Market correction brings growth equity ‘back to basics’: Sageview’s Stuart

"There has been a shift now to efficient growth," Sageview co-founder and partner Scott Stuart told Buyouts. "This is not a change for us, but it’s a big change in the markets."

Growth equity has been wildly successful in recent years, with dealmaking and fundraising hitting unprecedented levels in 2021.

The strategy is now facing a major test, however, as beaten-down tech stocks and macro concerns cast a pall over investing and portfolios.

Sageview Capital, founded in 2006 by Ned Gilhuly and Scott Stuart, both ex-KKR partners, may be better positioned than many for what is to come. The firm last year closed a third fund at $710 million, giving it dry powder to help weather a slump and invest in emerging dealflow.

Buyouts sat down with Stuart to talk about the market correction’s impact on growth equity, how Sageview is preparing itself and portfolio companies for a downdraft, and the opportunities the firm sees today and over time.

How has the correction impacted the growth equity space?

When you talk about the environment for growth equity, I think it’s important to first talk about what is growth equity, because there are many flavors.

There were a bunch of firms that over the last five years were acting as an arbitrage between private market valuations and frothy IPO valuations. It was a pretty successful strategy run by very smart people. With the collapse in public market values, however, I think that strategy is temporarily dead.

That’s very different from what we do. We consider ourselves to be true growth equity. In our businesses, there is an entrepreneur who has developed a product or service – for us, it’s largely software – which is past the venture capital stage, is proven, and has a big market to go after.

We like to say we have a strategy for all markets. We offer scale capital and [the companies] hire sales and marketing people and they grow. We’re a value-added partner because of our extensive network. [Sageview’s] senior partners have been doing this for 35 years, so we know a lot of people in the Global 2000 C-suite. For our B2B companies, we can make high-quality customer introductions. We can help them hire. And we can help them with compensation and setting up the right metrics.

So, we never left the basics. But I think the market is now back to basics.

Specifically, how have growth equity investing and portfolios changed?

The change, I would say, has two stages. One is the [public] markets collapsed because rates went up. I think those multiples will eventually spill over into private market values. They have a little bit, but it’ll probably happen more.

In addition, prior to the beginning of this year, markets were valuing businesses solely based on their growth rate. There has been a shift now to efficient growth. This is not a change for us, but it’s a big change in the markets.

Software businesses in and of themselves shouldn’t be impacted too much by [a downturn] but end-customers matter. If you’re selling into a cyclical industry, they may not be as willing to spend on some new piece of software. The exception are big companies that feel we’re heading into a recession and are more interested in software providers [like Sageview-backed Drivewyze and Specright] that can save them money.

I lived through the crash of ’87, the correction of ’91, the teletech bust, the Great Financial Crisis and now this. The good news is this brings experience and there is some pattern recognition.

For example, we are seeing a slowdown [in growth equity investing]. Businesses which thought they were going to raise capital at a gigantic multiple can no longer get that. I would say there’s sort of a gapping-out, where companies needing to raise capital are still looking at the old multiples and investors aren’t. It’ll take time for the private market to find its equilibrium, but it’ll happen.

Sageview has invested over several cycles. How is it coping with this one?

During the frothy market of the last few years, we were very careful because we knew this day was coming.

Having seen this movie before, we also anticipate that there’ll be really good opportunities. We’re not there yet, but if we hit a recession, if the markets go even lower, if we have big problems with companies and countries, that’s when you can find some compelling investment opportunities. We think this next vintage of funds may be very good. That’s been the historical pattern.

We’re a more concentrated investor, doing only two to five deals per year. Part of that is the fact that the individuals at Sageview are the largest single investor. We are a large investor in our funds [with more than 20 percent of committed capital]. That’s a lot of good alignment with LPs and the entrepreneurs we invest in like it. When I sit down with them, I say: ‘We’re like you, Mr and Ms Entrepreneur, we’re all in with our own money.’

We have a very active portfolio management committee. We meet quarterly and review every company. And as I mentioned before, we have always focused on efficient growth, even when it was not popular in the public markets.

When covid hit, we had all-hands meetings to say every management team should reforecast their numbers such that we’re cash-flow break-even – so we don’t have to raise capital in a downmarket. Or if you’re still investing for growth, and you’re burning some cash, we want to make sure you have two years of cash runway on your balance sheet. After a week, I slept really well. It was a real asset test for our strategy and I liked what we found.

We’ve done that again now with this market correction. It’s not a great time to go out and raise capital, so we’ve reiterated that you have to cut to cash-flow break-even or have two years of cash on your balance sheet. Overall, our portfolio is holding up very well.

What opportunities does Sageview see in this environment?

There’s still plenty of competition [in growth equity investing] but I think a lot of players have been taken out of the market. So, we expect some softening on multiples going in.

I would say that in downturns in general, the strong tend to get stronger and can gobble up smaller, weakened competitors. In growth equity that could be particularly acute because some of the smaller, not-great technology companies are burning capital and they can’t find new capital, so they are sort of pushed into the arms of the consolidators.

That’s a volume knob we’re turning up. We have companies in supply-chain technology – that’s a classic industry where the end-customers are going to be feeling pain. Some of the smaller competitors may not be growing as rapidly as they hoped, they may not be able to get capital, and to the extent that our really good company could be a platform, that’s something I want our firm to pursue with more energy.

If we have a strong company with positive cash flow, and we’ve hired a bunch of new sales and marketing people, we’re going to be aggressive and try to win more business and grow faster. For those that are struggling, and can’t hire more salespeople, it’s a tough competitive dynamic. We’re already seeing companies in our portfolio gain more market share.

Historic tech adoption has recently powered growth equity. Does it remain a force?

When you’re at the peak of a raging bull market, like we had last year, the key is to try to figure out what part of the mania is cyclical frothiness and what part is secular growth.

We’re long-term investors. We subscribe to the theory that software or digitization is eating the world. There is a lot more to go for in terms of our small growth technology companies making big traditional companies better. That has been our main thesis when the markets were frothy. It is our main thesis now.

If there were no stock market, we would just be saying, ‘Wow, this company Drivewyze is really cool. They allow truckers to miss way stations and save a lot of money and a lot of fuel. That’s just a good idea, so let’s help them grow.’ It’s just amazing to me how much more runway there is around this idea of software, digitization and other technological changes making business better. That’s still a robust theme.

What things will Sageview be looking at to gauge what is to come?

We’ll be looking at inflation, interest rates, growth or contraction in GDP and the functioning of markets. There’s an argument that we’ve had an unprecedented, 30-year, co-ordinated monetary expansion experiment and it’s now coming undone. There is an argument that it could get really ugly. That is out there kind of lurking.

We’ve battened-down the hatches with our portfolio. And now in our quarterly reviews we want to look at more granular detail about how our companies are doing. What’s the growth rate in revenue? What’s the growth rate in new customers? What’s the growth rate in expansion? Really try to break it down.

We look at things like customer retention. The great thing about software companies is you have long-term contracts, it’s an essential service. People don’t cancel critical software as they need it to run the business. That speaks to the resiliency of our companies. We want to make sure that LTV/CAC [life-time value to customer acquisition cost] is strong, i.e., the money or spending to acquire a customer is justified by net present value. So, those are some of the metrics we’ll be focused on.