There is a well-known philosophical thought experiment that goes “If a tree falls in a forest and no one is around to hear it, does it make a sound’’. It could, at a stretch, be applied to the difference between public and private investments.
Over the past seven weeks, equities have endured one of their longest and most brutal sell-offs, resetting valuations from high levels. In alternative asset classes, like private equity and venture capital, the rerating is less public, but is now becoming noisier as it spills over to business and fundraising strategies.
Softbank under pressure
In particular in the venture capital space, there has been a turn in the funding environment brought on by tighter liquidity and a deepening of risk aversion. Klarna, for example, has reportedly been raising capital at a thirty percent discount to its previous raise. Notably, amongst investors stark underperformance from high profile growth investors like Softbank and Tiger Global is contributing to the crashing sound.
This change in the investment climate will be decisive in determining those growth businesses that are truly disruptive and innovative as opposed to those that, like many projects in the crypto space, are effectively financial leverage ‘dressed’ as innovation.
End of globalization
While the change in the funding environment is largely composed of two elements that growth companies will need to focus on. The first is a negative liquidity effect caused by central banks chasing their policy mistake of overly generous monetary policy through 2021 and targeting asset prices as a means of tightening financial conditions. The second is a historic reversal of the boons of globalization – an end to low inflation, fluid supply chains and geopolitical peace.
While this adjustment will be a noisy, distracting process, the shape of ‘what’s next after globalisation’ will also be driven by new technologies and their application across multiple sectors – notably the digitization of consumer services and finance, a revolution in biomedicine and healthcare technology and an intensification of data driven economics.
Companies operating in these and related secular growth areas should hope to be able to look beyond the current liquidity crunch, but in the medium term most will still need to demonstrate that they can pass several hurdles.
The first is to be able to pivot operating leverage. This benchmark event for this liquidity crunch is the 2001 dot.com collapse, where much of the economic pain was concentrated in the technology sector. The fact that other comparable periods of inflation induced policy tightening are located far back in the 1990’s and 1980’s also demonstrates that most growth company management teams have little experience of the macro conditions that will persist for at least the rest of this year.
As such, investors participating in future funding rounds will carefully examine whether business models can move from ‘growth to value’ and the extent to which customer bases are sticky, and whether the consumption patterns of the past two years are merely ‘transitory’.
A second test that private capital investors will apply is what we might call the ‘tide going out’ test, which is that compliance, governance and other risks are often disguised in a pro-growth environment, but exposed under the stresses of a low liquidity environment.
Tide goes out
A third area of focus is talent, and whether entrepreneurial, growth teams need to be complimented with executives who have skill sets more suited to a choppy operating environment. Of note also, is whether under the exigencies of this environment, growth companies live up to the ‘new economy’ ethic that many have espoused. One area that I (as a co-founder of a French startup called Women Empowered to Invest) have seen many growth companies fall short on is hiring women executives, and credibly serving the female demographic (fintech is poor here).
There is one more criteria or ‘stress tests’ to bear in mind through the rest of 2022. One is the ability of the management teams of growth companies to communicate to investors, customers and employees. Many growth executives are well practiced in selling ‘dreams’ but fewer are used to explaining the adjustment to new realities.
The swift change in the macro environment has brought new challenges for growth companies, some of whom may see value destroyed faster than it was built up, and others will survive, wiser and tougher.