As valuations for technology companies soften, certain private equity LPs see new opportunities to invest in tech funds.
For Samer Ghaddar, deputy chief investment officer for the $50 billion Arizona State Retirement System, the tech market correction benefits certain new PE tech funds launched in late 2022 and early 2023, which will have the opportunity to buy assets at attractive multiples. “I think this vintage is going to be phenomenal,” he says.
Since the Arizona pension fund’s managers determined three years ago that its $6 billion private equity allocation was underweight tech, they have added to the allocation, guided by pacing investment models with extremely long-term outlooks. If the allocations weren’t capped at a set amount each year by the models, this would be a good time to add even more tech PE, Ghaddar says – that is, if the right managers happened to be in fundraising mode right now.
“Some part of this is wishful thinking because you cannot time everything perfectly; you need your managers to be coming to the markets,” he says.
Staying the course
The tech market downturn has not affected Arizona retirement’s investing approach with tech PE, Ghaddar says. The pension fund still seeks managers that have very specific sector expertise, that are more operationally hands-on with their portfolio companies, that tend not to use auctions for acquisitions and that don’t make large-leverage buyouts. They also like managers that focus on their companies’ margins and sales growth, and that perform consistently over time – the pension has no dedicated program for investing with emerging managers, Ghaddar adds.
The tech correction was inevitable, given how high private-company valuations had soared by the first quarter of 2021, Ghaddar says. “Any person who would say, ‘Oh, the markets are here to top that level,’ I would say they need to revisit what they’re saying.”
On the publicly traded side, tech companies reached their peak in November 2021, as priced by the Nasdaq-100 Technology Sector Index, then fell 39 percent off the peak by June 2022. By the end of July, the index was only 29 percent below the peak.
“After a crazy couple of years of mega-funds coming back for re-ups at accelerated paces and at higher rates, the LPs now seem to be able to take a breath and step back. They seem to have more time and more openness to new managers again”
Kelly Ford Buckley, Edison Partners
Kelly Ford Buckley, general partner at Edison Partners, a technology-focused growth equity firm in Princeton, New Jersey, says she’s heard from current and prospective LPs that the cooling off of fundraising by giant tech funds following the tech market correction has allowed investors space to consider other tech allocations.
“After a crazy couple of years of mega-funds coming back for re-ups at accelerated paces and at higher rates, the LPs now seem to be able to take a breath and step back,” Ford Buckley says. “They seem to have more time and more openness to new managers again.”
Growth equity tech funds should benefit from LPs seeking to rebalance from overallocations to the giant PE fund managers and from LPs pausing their venture capital allocations because of their aversion to risk in this environment, Ford Buckley says. “I do see that growth equity allocations seem to be increasing.”
Ford Buckley says LPs tend to favor specialists over generalists in this kind of downturn, even specialists in an especially hard-hit sector, as with business-to-consumer technology. That’s because an experienced specialist who has been through previous down cycles has a deep knowledge of the market dynamics and how to weather them.
“Being a generalist, you might have diversification leverage, but going so wide and not so deep, that can represent more risk,” she says.
The number of software PE deals in the first half of this year, according to Pitchbook, worth $74.4bn. For all of last year, there were 1,076 deals worth $173.1bn
LP aversion to risk in this environment is also why emerging tech PE managers will probably have difficulty raising new funds, with one exception: the emerging tech manager with an ESG focus.
ESG “opens up a whole other pool of capital for you,” Ford Buckley says. “LPs want that kind of diversification and will place some bets and take that risk because they want some sort of coverage there. They want to be in that game.”
The tech market correction has also had a significant impact on the values of companies looking to raise capital, of course. Some tech companies “are getting a real wakeup call,” with strong companies finding their valuations pegged at 5-8x revenue, compared with 15-20x revenue before the downturn, Ford Buckley says.
The strong companies – those with strong fundamentals that are sustaining growth – can raise capital at reasonable valuations even in this environment, Ford Buckley says. But some companies are coming to market before they have done the work of reducing costs and burn rates.
“We like the capital-responsible mindset even when we’re not in a downturn, but I think we pay a little extra attention to it when we are in the downturn,” says Ford Buckley, whose firm makes growth-equity minority investments and recap control investments.
“It’s not a bad thing to put forth a plan that shows 40 percent profitable or close to break-even growth instead of 60 percent on a significantly higher expense base. We are seeing some companies that are still coming into the fundraising market swinging with huge losses, and it feels a little tone deaf,” she says.
“PE sponsors still have a lot of dry capital to deploy, and as public market valuations come down, they’re looking for opportunities that might have been too expensive for them just a few quarters before”
Jinny Choi, PitchBook
Another trend expected to be enhanced by the market correction for tech company valuations is the number of take-private deals in the space, says Jinny Choi, PE analyst at PitchBook.
There was a record-breaking level of overall take-private deal activity in 2021 due to the levels of dry powder accumulated by PE firms and fierce competition for deals, Choi says. That take-private trend is carrying over into 2022.
Most of the public-to-private transactions so far in 2022 have come from the technology sector. “It just shows that there are a lot of attractive tech assets in the public market right now,” she says. “PE sponsors still have a lot of dry capital to deploy, and as public market valuations come down, they’re looking for opportunities that might have been too expensive for them just a few quarters before.”
Within the overall tech deal activity, PitchBook tracked 378 software PE deals worth $74.4 billion through the first half of 2022, compared with 1,076 deals worth $173.1 billion for all of 2021. There were 4,337 total PE deals worth $529.2 billion in the US in the first half of 2022, compared with 9,171 worth $1.232 trillion for all of 2021.
Volatility for the market in general has affected PE exits more than deals in 2022, Choi says. “[Initial public offerings] are pretty much off the table for a lot of PE firms as exit strategies, which is a very stark turnaround from last year, when public listings really drove the phenomenal activity that we saw.”