IPO freeze gives way to cautious optimism as dealmakers see signs of a thaw

By Steve Gelsi

Venture-capital and private-equity firms eye potential uptick after some of the toughest conditions since 2008

Private-equity and venture-capital firms flourished during the low-interest rate period that followed the 2008 financial crisis with a brisk pace of mergers and acquisitions, as well as a healthy pipeline of initial public offerings.

That trend began to taper in 2022 and continued through most of 2023, as markets went from a risk-on to a risk-off environment amid higher interest rates, inflation and heightened geopolitical uncertainty.

The money cycle for venture-capital and private-equity firms of exiting deals through IPOs or selling a company and returning capital to their investors has fallen to the lowest level in about 14 years. (See chart below)

With less money going back to their fund investors, those same investors have been less willing to put money into new venture-capital funds.

Fundraising by U.S. venture-capital firms dropped by more than half to $67.3 billion via 488 funds in 2023 from a record $172.8 billion via 1,351 funds in 2022, according to PitchBook data.

Market volatility is still cooling conditions around IPOs, as seen in Tuesday's massive selloff after hotter-than-expected inflation data.

Prior to Tuesday's plunge, the S&P 500 SPX had hit new records, but most of the gains came from the "Magnificent Seven" stocks, and less from most other listed companies. The rally has not extended into the world of IPOs.

Read more: The 'Magnificent Seven' are so big, they are worth as much as all the stocks in Japan, France and the U.K. put together

Despite this latest market swoon, the Fed is still expected to cut interest rates later this year, and dealmaking has already started picking up among private-equity firms.

Total global private-equity transaction value rose 58% in the fourth quarter to $147.6 billion, according to Preqin data.

"The rebound indicates that the market's coming to terms with interest rates, inflation, economic uncertainty, and even the political landscape (globally and in the U.S.)," Preqin said in a recent newsletter.

Preqin analyst Cameron Joyce went so far as to say that the research firm is "upbeat about the outlook in 2024."

The more robust M&A environment means that venture-capital firms may have an opportunity to sell their private portfolio companies to private-equity firms or strategic buyers instead of taking them public, and start to return money to their investors.

Meanwhile, initial public offerings are starting to stir in 2024, although few have come from venture-capital-backed companies.

"No one wants to be first. There's always a risk when an IPO prices in an uncertain market. Will the price hold or up, or more importantly, trade higher? Seeing a few deals debut so far this year is an encouraging sign. Just having the first one trade well will help - psychology matters." Chris Sugden, managing partner, Edison Partners

After no major deals in the fourth quarter, the IPO market has seen 22 companies go public in 2024 as of Tuesday.

Buyers remain in control rather than sellers at this point, as demonstrated by the need for discounts on deals to get them to the finish line.

BrightSpring Health Services Inc. (BTSG) priced its Jan. 26 IPO at $13, below the low end of its $15-$18 price range. Amer Sports Inc. (AS), owner of outdoor brands Salomon and Louisville Slugger bats, also cut its price to $13, below its $16-$18 price range for Feb. 1 trading.

BrightSpring's stock has since fallen below its IPO price while Amer Sports has gained.

Other deals such as specialty insurer Fortegra Group Inc. withdrew from the IPO market entirely on Feb. 7.

In a statement, Fortegra said its decision was based on the "prevailing market conditions" and the "high value" placed on the company by its backers Tiptree Inc. (TIPT) and Warburg Pincus. In other words, they didn't get the price they wanted from picky investors, so they pulled the deal to await a better environment.

Some IPOs have had more bullish receptions such as Friday's deal from Mexican supermarket chain BBB Foods Inc. (TBBB) or CG Oncology Inc. (CGON), which has gained 130% since its IPO on Jan. 26.

Still, while the IPO market has started to show some signs of life, none of the higher-profile private companies - names like Stripe, ZocDoc, SpaceX, Ripple, Plaid, Impossible Foods, Epic Games, Reddit, Chime and Anduril - have yet emerged with deals.

"No one wants to be first," said Chris Sugden, managing partner of Edison Partners. "There's always a risk when an IPO prices in an uncertain market. Will the price hold or up, or more importantly, trade higher? Seeing a few deals debut so far this year is an encouraging sign. Just having the first one trade well will help - psychology matters."

Recent investments by Edison Partners include cloud-based water management company 120Water and Take Command, an individual coverage health reimbursement arrangement provider, or ICHRA.

Edison Partners has also invested in Overhaul, a supply-chain software specialist, cybersecurity company Sphere Technology, as well as RapidDeploy, a 911 mapping and analytics company, and GoHenry, which is focused on teaching children about money and merged with investing app Acorns last year.

Currently, the exit environment for the sale to a private-equity firm or strategic player has become more active than it has been in recent quarters, but buyers and sellers often remain far apart on price.

"Private companies were being valued at a premium to public company valuations during the ZIRP [zero interest-rate policy] period, but now they're often at a discount, which is consistent with historical norms" Sugden said. "It's come full circle."

The risk-off mood that dominated during the low interest-rate years has been replaced by a risk-on mood in which profitability is much more important. This is leading to many layoffs in the tech sector.

Also read: As tech layoffs mount, communities on LinkedIn are trying to find jobs for affected workers

"It used to be all about growth instead of profit and now it's truly flipped," Sugden said. "That's why technology companies are cutting jobs. You need to demonstrate profitable growth."

Wall Street is focusing on companies with $500 million to $1 billion or more in revenue, with growth of 20% and either profits now or profits in the near future. That's the best way to attract analyst coverage and flourish in the public company ecosystem of more mature businesses.

To be sure, plenty of venture-capital firms may want to wait a bit longer, possibly until after the U.S. presidential election, to take portfolio companies public.

And not all the indicators remain positive. Along with the roughly 700-point drop in the Dow Jones Industrial Average on Tuesday, fresh data on January dealmaking by private equity revealed a drop in activity to $24.45 billion from $29.4 billion last year.

Steve Brotman, managing partner with later-stage venture capital investor Alpha Partners, said cybersecurity and artificial intelligence remain fertile for growth.

"Businesses are focusing on profitability - that means they're not growing as quickly," Brotman said. "Some are facing the idea that they can be profitable with half the staff but they're not going to grow."

The regulatory push to restrict big mergers, along with heavy compliance costs for companies going public, have also hampered growth, he said.

'Businesses are focusing on profitability-that means they're not growing as quickly. Some are facing the idea that they can be profitable with half the staff but they're not going to grow.' Steve Brotman, managing partner, Alpha Partners.

The uncertainty around the geopolitical situation and the presidential election may also keep IPOs off the table for many companies until late 2024 or 2025, Brotman said.

While conditions appear to be slightly better now that interest rates are on hold, many venture-capital firms will not be able to raise new funds.

Many of the so-called unicorns of the 2018-2021 boom years are now "zombie unicorns" as Brotman describes them, because they're using all their capital to become profitable instead of using more money to fuel growth. Many venture-capital firms may not be able to raise new funds.

Meanwhile, venture-capital fund investors, which are known as limited partners or LPs, have become more conservative.

"LPs are very choosy," Brotman said. "They're not backing as many new names - they're gravitating toward safer names."

While the environment remains challenging, the years following big market downturns have delivered some of the strongest performances from venture-capital firms, he said.

Some examples include the fund vintage year of 2011, three years after the financial crisis, or the 2003-2004 time frame, which was two or three years after the Sept. 11, 2001 downturn and the dot-com bust of 2000.

Meanwhile, bankers have remained optimistic about a better IPO market in 2024.

"I do think you're going to see some more meaningful IPOs in 2024 and we are, just across debt and equity issuance, seeing more activity and more engagement," Goldman Sachs Chief Executive David Solomon told analysts on Jan. 16.

Companies had done a lot of funding that takes them out for a period of time," but they've got to start thinking about their capital structures and accept the reality of the market and we're seeing that come through. So, when I look broadly, it feels better," he said.

Also read: Private equity: Everything you always wanted to know about this $12 trillion asset class but were afraid to ask

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02-15-24 0723ET

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