Venture-backed companies tend to be nascent and typically deploy investment capital in an effort to drive revenue expansion, often to a point at which they are losing money. Given this profile, these businesses must raise new capital every few years to fund future growth. In normal circumstances, each capital raise is conducted at a higher valuation, assuming the company remains financially viable. That said, there are occasionally instances in which the market’s perception of valuation has materially changed or the company is not achieving specific growth targets. Cases like these, which are referred to as down rounds, result in companies being forced to raise capital at lower valuations than the ones exhibited during the most recent fundraising period.

Many venture-backed companies raised capital in 2020 and 2021 at relatively high valuations. Since that time, a significant portion of those companies have seen cash levels depleted and are now returning to the market in order to fund operations for the next few years. However, today’s market environment looks quite different from those of 2020 and 2021, which means these companies are being confronted with much lower valuations as they attempt to raise capital. As displayed in this week’s chart, these dynamics have led to a steady increase in the number of down rounds over the last several quarters. To that point, down rounds (as a percentage of all fundraising rounds) hit a new high of nearly 27% in the third quarter, which is more than double the long-term average.

The trends depicted in the chart above are likely to lead to some disappointing returns for venture capital funds with vintages from 2018 through 2021, as these funds deployed significant amounts of capital during those years and now face a more challenged valuation landscape. On the bright side, these dynamics may present an opportunity for funds with more recent vintages and fresh capital to invest at more attractive valuation levels. Marquette will continue to monitor developments within the venture capital space and provide recommendations to clients related to existing exposures and future commitments.

Stalled sale processes have become the norm in the private equity market due to several factors, including a mismatch between buyer and seller expectations around price and interest rates. Private equity owners have been forced to pivot from the traditional leveraged buyout model, now taking on less debt as they look to create an asset that will be attractive to potential acquirers. One way to do this is to build a better business, including via add-on acquisitions, which have been growing as a proportion of buyout transactions for the last several years. In 2008, add-ons accounted for 50% of deal volume. In the first quarter of 2023, that amount was close to 80%.

Add-ons offer several benefits to private equity firms. First, they are an efficient way to expand and diversify a business’s geographical footprint, customer base, and product offering. Second, add-on acquisitions tend to be smaller businesses, and thus typically less expensive than larger platform investments, allowing the private equity manager to average down the total cost of the combined investment. Third, add-ons tend to be accretive, increasing revenue, EBITDA, and EBITDA margins. Taken together, with proper integration, the end business can become a more attractive acquisition target for both large private equity firms and corporations.

Print PDF > If They Build It, Buyers Will Come

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Secondary market volume has grown from $37 billion in 2016 to a high of $132 billion in 2021. Despite macroeconomic instability, 2022 was still the second-highest year on record at $108 billion. The secondary market was initially dominated by LPs in need of liquidity, selling at a significant discount. Today, the secondary market is more institutionalized and the reasons for selling on the secondary market have expanded — only 10% of sellers are selling for liquidity reasons, while 64% of deals are done for portfolio management. The increase in GP-led transactions has also added to secondary market volume.

As the secondary market has grown significantly, the space has become increasingly undercapitalized. As shown in the top chart above, the ratio of dry powder to deal volume has steadily declined over the last several years, excluding 2020 when COVID hit deal volume. There is estimated to be only about one year of dry powder available to support the growing supply in the secondary market, well below the ratio in the buyout market. The limited amount of capital relative to secondary market volume has resulted in deals trading at significant discounts, as shown in the lower chart. Buyers can be more selective and have the opportunity to purchase high quality assets at a discount. From here, while there are still challenges given the level of macro uncertainty, there is a clear opportunity for investors active in the secondary market.

Print PDF > Secondaries Not So Secondary Anymore

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.