Sustainable Growth in Technology

We always advocate a sustainable and efficient growth strategy to all our portfolio companies. That’s because we have lived through several technology capital market valuation cycles as entrepreneurs and investors. This has meant that we have sometimes left some growth on the table, for the benefit of sustainability and continuity for entrepreneurs, employees, investors, and all other stakeholders in our portfolio companies. Tech is on a very long secular growth path, but investor psychology leads to valuations that at times get ahead of that path, then retreating again afterwards. It is sometimes said that the capitalist capital allocation system is flawed, but it is the best one available.

We would like to share some of our thoughts in three short articles on these topics. In this blog, we capture our observations on the market and our research on what is driving value and valuations.

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What is the Market Thinking?

In fact, the question one should ask is: What was the market thinking?

We have all learned that the real value of an asset or a company lies in its future cashflow generation. However, during the past decade, “growth-at-all-cost” has become the dominant ethos for how to successfully scale a technology business. In essence, giving up current cashflow for larger future cashflows. Even for early-to-mid stage growth companies, talking about profitability was often regarded as a lack of ambition toward gaining market share. However, as technology cycles have proven in the past, the duration of a tech company’s market position is shortening in nature and future cashflows are uncertain.

However, that sentiment is now changing. Public companies that have high growth, but no near-term prospects for profitability, have been discounted significantly, with many growth stocks losing more than 50% of their value. Investors are shifting their focus from prioritising fast growth to business fundamentals and profitability. The correction that has already been seen in public markets is gradually becoming visible in private markets as well. For this post, we have delved into what is happening in public and private markets and the European VC ecosystem.

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An overview of Public Cloud Companies

In our analysis we take a closer look at the EMCLOUD index, which tracks emerging cloud companies. This index has now retreated to below recent historical norms, even as the companies indexed are some of the most predictable tech businesses with a high degree of recurring revenues. Other subsegments of the technology sector have fared worse, some slightly better, but the direction of travel is across the board.

While current financial health in the sector remains stable, public cloud companies are now trading on revenue multiples of 9.7x and 7.5x for businesses in the top and median quartiles respectively. Investors have also begun placing a premium on companies that have a balanced mix of revenue growth, margins, and capital efficiency.

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Momentum shifts from growth to fundamentals

Large institutional investors like sovereign wealth funds, pension funds, and asset managers are getting tired of unsustainable and loss-making operations. They are now drilling down into business economics, as well as discounting high growth potential assets that have no clear near-term prospects to become profitable.

Evidence for this change in the trend can be found by examining the historical and current relationship between growth rates and valuations for companies. The above chart compares the results of a regression of annual growth rates on EV/Revenue multiples for all companies in the EMCLOUD index based on data from 31 December 2021 and a regression based on data from 1 June 2022. This is a one-factor regression model that many growth capital firms redo regularly to assess current sentiment in the growth investment market. You can see that the R2, a measure reflecting the strength of the statistical relationship, has decreased meaningfully when comparing December 2021 with June 2022. This means that growth on its own has become less useful in explaining valuations. It can also be seen that the coefficient associated with growth is noticeably smaller for the June 2022 regression, indicating that investors are attaching lower valuation multiples to each percent of incremental growth. The intercept is also smaller for the June 2022 regression, indicating a lower overall baseline of valuations in the segment.

When also incorporating company’s EBITDA margins into the regression (applying then a less used two factor regression model), one again can see the coefficient associated with growth decreasing over time. It turns out that a higher EBITDA margin was associated with a lower valuation before February ’22, as reflected by a negative coefficient, once again underling the market’s extreme appetite for growth previously. This prioritization of growth has pushed overall growth investments beyond its natural and sustainable levels.

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Lately, coefficients associated with EBITDA margins have once again become positive. This reflects that the market has moved back into the direction of prioritising profitability for growth companies.

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Private market: Substantial dry powder and non-traditional investor involvement in VC and growth rounds

Following record levels of private capital raised the last couple of years, global private capital dry powder has grown at a +15% CAGR from 2016 to 2021. Venture Capital and Growth Equity are among the fastest-growing asset classes and dry powder in those funds were up c. 91% and 66% in 2021 from their 5-year average, respectively.

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Financial institutions including PE firms, hedge funds, pension funds, sovereign wealth funds, investment banks, and corporate VC arms, collectively referred to here as non-traditional VC and growth investors, have increased their presence in the VC ecosystem in the past five years. VC deal value with involvement from non-traditional investors accounted for more than 78% of total deal value in European VC over 2021, up from c. 57% in 2012.

The influx of non-traditional capital in the European VC landscape has contributed significantly to increased competition between investors, larger funding rounds, and high valuations. As a result of the turbulent markets, rising interest rates and a changing economic outlook in their core markets, their investment activity is likely to slow down.

In general, valuations and deal sizes where non-traditional investors are involved are higher at every stage than those led by focused VC and growth funds without non-traditional participation. Non-traditional investors softening their VC exposure is likely to have an important impact on valuations for new rounds in the future. In the graph below, you can see the impact that non-traditional investor participation has had on Early stage VC rounds in the US, where rounds that were led by focused VC and growth firms were 31% lower than those with participation of non-traditional investors.

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