And so the Latest Tech Wreck Continues
We’ve been here before, even if these specific circumstances have their own qualities.
Economic upheavals are more akin to droughts than meteorite strikes; they tend to be regular occurrences common across decades and reflect a cycle rather than random catastrophic events (although if we lived long enough, meteorite strikes might feel much the same!)
The backdrop is complex. After years of quantitative easing, a global pandemic and bailouts, global debt now stands at a concerning 340 percent of GDP versus the previous peak of 275 percent after World War Two. To put this into perspective, as S&P Global noted earlier this year, global debt represents “$37,500 of average debt for each person in the world versus GDP per capita of just $12,000.”
Against that backdrop, loose monetary policy and near-zero interest rates in recent years created the mother of all bubbles. It all began to unwind last year as tighter monetary policy was needed to address inflationary pressures. First hit was the tech sector, and now we have a banking crisis. Most (but not all) investors are ‘risk-off’, keenly surveying the horizon for the next trouble spot. It’s probably commercial real estate - if this hypothesis (not rocket science) is correct, it will compound the stresses in the banking system.
For the technology sector, the current correction shares many characteristics with the 2000 tech bubble, with most of the gains coming in the last 18 months, leading to classic valuation bubble profiles.
As Mark Twain once famously observed, “History doesn’t repeat itself, but it often rhymes.” So, what might we learn?
The first thing is to be patient.
It took over nine years from the previous bottom after the 1987 Crash to the top of the bubble in early 2000, but three-quarters of that gain came in the last 18 months – classic valuation bubble profile.
In a similar way, after the 2008 financial crisis, the tech market progressed steadily upward for 12 years and then saw a massive late expansion of multiples in the last 18 months – 55 percent of the gain over that 13-year period came in the last 18 months.
In that correction, the NASDAQ also gave up most of that ‘final bubble’ (80 percent) before starting to stabilise.
The second thing is that, as has happened in the aftermath of all previous crises, it’s tough for companies looking for funding.
Venture capital is in a world of pain. The deal pipeline is long, but deals are taking forever to close, and of those that get to market, only a handful are closing. Portfolio write-downs are prevalent.
Venture debt was a great option for young companies before the collapse of SVB. It’s still out there but it’s costly and covenants are getting tighter.
The equity capital markets are largely closed to IPOs, and capital remains expensive for all but the best companies.
Despite all of this, there are still some financing opportunities out there - you just need to know where to look.
Venture Capital
The current environment has led to a nuclear winter for all but the best venture funds, with few new investments being made except in breakthrough fields (see AI, below). The impact has been most keenly felt in growth stage businesses, since more ‘mature’ start-ups are easier to value and closer to an exit.
It is not only harder to raise money, but it also takes a lot longer since due diligence requirements have expanded materially. That is likely to continue.
Early-stage investing hasn’t suffered quite the same fate, probably because in this part of the market, valuation is more of an art than a science, and balance sheets don't have complicated preference stacks from prior rounds.
It now appears that many businesses were slow to respond to calls late last year to get to break-even quickly, and with cash reserves dwindling and access to capital constricted, the crunch is closing in.
Against that, research by venture firm Social Capital reveals that many of the most successful startups are born during times of breakthrough innovation and above-average interest rates.
lf anything, a lack of cheap capital sorts the wheat from the chaff, and those companies that can both operate in tighter fiscal conditions and leverage breakthrough innovation can become hugely valuable. For instance, despite the current travails around funding, 2023 looks like the breakthrough year for AI and it's likely that some of the companies emerging this year will go on to become hugely valuable.
Get ready also for the rise of zombie portfolio companies. The recapitalising of balance sheets/preference stacks (often by existing shareholders) will become a common occurrence, but it won’t be pretty or quick. When portfolio companies can't raise money from new or existing investors, M&A will become more prevalent as the only way to survive or face going broke.
Many first-time fund managers won't be able to raise money again as this vintage starts to mature, and results are crystallised. Meanwhile, the big will get bigger.
Venture debt is quite appealing to early stage companies in a market where equity is expensive, or worse, if the market for new equity is closed. Of course, with that venture debt stalwart SVB now out of the picture, venture debt will become more scarce, more costly and more of a noose around a company’s neck.
Equity Capital Markets
All but a couple of regional equity markets have been effectively closed to IPOs, and the (outrageous) SPAC bubble which existed in 2020 and 2021 has burst.
Q1 2023 global SPAC activity is at a six-year low, with proceeds down 92 percent in the past year, and 90 percent of US de-SPAC mergers from 2019 to 2023 trading below issue price.
Global IPO activity is down by 50 percent from average 2021 levels and while tech still represents the highest number of IPOs globally at 21 percent, the average transaction size is well down. Surprisingly the Asia-Pacific region has seen continuing IPO activity in recent times, albeit with relatively small transactions.
Despite all of this, because markets are forward-looking, when interest rates peak in the next few quarters, the IPO market will re-open, and there will be new opportunities to gain liquidity in the usual places if not in some new markets.
Whether for IPOs or follow-on investments, while capital is still available for good companies, there is an absolute bias to profitability and new capital is expensive for most. Companies which are already listed may seem to be well placed to raise follow-on money – but this depends on them having quality share registers. Small listed companies with lower quality registers may find being listed an uncomfortable place to be when investors are more discerning about investment quality.
M&A
Public markets tech M&A has surged in the wake of 2022’s sharp downward shift in public market valuations.
We expect to see more large, well-funded acquirers making high-quality, low-priced acquisitions of ASX and NZX-listed companies. The takeover activity seen by companies such as Pushpay, Tyro, Elmo, PayGroup, Nearmap, Proptech and Nitro is in our view the tip of the iceberg. Not a day goes by without the rumour mill in overdrive, as tech-focused PE funds run their slide rules over companies.
It’s worth noting that US corporations and private equity are prominent, with softer local currencies and share prices making USD acquisitions attractive.
Strong transaction premiums are a feature of current activity, with completed transactions boasting uplifts above 60 percent, and often closer to 100 percent, or even higher.
M&A in private markets is a little more subdued but we expect it to pick up sharply as long-suffering shareholders seek liquidity while markets are closed. Some will seek to merge the companies in their portfolios with similar businesses to accelerate their path to scale, profitability and exit.
The Wrap
The bottom line is that while there is no doubt the tech funding spigot has been turned off for now, there are still opportunities for companies to gain liquidity whether via new structures or new markets. But it’s a long, hard road.
Mergers and acquisitions are expected to surge. As always in downturns, those with strong balance sheets will win, and we will see large, well-funded acquirers making high-quality, low-priced acquisitions this year.