Inflation has hurt public companies, but even private tech firms will feel the pain
Public market companies – particularly those in the tech sector – have felt the impact of soaring inflation, as central banks continue to pump interest rates higher. The tech-heavy Nasdaq is down 30 per cent this year and private market companies will inevitably catch up.
A good benchmark to follow is often the valuations of venture or buyout backed companies. According to Pitchbook, venture backed IPOs are down 52 per cent while buyout backed IPOs are down by 32 per cent – this is a steeper fall even than the S&P 500 since the beginning of the year. It’s not a reassuring picture.
When companies gain most of their value from revenues and earnings forecasted far into the future, their valuations are highly sensitive to increases in discount rates and changes in implied growth rates. Downward revisions, then, are a certainty.
Over the past two years, there has been a huge surge in valuations on the back of a bull market, driven by an injection of pandemic-era state subsidies. Global venture investment reached an all-time high of $634bn last year, so we have a long way to fall.
So far, down rounds have been few and far between: in the first quarter of 2022 only 5% of completed rounds have come in at a lower valuation than when companies last raised capital. However, we’re starting to see signs of more down rounds to come.
Klarna, which became Europe’s most valued startup last March, laid off 10 per cent of its staff and is now raising a down round at a third of its previous valuation.
SumUp recently raised €590m on an €8bn valuation last week, less than half of the valuation that was expected according to reports in February this year.
Inflation is also likely to lead to some contraction in fundraising. As capital becomes more expensive, investors will be more picky and take longer over due diligence. When portfolio companies’ valuations finally adjust, some limited partners might find themselves overallocated to alternative assets and thus in need to cut down their exposure to private funds.
Distributions from funds will also likely slow down, limiting what capital investors have available for new commitments. Fund managers will be tempted to hold onto portfolio companies for longer, and if exits through M&A or IPOs are necessary, they will come at much lower valuations.
According to Bain Consulting, about 50 per cent of the median value creation by fund managers over the last decade came from multiple expansion. Such expansion was triggered by low interest rates that increased asset multiples. That has now stopped.
Buyout funds should be less sensitive to rising discount rates than venture capital portfolios. But most buyout transactions are still financed with a floating-rate debt, meaning firms will need to cover increasing interest payments while earnings are under pressure.
As interest rates rise, defaults could accelerate. And unlike in the global financial crisis, when commercial banks were reluctant to intervene, private debt and other institutional funds are more likely to enforce their debt contracts.
Meanwhile, buyout fund managers have been increasingly finding their way into tech deals before they reached public markets.
The likes of KKR (Zwift), Blackstone (recently backed SumUp) and Tiger Global (MoonPay and Checkout.com) have invested heavily in some of the fastest-growing tech companies and have also raised dedicated venture capital funds.
Many still doubt the ability of private equity houses to grow businesses. But specialist knowledge needed was brought in via whole teams of tech investors. For example KKR’s tech growth fund team has been packed with professionals from Salesforce Ventures or Silver Lake.
As a result, private equity’s role in the midst of this market adjustment could turn out to be crucial. The commitment (and capital) of venture and buyout fund managers could just take the edge off the violent adjustment experienced by stocks in the public markets.