Which tech investing strategies win when the markets lose?
The tech-heavy Nasdaq has tumbled 22% since the beginning of the year. And judging by the recent earnings reports of some of the bellwether tech companies, the rising interest rate environment and uncertain economic conditions, a rebound is clearly not around the corner.
In a matter of months, late-stage VC dealmaking has turned from frenzied to near-quiet. One such investor told me that he hasn’t made a single new investment since the start of the year, and he sees others in this market segment dramatically curtailing their dealmaking.
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At some point, this slowdown will likely spread to deals for early-stage startups.
While many tech investors are preparing for a rough time ahead, some private market strategies will find attractive opportunities in this environment. Here is how some investors are using their playbooks to win in current market conditions.
Structured debt is gaining a bigger role in deal financing
Since the IPO market is in a deep freeze and it is much harder for founders to raise equity rounds at increased valuations, late-stage companies in need of cash will turn to convertible debt or a similarly structured product.
Many recently announced late-stage deals with private equity involvement have included a significant structure component, an investor with a large PE firm told me. When these deals get announced, they look like a traditional growth equity round, but, according to the investor, in most cases these rounds consist largely of a structured product and a tiny portion of equity.
There has always been an interest in these debt products because they are relatively non-dilutive, but dealmaking in convertible debt has grown manyfold over the last couple of months, and the demand continues to build.
Buyout firms see juicy targets in tech
As tech-focused private equity buyout firms like Thoma Bravo, Silver Lake and Vista Equity Partners raise funds over $10 billion, they may want to use some of their dry powder to purchase public companies with valuations that have dropped significantly since the start of the year, said Wylie Fernyhough, a senior analyst with PitchBook.
Rumored take-private activity is very high now, including for software companies in the $1 billion to $10 billion enterprise value range, the investor at a large PE firm told me. He added that some companies that went public via a SPAC are also considered take-private candidates.
VC-backed ‘special situation’ deals take advantage of valuation markdowns
Special situations is a strategy that few venture capitalists used over the last 10 years, but it was popular with some VCs in the 2007-2012 era, according to Josh Wolfe, co-founder and managing partner at Lux Capital.
Lux is again actively looking for special-situations investment opportunities, which Wolfe describes as investing in late-stage businesses at early-stage prices.
These deals are essentially equity recapitalizations, Wolfe said, with most of the economic benefits going to the management team and the participating investors, but not the original backers.
What makes such opportunities “special” is that they can be found anywhere.
“It could be an R&D group inside of a major tech company. It could be a division within a private company. It could be a company where the investors are tapped [out],” Wolfe said. “We’re looking for those proverbial Rembrandts in the attic where something is really valuable but stuck.”
While special-situations financing isn’t a VC-specific strategy, Wolfe says that Lux’s approach to it is the “epitome of venture capital.”
“You’re still taking technology or market risks,” he said. “You are still funding losses. You are just doing it when a lot of those risks were taken by somebody else, but they’re not going to get the reward.”
Seed investors are in it for the long haul
It is generally understood that seed-focused investing is the most insulated from market gyrations because seed-stage companies are many years away from an exit.
A part of Lux’s barbell strategy is investing in new companies and fully funding them through a market downturn. But other large firms are likely to start clamoring more for this part of the VC market over the ensuing months.
“In the early stage, it is still blue sky,” Wolfe said.
These are by no means the only venture investing strategies that perform well when the tech market is in a downturn. I would be happy to hear about other ones. I invite you to share yours, so please drop me a line at marina.temkin@pitchbook.com.
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