Digitization and the growth in alternative investments

An indiscriminate selloff across fixed income may have created potential opportunities in income-generating alternative investments. For suitable investors, we believe certain strategies may offer diversified ways to enhance portfolio income.

The increasing role of alternatives in digitization

Innovation is the beating heart of the digital revolution. But developing new ideas and establishing a viable business around them requires significant amounts of capital over fairly long periods. The selloff in publicly traded technology equities in 2022 has made raising capital for private firms harder. At the same time, we believe these difficulties may create potential opportunities for the managers of various alternative strategies.

Venture capital, growth and buyout managers make up an important ecosystem for financing digital innovation. Venture capital managers incubate companies from initial idea and product development through all their expansion stages, typically called early-stage to late-stage venture capital. Growth managers select from some of the most successful private technology companies and support significant scale expansion. Buyout managers acquire more established businesses, often taking them from public to private ownership. 

Valuations decline but deals hold up

The selloff in publicly traded technology equities has driven valuations substantially lower substantially lower – see Deepening digitization. Market volatility and falling valuations pose challenges for VC-backed tech firms seeking to sell their shares to the public via an initial public offering (IPO). As a result, there have been only 60 such public listings in 2022, compared to 303 VC-backed IPOs in 2021.¹ The IPO route is likely to remain largely closed to tech companies until markets stabilize.

For US VC-backed companies that previously went public within the past two years, the valuation declines are especially pronounced. Such firms’ price-to-sales multiples – a metric expressing a company’s market capitalization in relation to its revenues – fell some 60% to 67% through 17 August 2022² – Figure 1.

This public market weakness has seeped through to late-stage VC companies. The median pre-money valuation – or valuation just prior to an IPO or funding round from private investors – was 9% below 2021’s level at $91m, as of the third quarter 2022.³

For seed and early-stage VC companies – those at an earlier stage of development – valuations have held up better. Deals involving such firms – i.e., when they sell ownership stakes to venture capital firms – are not heavily based on valuation multiples. Instead, they focus more on factors such as the size of the market they’re involved in, whether their product fills a gap in the market, their market leadership potential and growth rate.

That said, even seed and early-stage VC valuations will likely decline over the coming year, as valuations in late-stage private markets and public markets reset. Nevertheless, technology deal activity has remained robust in 2022. Although down 10% from 2021’s elevated levels, it still stands significantly above any previous year. And while overall VC deal activity has fallen for three straight quarters from those 2021 highs, VC activity has already exceeded all prior years except for 2021 – Figure 2. 

With valuations coming down, we expect to see an increase in buyout managers taking listed companies private. IT deal value accounted for 31% of PE deal activity in the third quarter of 2022, near the highest level ever.4 Technology is now a core focus for many buyout managers, given the sector’s growth prospects and today’s lower valuations.

With the IPO market effectively shut off for now, late-stage, growth and pre-IPO companies will need to access capital from private sources, including private lenders. Private equity’s appetite for IT acquisitions did not significantly decline in the first three quarters of 2022 compared to the same period in 2021. Capital still flowed into the sector, with 1,239 deals closed globally during 2022 as of the third quarter, with an aggregate deal value of $128.9 billion.⁵ 

However, leveraged loan and high-yield issuances are near the lowest levels since the global financial crisis6 at a time when rates and spreads have increased meaningfully, allowing alternative private credit providers to step in and provide financing to select deals – see Alternative investments may enhance cash yields.

Investing in digitization in 2023

Given the decline in tech valuations and our positive long-term outlook for digitization, we see a case for investing in such companies via early- and late-stage venture capital managers as well as growth and buyout managers. We also favor lending to late-stage, growth and pre-IPO companies via private credit managers. Once interest rates peak, we believe investors will focus more on digitization’s growth prospects again. As valuations recover over time, private managers will have scope to sell their stakes at higher prices.

While we believe a counter-cyclical approach of buying when others are fearful makes sense, these strategies come with risks, beyond that of rising interest rates undermining valuations. As private market strategies, they are illiquid, requiring investors to commit for a period of several years. For example, private technology investing typically involves investing in companies that are generating negative free cash flows and can require additional capital to fund growth. 

Many suitable clients’ portfolios do not have much exposure to private equity as an asset class. Indeed, many lack any exposure at all. We also note many of the same clients may be underinvested in digitization. Such clients should consider their current portfolio positioning and how they might add the potential for further return and diversification.