Making Sense of Market Momentum
Note: My Series 7, 63, and 79 licenses are as out of date as the Sex and the City reboot (sad). Accordingly, it should be noted that these are my mid-NFC Championship musings and do not constitute actual investment advice.
As a public markets junkie, nothing lights up my neural networks quite like volatility. Accordingly, while I would assert that this has already been a year to remember, my boyfriend might lament that our dinner table would prefer to forget it. Yet, as we early-stage investors continue to debate how much the ongoing public market meltdown matters to us, there remains a certain degree of uncertainty and confusion. I’ve loved the observations put out thus far by the likes of Greylock’s Sarah Guo on the recent market moves and Redpoint’s Tomasz Tunguz on valuation comparables in prior pullbacks, but I feel like we have yet to address what this all means for consumer companies.
Below, I seek to outline the 30-thousand-foot view, ground-level game, and what the flight path forward might look like from here.
The 30-Thousand-Foot View
If you paid 200x forward earnings in Q4 for a “hot” SaaS startup, I’m sorry for your (near-term) loss. And if you paid 200x forward earnings for a consumer business, I would love to send you a few deals to mark up! Yes, if Boston’s weekend snowfall is any indication, it is officially winter. Last week, stocks fell for the fourth consecutive week, marking the NASDAQ’s worst January since 2008, despite close to record-setting inflows from retail investors. Meanwhile, in other universes, the crypto market has shed more than $1Tn in value. These days, it certainly feels like the Grinch stole more than just Christmas.
With near-term investor attention shifting from searching for the next Snowflake to feeling out a floor, it seems like we could be approaching a trough. Today, revenue multiples for public software stocks have slid to around 10x (versus close to 20x in November 2021), still marginally ahead of five-year averages and pre-COVID levels. Bulls are beginning to point to more attractive growth-adjusted revenue multiples, which are actually trending below five-year averages.
However, private markets still have yet to capitulate. Venture capitalists continue to Twitter toast their 2021 markups, and founders far and wide are eying the market with sky-high valuation expectations. Might something have to give? In my opinion, private market valuations are indeed likely to come down — even if only marginally. Despite the record levels of dry powder sitting on the sidelines, the growing disconnect between public and private-market multiples feels increasingly unsustainable.
Before over-analyzing your various portfolio permutations, it’s worth first understanding the macro backdrop that got us here in the first place.
The Ground-Level Game
In a land that feels increasingly far, far, away, over 40 million workers (yes, a quarter of our nation’s workforce) filed for unemployment in the early days of the pandemic. With hysteria mounting faster than Kanye’s ego, the Fed was swift to put its full force behind the U.S. economy in the form of a 150bp rate cut and almost $9Tn in balance sheet purchases (roughly 3x the amount deployed during the Financial Crisis). Fast forward almost two years, and the labor market has since recovered with unemployment currently sitting at under 4%, and consumer and business balance sheets fortified (in most instances) to above pre-pandemic levels. Depending how you slice it, the top 50% (more on the other half later…) have never been in better shape. Not only do they have more money saved, but with debt-service ratios at multi-decade highs, there is arguably quite a bit to be excited about (for now).
However, while the parties of the past twelve months have led market optimists to rage like it’s the Roaring 20s, there is a growing sense that a hangover is looming. With markets currently pricing in four rate hikes over the next year, many fear that ongoing inflation trends, underscored by December’s 7% Consumer Price Index increase, are likely to put pressure on the Fed to accelerate liftoff. Rising rates mean higher borrowing costs for consumers and businesses alike. This typically slows economic activity, which, in turn, is likely to curb inflation.
Lower inflation = lower prices.
Higher rates = higher risk premiums.
Lower prices + slower economic activity = slower revenue growth rates.
Slower revenue growth rates + higher risk premiums = lower valuations.
If you’ve followed thus far, your third grade math teacher would be proud.
Yet, while the Reddit crowd has certainly felt some pain in their Robinhood portfolios as the market has readjusted lower in recent weeks, the true victims of the rate rises ahead will be those already beleaguered with poor credit scores and growing debt balances. These individuals are now facing a double whammy — not only are expiring pandemic-era federal aid programs meaningfully curtailing their incoming cash flow, but their monthly expenditures are also set to jump as each rate rise drives their borrowing costs higher.
Looking ahead, budgets across the board will likely pull back a bit as consumers take stock of their respective new normals. While I’m not calling for a 2008-like cliff, I do suspect we’ll see tempered demand for discretionary products and services. Accordingly, the ongoing flight to quality and real value (think healthcare, fintech, and enablers of economic opportunity) is likely to extend far beyond skeptics’ software speculations and bleed into the consumer landscape as well.
The Flight Path Forward
So, where to from here? With billions in LP commitments to deploy and a growing collection of companies itching for exits, investors today are eager for clarity on what the next twelve months might hold.
From an exit perspective, options remain — at least for now. However, after a record year for issuance across IPOs and SPACs in 2021, public market investors are now sanity-checking valuation expectations, given the notable underperformance of newer issuers. Likely gone are the days of companies (and their investors) naming their price as a new era of multiple rationalization takes hold. However, demand for high-quality public assets remains. On the consumer side, just look at Roblox, which is still trading at close to a $40Bn market cap, representing over a 30% premium to its last private funding round back in January 2021. While many expect to see a lighter IPO calendar this year, the new issue market is far from fully closed for business.
Furthermore, with fewer companies pursuing public listings, we are likely to see the exit pendulum swing back towards M&A, arguably an even better outcome for investors given the liquidity considerations. With company balance sheets flush with cash after 20 months of quantitative easing, there has arguably never been a more conducive environment for broad-based capital deployment by corporates. The question now will be whether tech companies (similar to crossover investors) are better off buying their own public stock trading at trough multiples or the inflated equities of late-stage startups. Accordingly, it seems likely that such exits will trend more towards “show me” stories than hype alone.
In the near to medium term, I suspect a path to profitability will be the name of the game. With valuations coming down (and dilution trending up accordingly, assuming similar round sizes), companies will be rewarded for capital efficiency. At the end of the day, businesses with sound fundamentals should weather the storm reasonably well. While demand will remain high for best-in-class assets (given the historical returns generated by such securities), this is also arguably the best time in recent memory to make money on riskier bets with unicorn potential as valuations reset to more rational ranges.
Fifteen years ago, I envisioned myself as a future ghostwriter for Perez Hilton, so I’ll be the first to admit that I don’t have a crystal ball. That said, it certainly feels like market musings will play an increasing role in investor, fundraising, and boardroom conversations moving forward. Accordingly, if you’re looking for an intellectual sparring partner, I’d love to hear from you on Twitter at @itsmeeraclark or at firstname.lastname@example.org :)
Please note that these are my personal views and do not reflect the opinions of my firm.