum of venture investing.

It soon became clear to the market that these valuations were propped up by a historic macro environment – and when inflation soared, geopolitical conflicts rose, supply-chains broke, and purchasing power deteriorated – they all got exposed. Public valuations reverted to under their previous 5-year median, IPO markets completely froze, and a sense of uncertainty entered the private markets. Investors who poured money into private companies at historic valuations saw mass value destruction across all their investments, at every stage, and for the big crossover investors that initiated this distortion – they reported mass losses[4] and retrenched on capital deployment entirely[5].

With companies across the entire spectrum being impacted by this valuation sobering, they are all faced with differing underlying issues. For late stage companies, specifically those who raised at the 2021 valuation peak, they have been forced to urgently cut costs to buy time and shift their P&L to one based on profitability and free cash flow – so that they can control their own destiny when it comes to financing the business and not needing to rely on expensive and highly-dilutive external capital. For early stage companies, where investors deployed capital furthest along their risk-curve, they now must show fundamental progress in the business to get further capital – across product, technology, commercialization, and scale.

Large paper mark-ups used to justify new large cap funds

With a liquid public market landscape and an abnormally strong macroeconomic cycle over the past few years, both general and limited partners further contributed to private tech by establishing a record number of large cap funds in 2021 – those above $250M. Specifically, and in the U.S. alone, 2021 recorded 78, 45, and 22 venture funds launched between $250 – $500M, $500M – $1B, and +$1B[6], a 100%, 137%, and 120% increase from 2019, across each tier. When aggregating the total venture dollars raised across those tiers, 2019 recorded $45B of large cap fund capital raised, whereas 2021 recorded $102B – an increase of almost 130%[6].

With a historic large cap fund explosion in 2021, two primary second-order effects impact our private capital ecosystem: i) with more capital committed, the velocity of capital deployed must increase, and ii) with larger funds needing to return more capital, GPs are incentivized to push higher paper valuations as a means of justifying subsequent fundraising and LP return expectations.

To overemphasize the former, let’s take Softbank’s Vision Fund II, raised in 2019 at $100B USD[7]. Structured as a ten-year fund with a typical five-year investment period, that is $20B invested annually, over $1.6B invested monthly, and over $400M invested weekly. With such a demanding deployment cycle, the quality of diligence by necessity is sacrificed and the market becomes both frothy and unfortunately, highly speculative. Comparing that pace to 2022, it is quite the opposite from the single investment Softbank Vision Fund II made in August and September respectively[8].

The more critical second-order consequence to an increase in large cap funds is due to the inherent nature of how venture capital is managed, with paper markups and total value to paid-in-capital (TVPI) being the lifeblood of the industry. Regardless of the fund size, all GPs regularly update their fund’s worth by using TVPI to show the aggregate valuation sum of each of their fund investments. Theoretically, this is used as a barometer to assess a GP’s investing ability and for LP’s to manage their own private portfolio values and future return expectations. For GPs to have a chance of raising their next fund