Link to original article: How long will the exit drought continue?
The Federal Reserve’s signaling in November that it expects to cut interest rates at least three times in 2024 delivered a welcome adrenaline shot to technology and other publicly listed stocks as 2023 came to a close. But most venture capital managers remain cautiously optimistic about 2024. Although some expect M&A exits to become more viable, most VCs don’t see the IPO market rebounding meaningfully until late 2024 or more likely next year.
Frank Rotman, co-founder, partner and chief investment officer at QED Investors, expects to see “a smattering of IPOs during 2024 while people test the market,” more likely in the latter half of the year. “But the real IPO market will open up in 2025. I think the companies just need more time.”
VCs’ portfolio companies need to be a little bigger, healthier and more mature before they are ready to go public, he told Venture Capital Journal. “We will see IPOs of good companies in the coming year, but not a lot of them until these businesses have refactored themselves and turned themselves into profitable machines that are still growing. You will see this logjam break. The question is when.”
QED invests in fintech companies on virtually every continent and closed its two newest funds last spring for a total of $925 million.
Demand for scaled assets
Nearly one-third (33 percent) of the VCs polled for Kauffman Fellows’ 2024 VC Trends & Predictions Survey said 2024 won’t be a good year for exits. (The survey polled 239 firms, including 205 VCs, representing $263 billion in assets under management.)
Among those surveyed who were more optimistic, 47 percent anticipate an increased focus on M&A, while just over 4 percent foresee greater interest in IPOs and 11 percent expect a balance between the two categories. Among the alternative exit options that 5 percent of those surveyed expect the market to explore are secondary sales, sales to strategic buyers and lateral mergers in which similar companies would combine.
Ivan Nikkhoo, founder and managing partner of Navigate VC, is predicting more M&A deals at all stages. From fast-growth tech start-ups with low burn rates and strong balance sheets buying their competitors, to private equity groups acquiring platforms and doing roll-ups by gobbling up struggling competitors at a discount, the M&A market will improve in the coming quarters, Nikkhoo said.
Navigate invests in the Series A extension rounds of SaaS start-ups that don’t yet have sufficient recurring revenue to meet Series B investors’ requirements.
In the second half of 2023, Dawn Capital was approached multiple times by private equity investors looking to buy its scaled assets, said Henry Mason, a partner at the London-based firm.
In addition to PE backers pursuing consolidation and roll-ups, there is interest from traditional companies that viewed all venture-backed assets as too pricey in recent years. They’re thinking “now is a great chance, if I have a cash pile, to go on a shopping spree and acquire great teams and technologies and get market share at a moment that may not come back again if prices go up,” said Mason.
Adobe’s decision last month to cancel its proposed $20 billion acquisition of Figma due to regulatory pushback in the EU and the UK augurs increased scrutiny of large acquisitions at billon-dollar-plus price tags, which will impede M&A activity, predicted Simon Wu, a partner at Cathay Innovation. But Mason said lots of smaller-scale versions of the Adobe/Figma deal are still proceeding.
The number of private companies that at some point in recent years were valued at $1 billion or more suggests a backlog of thousands of logical candidates preparing for an IPO. (Research firm CB Insights estimates there were more than 1,200 unicorns with a combined value of nearly $3.8 trillion as of December.) Many unicorns are in the process of turning themselves into healthy companies that public markets want to invest in, said QED’s Rotman.
During the peak market of 2019-21, a half-finished company could go public with investors accepting the risk that it would figure out how to scale into its expenses and become profitable, which very few did, Rotman continued. “Now it’s almost a condition of going public – at least for the first ones that will go out the door – that you either have to have a very understandable path to profitability or are already profitable. You need to be of significant size. And where that number is we’re trying to explore with the bankers.”
More stable and lower interest rates will make financing more reasonable, which should help motivate acquirers that need to assume any debt to help fund transactions, Adam Struck, founder and managing partner of Struck Capital, told VCJ in an e-mail.
“On the corporate strategic side, I anticipate a significant amount of acquisition activity in AI-related companies,” he said. Given how quickly generative AI is evolving, some of the new start-ups focused on it have already or will become obsolete as the major large language models release more feature sets and capabilities, Struck predicted. He sees 2024 as “the year the proverbial dust settles and corporates will look to bolster their AI teams and capabilities through that acquisition lens.”
M&A activity will also be fueled by public companies looking for growth opportunities to keep pace with increased shareholder expectations, he added.
Struck is more sanguine than most about an IPO resurgence in 2024. He pointed to three companies – ServiceTitan, Reddit and Shein – that have either resumed their IPO processes or confidentially filed for a listing. He believes there is “a cohort of well-positioned businesses that have used the last year to focus on more sustainable growth, an exercise which I think will leave them ready for the rigors of being a public company.”
More biotech IPOs
Barring a macroeconomic scare, biotech is poised to benefit from investors taking on more risk in 2024, Richard Murphey, founder of research firm Bay Bridge Bio, wrote in a blog post. “The last decade has showed us that risk tolerance can change quickly. While 2024 most likely won’t be like 2020 or 2021, it’s possible we could see a significant increase in IPO activity [among biotechs],” he noted. Bay Bridge works closely with VC-backed biotech companies and monitors the overall market.
Publicly traded biotech companies rebounded in late 2023 in anticipation of the Fed’s pivot to reduce interest rates and an uptick in M&A, though mergers and acquisitions remain suppressed compared to 2020-21 levels.
The S&P 500 and Nasdaq are back at record or near-record levels, so investors looking for more yield will eventually turn to riskier stocks like biotech. Currently, the most in-favor biotech stocks are M&A candidates (companies with differentiated, de-risked clinical stage assets), Murphey said. If the rally continues, eventually more speculative assets will appreciate as investors search for yield, though that could take significant time to occur.
Biotech IPO valuations have mostly stayed comparable to the 2020-21 period even amid lower IPO volume, he noted.
Citing a growing divide between haves that can still command high valuations and have-nots, Murphey said, “Big Pharma has demonstrated that it will pay large premiums to acquire strategic assets, but is quite selective and valuation-sensitive otherwise.”
Survival of the biggest
Normally, the fastest-scaling companies would have the best odds of an exit. In the current market, however, a less attractive exit of sorts is now more likely for struggling start-ups through consolidation within verticals.
More venture fund managers will drive mature portfolio companies to consolidate smaller competitors as an alternative road to growth, Navigate’s Nikkhoo wrote in an e-mail. For tech founders in industries with high customer acquisition costs or lengthy sales cycles, tighter market conditions are a major constraint. “They can’t carry on spending their way to growth, and in many of these markets there are too many start-ups competing for customers, further inflating their customer acquisition and retention costs,” he said. “VCs will advise portfolio companies to try and acquire competitors at a far earlier stage, wherever they’re showing genuine traction with customers.”
Some VCs see the current environment as an opportunity for strong portfolio companies to buy competitors or complementary companies. Several of Energize Capital’s climate management software start-ups that are generating $100 million or more of revenue and are profitable “are absolutely using their scale advantage of lower cost of capital to target acquisition offers,” Energize managing partner John Tough told VCJ. “The mantra for the last five or six years was grow through customer acquisition. And now, for a meaningful discount, you can go buy a subscale competitor and quickly bolt on some revenue or a new product.”
Tough predicts M&A and roll-up strategies will be more prevalent this year than in any recent years. Those are not typically an option that VCs explore, but they’re becoming more mainstream in climate tech and growth funds. More mature businesses are still able to raise capital, while subscale businesses cannot. Tough sees winners “getting better capitalized to do a roll-up strategy in this market,” either via geographic expansion or product.
“The way that most are thinking about it is increased share of wallet at the customer logo,” Tough said. “So in the state budgets, if you are serving a renewable energy developer and you’re addressing a pocket of their budget, how do you get more of their budget? Usually that means new features, new products. A different part of the organization could be a purchaser. Increasing share of wallet across a customer is a low-hanging fruit strategy right now for M&A.”