Trends in Tech Valuation and Impact on Private Equity
High interest rates and unparalleled inflationary environment
While the US inflation is at 40-year highs and rates have returned to pre-pandemic levels, the interest rates are still nowhere near the high of 6.5% witnessed in 2000s or the record high of nearly 20% in 19801 . The Federal Reserve’s summary of economic projections2 has revealed a median expectation, among FOMC members, of further rate increases going forward thereby bringing the federal funds rate to a range of 3.9%-4.6% by the end of 2022 and 3.9%-4.9% by the end of 2023.
Dislocation between public and private markets valuation
With rising discount rates and repricing of growth, private market investors should prepare for valuations to be marked down in the coming quarters. The churning in valuations happening in public markets is also happening in private markets, although it may take several quarters for this to show up in the data3. The performance of VC and PE backed companies that have recently gone public suggests there is a huge dislocation in valuations between private and public markets. Consequently, the PE-backed IPOs have almost disappeared in the first six months of 20224.
Higher rates impact high growth stocks more
Businesses that gain most of their value from expected revenue and earnings growth are more sensitive to increases in discount rates and changes in implied growth rates. In the public markets, the rise in discount rates has led to a fundamental repricing of valuations and allocation away from stocks with relatively high implied growth rates. However, the drawdown in the major equity indices has not captured the full extent of the drastic revaluation as many of the high growth tech stocks were down more than 30% during the market sell-off.
Impact on Private Equity
Historically, traditional private equity (PE) or leveraged buyouts consists of more mature companies with relatively strong and stable earnings and therefore lower sensitivity to change in interest rates. However, the PE funds with increased allocations to the tech sector and growth equity investments have higher rate sensitivity owing to two fold impact: (1) valuations and, (2) the impact on borrowing costs. Leveraged buyouts are typically financed using floating-rate debt. This means the PE-backed companies will have to cover increasing interest payments as the rates rise. The average large US buyout deal with leverage ratio of 6x EBITDA translates to around 3x interest coverage ratio. If the rates increase by ~300 basis points, this would result in interest coverage ratios falling to around 2x (if EBITDA is unchanged) leaving little room to absorb the impact of drop in revenue and earnings. For future deals, the leverage which has amplified positive returns in recent years, and valuations will need to come down.
The share of Tech sector in PE activity has increased
While there is a slowdown in the PE market, it is combined with a marked trend of larger share of technology deals in the total PE activity. While the number of PE deals declined for the second consecutive quarter, the deal value dropped more as tech valuations dropped. However, the tech deal value accounted for a whopping 27.7% of US PE deal activity for Q2 2022 compared to the average of 19.1% over last 5 years5 and 23.7% in Q2’21. Falling valuations are widely being viewed as a buying opportunity by PE funds to invest in tech companies that were earlier seen as overvalued. Tech deal activity is likely to remain strong owing to attractive growth prospects within the tech sector. PE is focused on long-term growth and will continue to seek opportunities in strong investment themes driven by increasing digitalization and technological innovation.
Deal activity to slow down, PE Exits through IPO to drastically reduce
In the current scenario, the deal activity will slow down but not stop. Despite higher financing costs and lower public comps leading to a challenging environment for deal making, sponsors are sitting on more than $1 trillion6 in dry powder with strong incentives to deploy. In comparison, the exit activity is set to slowdown more quickly than deal activity because most PE firms avoid forced selling. As the year 2021 was a record high for PE exits, it has reduced pressure on PE funds to sell. The value of private equity exits fell 47% year on year to $30.8 billion in the first half of 2022 as private equity-backed IPOs almost disappeared due to market volatility7 and lower valuation. The sale of portfolio companies to other sponsors or corporates is likely to remain as the primary path to exits in 2022.