Interest rates are up and growth rates are down, which has forced private equity investors to refocus on profitability, revenue quality and cash reserves in a “flight to quality,” FTV Capital principals Alex Malvone and Brent Fierro told FreightWaves.
Loose monetary policy in the preceding decades and generous fiscal stimulus during the pandemic encouraged animal spirits among investors, who bid up multiples on technology firms to never-before-seen heights. In February 2021, for instance, the median company in the Bessemer Cloud Index was valued at a 15.9x forward revenue multiple. Those days are long gone: Now those same companies are valued at approximately 5.5x forward revenue.
“Clearly, it’s been an interesting market,” Malvone said. “One of the benefits of being a firm with a 25 year history — and I’ve been with FTV for 10 years now — is that we’ve seen some of the ups and downs with how things have played out before. That allows us to be pretty disciplined: not overindulging in the high highs or being forced to step back when the market is pulling back. We’ve been relatively active in the context of what you’re seeing in the broader market.”
Because the cost of capital is higher and companies are growing slower, investors have become more selective about the companies they fund. Money is more expensive, so they need to get a higher return, but there aren’t as many suitably fast-growing targets.
“By the numbers, if you look at the ratio of invested capital to dry powder, 2021 was a local high in terms of a rapid amount of investment relative to dry powder,” Fierro said. “2022 and now into 2023 have been almost the exact inverse: the lowest level since the financial crisis, which is representative of the overall condition of the market. Investors are being very selective, but they have a lot of cash. There’s a flight to quality and a focus on businesses that can flourish in any environment.”
But what does a “flight to quality” mean? There was a period in the tech industry when blitz-scaling and growth at any cost was all the rage. Venture capitalist thought leaders opined about concepts like “the innovator’s dilemma,” reinforcing the idea that that speed to market was what mattered most. Investors and executives were bewitched by “network effects” that they thought would allow marketplace businesses to flip to profitability once they had reached critical mass. Today, it’s more common to hear about customer acquisition costs, churn rates, net dollar retention and yes, the “rule of 40.”
“Multiples on forward revenue growth may be a thing of the past; it may have been a very specific post-COVID 2021 dynamic,” Malvone said. “Some of those business models should have never been valued like that. We’re seeing a bounce back to traditional valuation methodologies in EBITDA and cash flow. Everything has flipped back to the rule of 40.”
The rule of 40 states that a software-as-a-service company’s growth rate plus its free cash flow rate should equal 40% or higher. The blended metric attempts to capture something like “growth efficiency.” A company that’s burning money can still be attractive, provided that it’s growing fast enough; conversely, a company that isn’t growing at lightning speed should be much closer to profitability. A reemphasis on the rule of 40 — and similar metrics around revenue quality and earnings — signals that investors are looking for companies that can perform well without consuming excessive capital.
FTV Capital has found traction in businesses that actually benefit from a tougher macroeconomic environment. Last year, FTV invested in Logixsource, a procurement and sourcing tech platform that enables businesses to manage contracts, analyze their procurement costs and get access to category experts who buy noncore goods and services on their behalf. And in 2020, FTV invested $42.5 million in Lean Staffing Solutions, which nearshores back- and middle-office workers for transportation and logistics companies. Both companies have benefited tremendously from the broader boardroom pivot to margin and cost.
“Some sector-specific work that we’ve been spending time on is in the procurement space,” Malvone said. “We’re finding opportunities where companies are benefiting from increased focus on cost savings and shoring up P&Ls in the context of the macro environment.”
Fierro added that Lean “has seen our stronger customers, some of the biggest players, continuing to grow and continuing to use Lean for broader pieces of their back and middle office,” adding roles like software development and IT support in addition to the back-office functions like invoicing and track-and-trace.
Malvone mentioned another FTV portfolio company, RapidRatings, which is a SaaS platform that gives companies visibility into their counterparties and allows them to quickly assess their partners’ financial health. The theme tying these together is that technology that enables businesses to deal with risk and firm up their balance sheets will be in higher demand in uncertain macroeconomic conditions.
Fierro said that he’s been talking to his portfolio companies about how to manage these risks as well.
“There’s a constant theme irrespective of the macro backdrop: Prepare for the worst, hope for the best,” Fierro said. “We talk about how to navigate an elongated sales cycles, potential incremental churn risk if businesses are facing more headwinds than they did 18 months ago, how to ensure we have cash balances, and certain levels of profitability and operational decisions made in case things are worse than we expect them to be. Most of our companies are growing fast enough that we’re focused on growing prudently to maximize returns and maximize potential.”
Malvone and Fierro find some encouraging trends among younger, fast-growing technology and services businesses. Among them is a demand for more visibility — not just into supply chain and freight movements, but into all kinds of data that can shed light on risks the business might face. Malvone likes new approaches to workforce management in the midst of an ongoing labor shortage.
“Where can organizations get support in areas they view as not their core strength?” he asked. “And cost optimization and efficiency — how they optimize profit and loss and margins — all companies are focused on that.”
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