“Technology is in everything that we touch, whether that’s food, medicine or commercially. It’s penetrating a lot of these areas to help solve some really big real-world problems, and I think that means it’s here to stay,” said Joshua Beers, head of private equity at independent investment consulting firm NEPC, when prompted to give an outlook on private technology assets for 2023.
Despite its prevalence in so many sectors, 2022 was not kind to technology investors. According to Goldman Sachs’ December special issue regarding global macro research, the Goldman Sachs Non-Profitable Tech Index (a measure of public equities) lost more than 50% through 2022.
The discounted-cash-flow model and its emphasis as a fundamental valuation tool is often to blame for the collapse of risk assets’ prices, from a theoretical standpoint. The DCF model uses expected future cash flows to evaluate a company against the risk-free rate of return.
Higher interest rates diminish the future value of cash flows created by an enterprise when compared to the discount rate, an effect which takes into account the time value of money and that money is worth more now, at present, than it will be in the future. Thus, by this model, the present value of companies automatically falls when applying a higher discount rate.
Because the tech sector often offers investors unprofitable enterprises pledging future cash flows, it has been punished.
Market participants in private markets have already seen valuations falter, and private technology assets are not immune to the valuation crunch seen in the technology sector in public markets. “I think we’re going to see [valuations depreciating] more holistically [in 2023],” Beers says.
So-called ‘unicorn’ companies, or private companies with valuations greater than $1 billion, fell 48.3% last year to 308 at the end of November 2022, compared to 596 at the end of 2021, according to Pitchbook data. “When you think about simple investment theory—buy low and sell high—we think that it’s starting to set up for an environment where that could happen,” Beers offers, noting that the drop in valuations could create buying opportunities.
Moreover, private assets enjoy the pliability of not being regularly marked to market, alleviating some of the paper losses experienced in public markets.
“What’s benefited private investors, in particular, are the growth rates within private portfolios. [For many investors, they are] significantly higher than the growth rate in public markets,” says Miguel Luiña, managing director of fund investments at Hamilton Lane. “As multiples come down, that growth rate can offset those multiple declines, so if you have a 50% reduction in that multiple, but the company is growing 50% year over year, that’s going to help quite a bit, because you’re growing into that valuation.”
Better yet than any accounting procedures or growth rates is the way the tech sector is set up entering 2023. It is almost a natural law of markets that some of the worst performing sectors the prior year will rebound to be some of the best performing sectors the following year. In 2020, of the 11 sectors in the S&P 500, energy performed the worst, falling 33.7%, and real estate second worst, falling 2.2%, according to Statista. In 2021, energy and real estate were the two highest performing S&P 500 sectors.
Additionally, information technology, as a sector in the S&P 500, has only had two negative yielding years since 2010: 2022, when the sector fell 29.6%, and 2018, when the sector fell 0.3%, according to Yardeni Research.
“The long-term growth dynamics of tech-enabled businesses [haven’t] changed because the stock market is up or down; we look at it over a much longer-term holding period,” says Jeffrey Stevenson, the managing partner in VSS, a structured capital investor that invests in healthcare, education and business services technology companies in the lower middle market. “Now is actually an interesting time to be investing in these kinds of businesses.”
But just because an opportunity exists for buyers, does not mean sellers will be happy to close deals at lower evaluations. Stevenson indicates that 2023 will be a markedly tough year for private equity exits. He suggests that buyers and investment committees are being much more cautious and conservative in valuing businesses, noting that deal sale processes are being deferred or cancelled.
Valuations, having fallen in 2022, may provide headwinds for exits for the foreseeable future, though Stevenson sees the lack of exit activity and lack of appetite for lofty multiples as good for private credit strategies.
“The typical path for an exit of a technology company is an IPO,” Beers says. “We’ve come off a period in which IPOs have been fairly robust. Now that window is essentially closed, and I suspect it will be closed for some time.”
While Beers attributes the lack of activity in the IPO market to valuation concerns, Luiña says “not going public is more of a choice than it is the market forces upon them. In the late [1990s], venture companies were funded typically through Series A, Series B and Series C rounds. There was very little private growth equity capital available, so companies really needed to tap the public markets to continue their growth trajectory. A lot of the value creation and a lot of the growth in those companies happened within the public markets.”
Beers verifies that companies are not limited to simply going public to access financing options or exits, as was the case decades ago. “There’s been a growing trend of [general partner]-led secondaries-type transactions in the form of continuation funds,” he says. “Activity in the venture world will start to pick up, providing liquidity to [limited partners] and some longer funds.”
Higher interest rates produce more outcomes than just lower valuations and tighter liquidity conditions. Furthermore, not all outcomes of higher interest rates are negative: Some outcomes create positive net externalities for the venture space and private tech assets.
“I think there will be less innovation, at least in terms of bad ideas getting financed,” quips Stevenson on the long-term effect of rising interest rates’ impact on innovation in the technology sector. “The cream always rises to the top, and the deals that never should have been financed in the first place will probably not get financed. Innovation will continue because it makes sense, and the demand [for innovative technology solutions] will always be there.”
Luiña agrees that tighter economic conditions can “have a very positive trend on venture performance,” citing less competition among investors to get into new deals; a stronger focus on proving a business model earlier in a company’s existence; reaching more milestones ahead of Series A financing rounds; and, “theoretically, investors allocating less to companies that ultimately fail, limiting the write-off ratio.”
Moreover, higher interest rates do make private credit opportunities more attractive, because a higher yield is now attached to the product.
“In private credit, there will be fewer deals, with leverage multiples lower and interest rates higher. Deals will end up having less risk, but with a better return profile,” says Stevenson. “Private credit that’s got an equity twist to it has two advantages: One is that you generate above average current income. … Secondly, you can participate in the equity upside. In general, you can generate consistently higher rates of return [from structured capital].”
Luiña favors venture equity as an approach to invest in the asset class.
“I think there’s an attractive market within venture. The biggest driver of venture returns is the underlying success of the company’s operating performance, and less so the market environment that you have,” he says. “Taking a look at some of the recent tech companies that have gone public and reached $25 billion, $50 billion plus market caps, even if you slash that in half, an early-stage investor that came into these companies at less than $1 billion dollar valuation, or less than $100 million, they’re still going to do really well, even in a tighter environment.”
Beers cites health-care technology as the most exciting investment sector in the private technology asset class, a class he believes vital to solving problems of the future.
“(Technology) is what is going to change the world, at the end of the day,” Beers says. “So if we think about climate change, or other factors that we’re dealing with—to bridge those gaps, technology will have to kind of step in and play an important role.”
Tags: Goldman Sachs Non-Profitable Tech Index, Hamilton Lane, Jeffrey Stevenson, Joshua Beers, Miguel Luiña, NEPC, private assets, Private Debt, Private Equity, Special Coverage: Technology, Technology, VSS, Yardeni Research