What’s next for private markets

Highlights:

  1. COVID-19 will result in fewer investments into new companies and a mix shift to follow-ons as investors’ portfolios demand attention and capital. Appetite for new investment is diverging according to firms’ risk tolerance, fund cycle and ‘dry powder’.
  2. Among investors, selectivity is displacing shock. Investors are evaluating which companies’ fundamentals are aligned for post-crisis advantage. Structural growth opportunities with weakened incumbents and robust unit economics can remain attractive despite air pockets in short-term demand. Greater selectivity will widen the gulf between industry leaders and challengers.
  3. Markets are refocusing on fundamentals. Validating customer acquisition costs, lifetime values and payback periods has become critical for companies’ planning and investors’ attention.
  4. Start-ups and scale-ups should beware the enterprise ‘shoe to drop’. COVID-19 has caused radical, immediate and visible changes in consumer behaviour. Changes in corporate behaviour will be less sudden but as significant.
  5. After 2008, rounds shrank 20%-40% and remained smaller for 4+ years. Rounds reduced by investment stage. In 2020 deals will shrink 25%-50% as large ‘offence’ rounds are replaced with ‘defence’ raises and capital becomes scarcer and more expensive, with later stage rounds more affected.
  6. After 2008 valuations declined 15%-40% and took three years to recover. Valuations compressed progressively by stage. In 2020 we expect greater — 25%-50% — compression given public market declines and the tripling (Series A, B and C) or quadrupling (Series D) of valuations in the run up to 2020. Extraordinary companies can sustain a pricing premium.
  7. Total investment in start-ups and scale-ups followed a multi-year ‘U-shaped’ decline and recovery after 2001 and 2008. In 2020–2021 private capital will likely exhibit a ‘U-shape’ again, weighed by the ‘denominator effect’ — but long term rotation into private markets will lessen the depth of the pullback.
  8. ‘COVID Convertibles’ and ‘Insider+’ rounds will dominate in 2020. Frequently, priced rounds with multiple new leads will be replaced with convertible structures comprising insiders and, perhaps, a new investor — with whom the Company or shareholders have some familiarity
  9. Customer acquisition, talent and rent will become cheaper in 2020, increasing companies’ capital efficiency. The cost of impressions on Facebook has declined 53% in 30 days.
  10. For ‘disruptors’, beyond accelerating digitisation COVID-19 will re-shape adoption, catalyse the ‘home economy’, evolve public/private engagement and accelerate the decline of incumbents.
  11. Accelerated adoption, weakened incumbents, enhanced access to talent and more discriminating capital will bolster leading disruptors’ comparative advantage, presenting opportunity.
  12. While fewer, less valuable exits will weigh on current fund returns and liquidity, average returns from private market investment made through the downturn will increase given lower valuations, greater capital efficiency and accelerated adoption of innovation. Average multiples from in-year investments increased by 1.25 and 1 turn following 2001 and 2008 respectively.

Founder recommendations

  1. If your company is a beneficiary of COVID-19 with a strong secular growth story, in a deteriorating funding environment raise capital while you can attract investors’ attention and ‘dry powder’.
  2. Best-in-class companies with strong structural growth stories, weakened incumbents and solid unit economics can attract investors’ interest even if short-term performance is impaired by COVID–19.
  3. With capital allocation to private markets set to reduce, be proactive in seeking capital. Better to be at the front of the queue than the back of a stampede.
  4. Appetite for new investments is diverging according to firms’ risk tolerance, portfolio obligations and ‘dry powder’. Seek targeted introductions and guidance regarding individual partners’ preferences.
  5. Re-cut capital raising plans to replace large ‘offence’ rounds with tactical ‘defence’ raises. Expect like-for-like round sizes to shrink 20%-40%.
  6. Investors are refocusing on fundamentals. When raising capital highlight robust unit economics and present a plan for achieving positive cash flow without further funds.
  7. After 200% (Series A/B/C) and 300% (Series D) run-ups in recent years, re-adjust valuation expectations. While extraordinary companies can sustain premium pricing, anticipate compression given 25%-50% general declines in private market valuations.
  8. Defer pricing, save time and reduce risk by structuring rounds as ‘COVID Convertibles’ (convertible structures specifying a percentage discount to a future round) with ‘Insider+’ participation (existing shareholders plus one new investor with whom you or your shareholders have a relationship).
  9. With the cost of capital increasing for two to three years, re-evaluate investment initiatives. Not all undertakings that produced a return one month ago will do so going forward.
  10. Take advantage of reduced customer acquisition costs (Facebook CPMs -53% in 30 days), cheaper talent and falling rents to extend runway, boost capital efficiency and gain share.
  11. B2B companies should beware the enterprise ‘shoe to drop’. Lengthening sales cycles are a pre-cursor to changes in corporate behaviour that are less sudden but as significant as changes in consumer activity.
  12. Beyond ‘accelerating digitisation’, evaluate how COVID-19 will reshape your company’s fundamentals — from user demographics to the positioning of incumbents — and present opportunity.

1. Fewer new deals and a shift to follow-ons

COVID-19 is resulting in fewer investments into new companies and a mix shift to follow-on, as: a greater proportion of investors’ time and capital is required to support existing portfolio companies; building relationships and undertaking diligence becomes more challenging without physical meetings; and corporate venture capital retrenches.

Source: NfX, Numis Growth Capital Solutions
Source: CBInsights, Numis Growth Capital Solutions
Source: CBInsights, Numis Growth Capital Solutions
Source: NfX, Numis Growth Capital Solutions
  • unprecedented levels of ‘dry powder’. In the last 24 months Accel, Atomico, Balderton and Index alone have raised $7.4B for venture and growth investment.
  • the rise of the European ecosystem: since 2010, the number of European ‘unicorns’ has grown ten-fold, reflecting significant potential for value creation outside the US, while Europe’s share of US and European investment has doubled by value and tripled by volume.

2. Selectivity is replacing shock

Public markets influence private market activity. In public markets, after moving in lock-step, sub-sector performance is diverging — with variance between daily sector changes quadrupling since mid-February.

Source: Numis Growth Capital Solutions

3. Investors are refocusing on fundamentals

With capital scarcer and more expensive, focus on unit economics has increased. Validating the accuracy and viability of customer acquisition costs, lifetime values and payback periods has become critical for companies’ planning and investors’ attention.

4. Beware the enterprise ‘shoe to drop’

5. Round sizes will shrink 25%-50%

Source: CBInsights, Numis Growth Capital Solutions
  • large ‘offence’ rounds to catalyse growth are delayed to 2021 and replaced with interim ‘defence’ rounds;
  • capital becomes scarcer and more expensive;
  • more companies rely on existing shareholders;
  • companies’ cash requirements are reduced.

6. Valuations will compress 20%-50%

After 2008, valuations declined 15%-40% and took three years to recover to pre-crisis levels.

  • 14% (Series A);
  • 19% (Series B);
  • 35% (Series C);
  • 36% (Series D).
Source: CBInsights, Numis Growth Capital Solutions
Source: Nfx, Numis Growth Capital Solutions
  • greater public market declines, which inform growth stage valuations.
  • the aggressive increase in private company valuations between 2012 and 2019, when Series A, B and C valuations nearly tripled and Series D valuations nearly quadrupled.
Source: Cambridge Associates, Numis Growth Capital Solutions

7. Private market investment will follow a U-shape

After previous crises, total investment in start-ups and scale-ups followed a multi-year ‘U-shaped’ decline and recovery. Capital allocation is slower to adjust than transaction volume.

Source: CBInsights, Numis Growth Capital Solutions

8. Expect ‘COVID Convertibles’ and ‘Insider+’

With revenue forecasts less certain than ever, pricing rounds is challenging and time-consuming. As reduced runways necessitate earlier investment than planned for many, we see and anticipate a further mix shift to ‘COVID Convertibles’ — simple convertible structures that specify a percentage discount to a future (priced) round with no valuation cap on that round. Discounts of 25%-30%, which are higher than pre-COVID levels, will be common.

9. Cheaper customer acquisition, talent and rent will boost capital efficiency

Customer acquisition, talent and rent will become cheaper in 2020, increasing companies’ capital efficiency.

Source: Eka Ventures, ONS, Google, Numis Growth Capital Solutions
Sources: Eka Ventures, ONS, Numis Growth Capital Solutions

10. COVID-19 will reshape behaviours and disruptors’ environment

  • reshape, as well as accelerate, adoption of online services (groceries, healthcare consultations, meetings and gaming). For Echo, an online prescription fulfilment service, users aged 65 or over increased from 20% of the Company’s user base to 50% in three weeks. Having accessed online shopping or consultations, seniors are unlikely to revert.
Source: Echo, Numis Growth Capital Solutions
  • catalyse the ‘home economy’ as populations with new experience of at-home functionality and autonomy embrace new models of commerce, food and entertainment. For the first time, Universal is making films available to stream on the same day they appear in cinemas. Not all consumer and vendor dynamics will revert to pre-COVID dynamics after the crisis passes.
  • reshape public/private engagement and procurement dynamics — as COVID-19 highlights the value of state support combined with private logistics, and the possibility of accelerated procurement (in place of a multi-month program, NHS England issued a 48 hour tender for the immediate provision of online primary care).
  • accelerate the decline of offline incumbents, many of which will struggle to survive the additional financial challenges posed COVID-19 and are less capable of adapting their service offerings to emerging consumer demands.

11. Returns from private market investment will increase

While fewer, less valuable exits will weigh on current fund returns and liquidity, venture capital investment made through the downturn will likely deliver enhanced returns.

Source: Correlation Ventures, Numis Growth Capital Solutions
  • Following a near-tripling (Series A/B/C) or quadrupling (Series D) of valuations between 2012 and 2019, investors’ entry points will reduce by 20%-50%.
  • Investees’ marketing and salary costs will also fall after years of increases, boosting capital efficiency.
  • Capital outflows from private markets will reduce competition.

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David Kelnar

David Kelnar

Head of Numis Growth Capital Solutions. 2x start-up/scale-up CEO/CFO. Love tech, scale-ups, trends and triathlon. http://www.linkedin.com/in/kelnar