Dear readers,
I hope you have had an excellent start to the year's second half. Although I am a profound optimist regarding Tech, as mentioned in last month's edition of this newsletter, the current environment is highly challenging across the spectrum of the Private Markets, and high-growth and disruptive assets are not immune to this.
Macroeconomic indicators point to a high probability of a recession in the next 18 months, contributing to the ongoing uncertainty we are facing in the Private Markets. Also, the platform shift brought by GenAI takes on greater significance each day, and the era in which it remained a field solely invested by VCs (and this was just a couple of months ago) is gone. The magnitude of start-up and incumbent revenues in the area and the extension of use cases have reinforced, if need be, our conviction on the magnitude of the opportunity.
GenAI is having a massive impact across all asset classes, and this is more an opportunity than a problem, but it is causing seismic shifts and changing how investors should read companies. And if this is true for software businesses, it goes well beyond that.
So, why are we worried? And what is to be done?
First, let's look at what is happening at the Private Equity buyout level. Private equity firms are facing a double whammy.
First, many of their existing software lines appear to have unsustainable debt ratios in today's environment. In the bygone area of affordable debt, some software LBOs were financed with loans based on ARR from software subscriptions, implying leverage sometimes exceeding ten times EBITDA (which is very high!). But, as growth has slowed and become more challenging, and with interest rates remaining high, many of these loans still need to be revised. Gaining a clear understanding of these companies' revenue and cost drivers and resolving margin leakage issues is critical in the perspective of future refinancings for these companies.
Second, PE firms are now seeking to exit many of their investments as the exit window reopens, but the spread in valuations is high between high-quality assets – those that command strong quality of Revenue, Growth, and Margins – and tier-2 ones. Preparing their assets for sale will be critical to ensure optimal valuation. I explore in our first article how I find growth to be the crucial factor behind successful exits and how to build an adequate framework for evaluating its components correctly.
Then, at the Venture Capital level. Though Q3 figures for US VC activity are not yet out, it is clear that VC activity continued to decline over Q3, except for artificial intelligence and machine learning, which shows strong resilience, largely due to the GenAI wave. This results from valuations perceived to be still too high – and not in minor proportions – and from a sluggish exit market. Though the recent introductions of Arm, Klaviyo, and Instacart have given reasons for cautious optimism (that has yet to be confirmed), a recent Pitchbook study reveals that 77 US start-ups are waiting to go public and that $800 billion was trapped in the VC ecosystem as of the end of 2022. Thousands of start-ups, representing an essential part of the EU and the US economies, are struggling to raise and are at risk of extinction. For founders, it is critical to establish a clear road to profitable growth, as this is the only condition for taking your company to the correct next step, be it venture funding, M&A (incl. through PE), or IPO for those candidates that meet the increased requirements.
While the horizon for new investments is uncertain (but hopefully brightening), today's focus should be at portfolio level to allow high-growth companies to write their next chapter of growth with optimal conditions. This latter will certainly imply some kind of positive GenAI transformation but securing financing will be critical for PE and VC-backed assets first.