Over the course of the last month, we have spent a lot of time with growth and venture investors, limited partners in the private asset class and venture-backed companies at all stages. Most of the questions that we receive fall into a few primary categories which we’d like to share some thoughts on:
1. How are investors reacting to the current market environment?
The breadth of the private markets is vast, ranging from very early-stage seed investors to very late stage “pre-IPO” investors. Each investor has its own strategy, and most would disagree with being lumped into a large, generalized category, BAM Elevate included. Having said that, the broad categories break down into Crossover (funds that do both public and private by a single investment team), Growth (specifically focused on Growth stage), Venture (Series A-B) and Seed (pre-Series A). Many firms invest across multiple stages with different teams and some with the same team, so this is largely ‘one size fits many’ but certainly not all. In addition, all firms with specific closed-end funds will be sensitive to the pace of deployment given the overall market and the timing of a new fund raise, but that applies almost universally.
We’ll break down stage by stage. In the Crossover category, it is no surprise that the most active private market investors last year fell into this category, with a notably accelerated pace during the 2020-2021 “Covid Era” timeframe. We have seen the biggest pullback from new investments here for a variety of reasons but mostly due to the current market environment. First, the volatility in public markets alone has caused a shift of focus away from private markets and towards public markets for teams that straddle both. Second, the relative value of public equities vs. private investments has caused a shift in focus to public equities. There is often a lag in valuations in private markets to catch up to public markets – in both directions – and some consider the valuations in public equities to be more attractive both on an absolute basis and given their liquidity profile. Lastly, the denominator effect has impacted public market investors, especially those that invest in both public and private out of a single fund, but even those that have separated or mostly separated these activities by fund. It is no surprise that among this category, we have seen almost no activity this year, after a year in which there were daily deal announcements.
Next, the Growth funds – those with an exclusive focus on private markets – have also significantly scaled back activities. As is often the case when there is an onset of change in market conditions, the initial focus tends to shift towards the current portfolio, as was also true at the onset of the Covid pandemic in early 2020. Investors with dedicated resources, both time and capital, to shoring up existing portfolio companies end up spending less focus on sourcing new investments. In the case of new investments, investors will be highly sensitive to the valuation environment, both for new and existing investments.
When it comes to the Venture and Seed stages, there is generally less sensitivity to the valuation environment at any point in time due to the binary nature of outcomes at this stage. In addition, there is often a dual focus on both new deals as well as the financing environment for, and health of existing portfolio companies. We’ll get into more detail below on the company fundraising cycle, but there tends to be higher sensitivity in this category because investors here are typically more hands-on, and the health of their overall portfolio depends on the ability of companies to raise capital prior to proving themselves as long-term viable. At the Seed stage in particular, I’d expect the trend of lower ownership to reverse and while there may be lighter deal activity overall, the institutional Seed investor likely will not entirely sit out.
2. What is the outlook for deal activity for the remainder of the year?
This question takes two primary forms:
-
“How active will the market be?”, which can be generally categorized into pacing, and
-
“Will private valuations have a hard reset?”, which will generally take the form of how deals get done vs. if deals get done.
These are two different questions, but they’re inter-related, so let’s start with the first, pacing. The accelerated market activity of the Covid Era was largely investor driven. If you look back at the funding environment over the course of the last decade excluding the Covid Era, private company funding followed a predictable course: companies would generally raise a round of capital that would provide 18-24 months of operating runway and enable that company to achieve certain operating milestones (i.e., product launches, revenue milestones) which would unlock the next round of capital. There was not a lot of consideration given to changes in market environments, so companies were cautious on overcapitalizing and taking greater dilution early on. This activity was largely company driven. Conversely, during the Covid Era, funding activity was largely detached from company operating plans and capital needs. There are many examples of companies that raised 2, 3, 4 or more large rounds of capital, well beyond the company’s operating needs at the time and at significant valuation step-ups. This activity was largely investor driven by the desire to put more capital to work. The funding market was open for business for most companies that fit a growth profile, with the best companies exiting the Covid Era with very strong balance sheets, and in many cases operating expense budgets to match (more on that later). As a result, many private investors deployed funds quickly vs. historical averages, and raised successor funds at multiples of the size of the previous fund(s). While this is all well-known, what is less certain is where we will go from here. While the private market tends to take its cues from the public markets, our expectation is a reversion closer to the mean in the mid- to long-term for attributes specific to the private market: deal pacing, round sizing, fundraise processes and round-specific valuations. Investors that invested full funds in 2021 and have raised successors are far more likely to pace deployment in the traditional 2-3 year timeframe, capturing time diversity in their portfolio of investments. Those that have not raised new funds may seek to raise smaller funds, evolve, narrow their strategy or pause completely (for now).
Now to the second question of how vs. if deals get done, and maybe for some context given the above, let’s start with which deals are getting done. The funding market is certainly less active today than it was a year ago, and to be clear, many of the fundraising announcements that you see today are for rounds that were negotiated or closed months or a quarter ago, and in some cases last year. So which companies are out in the market raising now? Fundraising is the lifeblood of private companies, and eventually most will come back to market. Those that are actively seeking funding today are those that have to, with the vast majority of companies being counseled by their current shareholders to stay put for now. So then let’s get into the how vs. if. Deals are getting done, but how they are getting done is also a result of last year’s market as well as the strength of a company’s balance sheet. Most companies are investigating the feasibility of round extensions – that is, a re-opening of a Covid Era funding round to take in more capital, either from insiders, new investors, or both. Most companies would consider this to be a favorable outcome given the reset in the valuation environment. The second way many deals are being done is with the introduction of structure (i.e., senior and multiple liquidation preferences, “guaranteed” returns). This is now being done both by investors that have always utilized structure as part of their investment strategy, as well as formerly “clean structure” investors now offering structured deals as an alternative. Along the lines of the old Wall Street adage “you name your price; I’ll name the terms”, many companies will be sensitive to headline valuation and the dreaded ‘down round’. We have pleaded with many founders over the years to let the market set the price and focus on clean terms. Founders are most willing to accept structure in order to preserve a high headline valuation, and once structure is introduced on the cap table, an IPO is the only way to remove its impact. Structure ultimately has the largest impact on common equity holders (i.e., employees and founders), and ironically the most common pushback we experience is when the founder reminds us, we are not the ones that have to stand up at the company all-hands and explain the down-round. This is very true. So, our expectation is that deal activity will remain muted until volatility tamps down in the public markets. Of course, we have the traditional summer pause coming upon us, and for the time being the deals that do get done will fall into one of the two categories above or will be done at pricing that reflects the current market environment, whether that is a down round or not.
3. How are companies reacting?
Companies take their cues from the current market environment and counsel from their existing investors. Whether that is today’s crucible moment or the Great Financial Crisis’ RIP Good Times, investors are often vocal, and aligned, on the advice given to portfolio companies. For most companies, that advice is to make do with what you have while finding a balance between continuing to invest for growth while extending the runway as much as possible. For some companies mentioned above that are out fundraising or seeking round extensions, that isn’t possible. However, if there is a silver lining of the tremendous amount of funding activity during the Covid Era, it is that many companies have ample cash on hand and strong and mature business models. Neither was true in the Dot-com Crash nor the Great Financial Crisis.
So, the expectation is that companies that have ramped operating expense to match balance sheet strength will cut expenses. This will come in the form of layoffs, reduction of brand advertising and other areas where expense cuts will have the least impact on the core business. Other companies that have not ramped expenses may delay plans to significantly ramp burn. The message that most companies are receiving is to plan according to a 24-36 month runway. Yes, 2-3 years is a very long period, especially in technology, and this is a conservative view. However, the pressures of the inability to hire and seizing a market opportunity by outspending a competitor have largely subsided.
Companies are also spending more time considering their capital structure. This can include seeking equity extensions where available, and/or taking on debt to strengthen balance sheets. While we are proponents of the smart use of debt for companies that can service it, the debt-as-equity-replacement strategy is dangerous, and we caution companies from using it as anything other than its intended purpose.
Lastly, from a fundraising standpoint, we have always counseled our companies to think of fundraising in a “two round” context. That is, think of the current round with both this financing event as well as the next financing event in mind. This forces companies to look forward to future milestones, what a company needs to look like – scale, growth, unit economics – to achieve success at the next fundraise and what can be done now to optimize for that later success. The components of this analysis are the core business model, what the next milestones are (customers, product, scale), the funding needed to get there, as well as thoughts around how the next round investor is likely to view the company – valuation, maturity, likely growth path. While this is an imperfect exercise, it forces discipline on optimizing for the long term, instead of optimizing for the short term. While this exercise was rare in the Covid Era and the lack of long-term thinking will result in some pain, there will also be opportunity.
So, what does this all mean for BAM Elevate? Optimism that we return to a more measured market environment, both in terms of the overall valuation environment relative to historical averages and in terms of market pacing, fundraising processes, and expectations. We’ll remain selective, and as one of few active growth-stage investors, we will have opportunities that we would not have seen previously. We continue to work very closely with our portfolio companies, providing strong support and counsel. Our approach, engagement and value-add is resonating with companies, and this market environment is affording us the opportunity to tell the BAM Elevate story more broadly.
Over the course of the last month, we have spent a lot of time with growth and venture investors, limited partners in the private asset class and venture-backed companies at all stages. Most of the questions that we receive fall into a few primary categories which we’d like to share some thoughts on:
1. How are investors reacting to the current market environment?
The breadth of the private markets is vast, ranging from very early-stage seed investors to very late stage “pre-IPO” investors. Each investor has its own strategy, and most would disagree with being lumped into a large, generalized category, BAM Elevate included. Having said that, the broad categories break down into Crossover (funds that do both public and private by a single investment team), Growth (specifically focused on Growth stage), Venture (Series A-B) and Seed (pre-Series A). Many firms invest across multiple stages with different teams and some with the same team, so this is largely ‘one size fits many’ but certainly not all. In addition, all firms with specific closed-end funds will be sensitive to the pace of deployment given the overall market and the timing of a new fund raise, but that applies almost universally.
We’ll break down stage by stage. In the Crossover category, it is no surprise that the most active private market investors last year fell into this category, with a notably accelerated pace during the 2020-2021 “Covid Era” timeframe. We have seen the biggest pullback from new investments here for a variety of reasons but mostly due to the current market environment. First, the volatility in public markets alone has caused a shift of focus away from private markets and towards public markets for teams that straddle both. Second, the relative value of public equities vs. private investments has caused a shift in focus to public equities. There is often a lag in valuations in private markets to catch up to public markets – in both directions – and some consider the valuations in public equities to be more attractive both on an absolute basis and given their liquidity profile. Lastly, the denominator effect has impacted public market investors, especially those that invest in both public and private out of a single fund, but even those that have separated or mostly separated these activities by fund. It is no surprise that among this category, we have seen almost no activity this year, after a year in which there were daily deal announcements.
Next, the Growth funds – those with an exclusive focus on private markets – have also significantly scaled back activities. As is often the case when there is an onset of change in market conditions, the initial focus tends to shift towards the current portfolio, as was also true at the onset of the Covid pandemic in early 2020. Investors with dedicated resources, both time and capital, to shoring up existing portfolio companies end up spending less focus on sourcing new investments. In the case of new investments, investors will be highly sensitive to the valuation environment, both for new and existing investments.
When it comes to the Venture and Seed stages, there is generally less sensitivity to the valuation environment at any point in time due to the binary nature of outcomes at this stage. In addition, there is often a dual focus on both new deals as well as the financing environment for, and health of existing portfolio companies. We’ll get into more detail below on the company fundraising cycle, but there tends to be higher sensitivity in this category because investors here are typically more hands-on, and the health of their overall portfolio depends on the ability of companies to raise capital prior to proving themselves as long-term viable. At the Seed stage in particular, I’d expect the trend of lower ownership to reverse and while there may be lighter deal activity overall, the institutional Seed investor likely will not entirely sit out.
2. What is the outlook for deal activity for the remainder of the year?
This question takes two primary forms:
-
“How active will the market be?”, which can be generally categorized into pacing, and
-
“Will private valuations have a hard reset?”, which will generally take the form of how deals get done vs. if deals get done.
These are two different questions, but they’re inter-related, so let’s start with the first, pacing. The accelerated market activity of the Covid Era was largely investor driven. If you look back at the funding environment over the course of the last decade excluding the Covid Era, private company funding followed a predictable course: companies would generally raise a round of capital that would provide 18-24 months of operating runway and enable that company to achieve certain operating milestones (i.e., product launches, revenue milestones) which would unlock the next round of capital. There was not a lot of consideration given to changes in market environments, so companies were cautious on overcapitalizing and taking greater dilution early on. This activity was largely company driven. Conversely, during the Covid Era, funding activity was largely detached from company operating plans and capital needs. There are many examples of companies that raised 2, 3, 4 or more large rounds of capital, well beyond the company’s operating needs at the time and at significant valuation step-ups. This activity was largely investor driven by the desire to put more capital to work. The funding market was open for business for most companies that fit a growth profile, with the best companies exiting the Covid Era with very strong balance sheets, and in many cases operating expense budgets to match (more on that later). As a result, many private investors deployed funds quickly vs. historical averages, and raised successor funds at multiples of the size of the previous fund(s). While this is all well-known, what is less certain is where we will go from here. While the private market tends to take its cues from the public markets, our expectation is a reversion closer to the mean in the mid- to long-term for attributes specific to the private market: deal pacing, round sizing, fundraise processes and round-specific valuations. Investors that invested full funds in 2021 and have raised successors are far more likely to pace deployment in the traditional 2-3 year timeframe, capturing time diversity in their portfolio of investments. Those that have not raised new funds may seek to raise smaller funds, evolve, narrow their strategy or pause completely (for now).
Now to the second question of how vs. if deals get done, and maybe for some context given the above, let’s start with which deals are getting done. The funding market is certainly less active today than it was a year ago, and to be clear, many of the fundraising announcements that you see today are for rounds that were negotiated or closed months or a quarter ago, and in some cases last year. So which companies are out in the market raising now? Fundraising is the lifeblood of private companies, and eventually most will come back to market. Those that are actively seeking funding today are those that have to, with the vast majority of companies being counseled by their current shareholders to stay put for now. So then let’s get into the how vs. if. Deals are getting done, but how they are getting done is also a result of last year’s market as well as the strength of a company’s balance sheet. Most companies are investigating the feasibility of round extensions – that is, a re-opening of a Covid Era funding round to take in more capital, either from insiders, new investors, or both. Most companies would consider this to be a favorable outcome given the reset in the valuation environment. The second way many deals are being done is with the introduction of structure (i.e., senior and multiple liquidation preferences, “guaranteed” returns). This is now being done both by investors that have always utilized structure as part of their investment strategy, as well as formerly “clean structure” investors now offering structured deals as an alternative. Along the lines of the old Wall Street adage “you name your price; I’ll name the terms”, many companies will be sensitive to headline valuation and the dreaded ‘down round’. We have pleaded with many founders over the years to let the market set the price and focus on clean terms. Founders are most willing to accept structure in order to preserve a high headline valuation, and once structure is introduced on the cap table, an IPO is the only way to remove its impact. Structure ultimately has the largest impact on common equity holders (i.e., employees and founders), and ironically the most common pushback we experience is when the founder reminds us, we are not the ones that have to stand up at the company all-hands and explain the down-round. This is very true. So, our expectation is that deal activity will remain muted until volatility tamps down in the public markets. Of course, we have the traditional summer pause coming upon us, and for the time being the deals that do get done will fall into one of the two categories above or will be done at pricing that reflects the current market environment, whether that is a down round or not.
3. How are companies reacting?
Companies take their cues from the current market environment and counsel from their existing investors. Whether that is today’s crucible moment or the Great Financial Crisis’ RIP Good Times, investors are often vocal, and aligned, on the advice given to portfolio companies. For most companies, that advice is to make do with what you have while finding a balance between continuing to invest for growth while extending the runway as much as possible. For some companies mentioned above that are out fundraising or seeking round extensions, that isn’t possible. However, if there is a silver lining of the tremendous amount of funding activity during the Covid Era, it is that many companies have ample cash on hand and strong and mature business models. Neither was true in the Dot-com Crash nor the Great Financial Crisis.
So, the expectation is that companies that have ramped operating expense to match balance sheet strength will cut expenses. This will come in the form of layoffs, reduction of brand advertising and other areas where expense cuts will have the least impact on the core business. Other companies that have not ramped expenses may delay plans to significantly ramp burn. The message that most companies are receiving is to plan according to a 24-36 month runway. Yes, 2-3 years is a very long period, especially in technology, and this is a conservative view. However, the pressures of the inability to hire and seizing a market opportunity by outspending a competitor have largely subsided.
Companies are also spending more time considering their capital structure. This can include seeking equity extensions where available, and/or taking on debt to strengthen balance sheets. While we are proponents of the smart use of debt for companies that can service it, the debt-as-equity-replacement strategy is dangerous, and we caution companies from using it as anything other than its intended purpose.
Lastly, from a fundraising standpoint, we have always counseled our companies to think of fundraising in a “two round” context. That is, think of the current round with both this financing event as well as the next financing event in mind. This forces companies to look forward to future milestones, what a company needs to look like – scale, growth, unit economics – to achieve success at the next fundraise and what can be done now to optimize for that later success. The components of this analysis are the core business model, what the next milestones are (customers, product, scale), the funding needed to get there, as well as thoughts around how the next round investor is likely to view the company – valuation, maturity, likely growth path. While this is an imperfect exercise, it forces discipline on optimizing for the long term, instead of optimizing for the short term. While this exercise was rare in the Covid Era and the lack of long-term thinking will result in some pain, there will also be opportunity.
So, what does this all mean for BAM Elevate? Optimism that we return to a more measured market environment, both in terms of the overall valuation environment relative to historical averages and in terms of market pacing, fundraising processes, and expectations. We’ll remain selective, and as one of few active growth-stage investors, we will have opportunities that we would not have seen previously. We continue to work very closely with our portfolio companies, providing strong support and counsel. Our approach, engagement and value-add is resonating with companies, and this market environment is affording us the opportunity to tell the BAM Elevate story more broadly.
