Staying true to your LPs: Navigating strategy drift in a challenging environment

In the world of private equity, limited partners entrust general partners with a portion of their capital, expecting them to execute their strategies diligently. As GPs gear up for a potential fundraising year, it is crucial to consider how they can maintain this trust in a challenging landscape.

Macro volatility will likely weed out pure momentum investors who benefited from a decades-long valuation environment that (notwithstanding a few speed bumps) continued to move up and to the right until 2021. Over the last 18 months, persistent inflation, higher-for-longer interest rates and geopolitical tensions have caused significant uncertainty for GPs looking to deploy capital and exit current positions. Both capital deployed and capital returned have lagged significantly over the last 12 months and are down 63 percent in the software and technology sectors in which Sageview invests compared to 12 months prior, according to Pitchbook data¹.

Given this backdrop, GPs who have remained prudent in their investment strategies and who didn’t get over their skis in the hype of the bubble have an opportunity to take advantage of this market correction, as their current portfolios remain well-capitalized and financially sound. LPs should rely on their strongest GPs’ discretion to deliver strong returns in their current funds and create an attractive next vintage.

Strategy drift in the boom times

When markets surged relentlessly, risk-taking was a more rewarding strategy for GPs. However, strategy drift became a concerning trend, with GPs often offering term sheets for deals with limited due diligence. This had several consequences, including valuations that reached unprecedented levels. Even classic buyout firms, traditionally focused on margin improvement, jumped on the growth bandwagon. Larger software LBO firms secured loans based on Annual Recurring Revenue as their portfolio companies remained unprofitable, while traditional buyout firms started taking more minority stakes. Hedge funds, usually confined to public markets, delved into the private arena, capitalizing on pre-IPO arbitrage opportunities.

At their peak in March 2021, public SaaS companies were valued at levels previously unseen. According to data from S&P Capital IQ, the median BVP Nasdaq Emerging Cloud Index NTM Revenue Multiple hit 18.6x². These companies were almost solely valued on growth—capital efficiency was essentially irrelevant.

But when the market started to trend downward it forced investors to focus on what companies were offering them at that moment in time, as opposed to their projected growth. Both deal and exit activities have sharply declined. Firms that paid higher revenue multiples for software or tech companies do not want to exit in an environment where the median multiple is significantly lower.

We have returned to an era of capital efficient growth, and metrics like the Rule of 40 (revenue growth + EBITDA margin) are impacting valuations.

Striking the right balance: The role of caution and prudence

Being opportunistic is a virtue and part of what LPs pay for when entrusting GPs with their capital. Occasionally, making judgment calls on “out of the box” investments can provide additional alpha. However, too many deviations from the core strategy, driven by the pursuit of high returns, can lead to misaligned interests. Caution is warranted, even in good times.

LPs invest in GPs not only for their market expertise but also for their ability to execute a predefined investment strategy. Staying true to this approach ensures that LPs’ trust remains intact, even during market volatility.

Despite the ultimate preference to stay the course, LPs may occasionally exert pressure on GPs to chase high returns – even if it contradicts the original strategy. GPs should resist this temptation and maintain their strategic focus. Succumbing to this LP pressure can lead to strategy drift, potentially jeopardizing long-term success. Effective communication and alignment of expectations with LPs are crucial to maintaining this delicate balance. The moment LPs and GPs focus on different priorities, the door opens to mistrust and a vulnerable portfolio.

Apart from providing LPs with essential portfolio updates, investor relations teams play a vital role as the voice of LPs on the inside. They bridge the gap between LPs and GPs, ensuring that LPs remain informed and engaged. Effective IR teams communicate not only successes but also challenges, fostering transparency and trust in the partnership. Furthermore, they serve as a conduit for feedback, helping GPs fine-tune their strategies and investment approaches based on LP input.

As LPs prepare for a new fundraising season, GPs must remain committed to their investment strategies, resist undue pressure and uphold the trust that LPs place in them. The role of IR cannot be underestimated in creating strong, transparent and long-lasting LP-GP partnerships.

When prudence and cautious opportunism pay off 

GPs that stuck to their strategies throughout the market mania of the last decade may well have missed some opportunities – especially in software. However, for fundamental investors with a steady pace of deployment and an active investment approach, returns should nevertheless be solid. Assuming GPs did their true and full diligence on their deals, entered at fair fundamental values and added value to their companies, their current portfolios are likely in better shape.

With current portfolios financially well-positioned, exercising capital-efficient growth and with no immediate need for cash to fund their operating expenses, GPs can focus on deploying capital in what will likely be a more attractive valuation environment.

According to Silicon Valley Bank, roughly 70 percent of companies that received funding in 2020-21 must return to market in 2024³. Even though many of these companies might not fit a GP’s mandate, the sheer number of companies needing to come to market will put a crunch on cash, and bootstrapped companies that also need to raise will be caught up in this pressure for funding.

For those GPs that were hesitant to pay ~15x-20x NTM revenue multiples in 2020-21, now is the time to create interesting portfolios and take advantage of a market that has adjusted back to historical long-term average multiples.

Footnotes

[1] Source: PitchBook as of October 1, 2023. For capital deployed, the screen includes all growth or late-stage VC software deals closed in North America with a post-money valuation of $75 million or greater. For exit activity, the screen includes all buyout, growth and VC software exits closed in North America with a post-money valuation of $150 million or greater. The last 12 months of data for October 1, 2023 is from October 1, 2022 to September 30, 2023. The last 12 months of data from the “last 12 months prior” is from October 1, 2021 to September 30, 2022.

[2] Data based on the constituents of the BVP Nasdaq Emerging Cloud Index as of the respective quarter-end over this period of time. Financial data pulled from S&P Capital IQ.

[3] Source: SVB proprietary data and analysis of 9,000 US VC-backed tech company financial statements. Percentage of US VC-Backed Tech Startups Running Out of Runway by Date

Amanda Stewart is director of investor relations and marketing at Sageview Capital