But tension is not necessarily a bad thing and can create clarity and actually be a positive driver for investors, their portfolio companies, and the companies they may be looking to back. Multiple layers of tension involve analysing and balancing competing demands. And we believe companies that effectively manage these competing demands tend to have better decision making and more creativity, which leads to innovative solutions. In 2023, some of these tensions are brought to the fore.
For investors, the tension about when to invest and in what asset class remains paramount. To stay on the sidelines would ensure no loss of capital but it also means investors miss out on opportunities. To put money to work may feel risky, but this is the business that investors are in – to manage the risk and reward profile.
To take the big picture, investors who were out of the market post-GFC missed out on great opportunities and fund vintages that actually outperformed. Most recently, America’s largest pension plan, CalPERS attributed its underperformance in the last decade to halting its private equity program between 2009 to 2018 with the estimated impact between US$11 billion to US$18 billion.
So, while it is tempting in this environment to do nothing, the tension of missing out drives the need to put capital to work but sensibly and with downside protection.
Private capital or public markets?
In recent years, there has been a flood of capital into the private markets, enabling companies to “stay private for longer”. This has shifted the discussion to companies potentially staying private forever on the assumption that the private market exists to fund these companies in perpetuity.
However, the tension here is that unless a business is profitable, it is more likely than not that there are third-party capital investors who not only require a return on their capital but also a liquidity event, often within a set time horizon.
So, a clear distinction is required to be made between “patient” and “perpetual” capital.
Recently, IPOs have received negative press due to a number of factors:
- perceived value destruction upon listing from poor aftermarket performance, which is partly attributed to broader market volatility, and in some cases, listing too early in the life cycle.
- increased time commitments as listing also entail continuous disclosure obligations and investor relations obligations.
- cost burdens from maintaining a listing.
However, for a growth company, a listing has many benefits including:
- instant liquidity for all shareholders including founders, existing investors, and employee shareholders with also an almost continuous valuation marker;
- reputation and signalling benefits as a listed company is synonymous with being more trusted given the higher governance requirements as well as the obligation to produce audited accounts, which is important for customers, suppliers, and employees; and
- acquisition currency and the ability to raise capital quickly to execute growth plans.
The common thread is that in the current market environment, the bar is high to raise capital from both private and public markets. The best funding or exit path for a company can be pursued because these two options exist in the first place and competition from both sides allows founders to weigh up the costs versus benefits to arrive at the best option.
Striking the balance: growth v profitability
Investors require companies to grow in order to realise a return on investment but with the era of “cheap money” gone, herein lies the tension of growth and profitability.
Capital is required to grow a business and also execute “experiments” or innovations which could be product improvements and research and development that result in finding alternate or complementary sources of revenue streams. The availability of capital in 2023 is scarce and founders are finding that they need to cut back on growth to ensure their business model is sustainable. The tension here is to find the balance of continued growth but not at the expense of profitability. With less capital availability, founders need to be more capital efficient and thoughtful on how capital is deployed to ensure there is a strong return on investment.
In 2023, this tension has resulted in many companies being able to streamline operations while maintaining and growing their topline, resulting in a far more efficient and scalable business. In comparison, in the free-flowing capital environment in 2020–21, there was no tension to reach profitability as companies were rewarded for topline growth only. However, a study by Goldman Sachs on nearly 4,500 US IPOs in the last 25 years demonstrated that high sales growth and a clear path to profitability was most important in predicting IPO outperformance. Only 18 per cent of IPOs during 2020 to 2022 outperformed in the first 12 months of listing and in this cohort, only 15 per cent were profitable. This is well below the cohorts for 1995–09 (46 per cent), 2001–09 (51 per cent), and 2010–19 (34 per cent). With this historical data and reversion to the norm, companies now need to both grow and reach profitability which is a hallmark of a good growth business.
To raise or not to raise?
Many companies are not looking to test the markets for a capital raise in the current environment with falling valuations in the private markets and supply and demand now in the favour of suppliers of capital.
Capital demand currently outstrips capital supply by up to 3.5x
Source: Pitchbook
This is especially the case if companies raised in the heady days of 2021 at sky-high valuations have yet to grow into their valuation. For some companies, there is no choice to raise. For investors, it is a great time to be deploying into a market with sensible valuations and limited competition, but they also face the tension of how far to go with valuation and structuring.
Investors need to be fiduciaries for their investors and drive strong returns but over-structuring deals can set a precedent and also be negative signalling for a company looking to raise their future round of capital. Founders would also push back on certain terms.
The tension here is to find a balance between founder and investor expectations, which would ultimately result in a win-win for both sides as more capital to a founder means capital to “live another day” and fight the scale-up battle or more capital to get ahead of the competition.
Final thoughts
Accordingly, it is incumbent on private companies as well as investors to manage the tension of competing demands to find the pockets of opportunity. In a capital-constrained environment, it is important to keep all options open and as highlighted, tensions can, in fact, be positive for companies and investors in driving more disciplined and better outcomes.
Karen Chan, portfolio manager, Perennial Private Investments
