Letter from the GP: The impact of market cycles on M&As

If you have followed the venture capital market for some time you have undoubtedly noticed how much our activity is made up of cycles. Managers, investors and founders need to be prepared for them and be aware that the market factors that influence the entry valuation of a startup can differ at different moments of liquidity – and be aware of how this can tip the scales one way or the other, for example for an M&A transaction or an IPO, sometimes favoring those who entered before in the captable, and sometimes those who entered at the end of the cycle.

The most visible face of this challenge is valuation.

If we lived in a market that is absolutely stable – something which by definition would not be a market – there would be almost no dilemma: valuation of the company would change according to simple objective criteria such as (for example) growth, and it would be enough for a start up to continue growing for its market value to increase.

In practice, things are not quite like that.

Economic cycles are major boosters and inhibitors of gains – and although they are not the only factor in determining the return from a given position, understanding the weight of the current cycle in a given investment decision can make a lot of difference for the investor, and can provide a little more security in the event that the market takes a turn for the worse.

Carefully analyzing past cycles always helps you to be prepared for the present moment. Just to take the example of some recent cases: multiples in 2020 and 2021 – considered by many at the time to be exorbitant – were very similar to those of other moments of history, such as the beginning of the 2000s – before the dot.com bubble burst – and in 2008 – before the sub-prime crisis.

Forward revenue multiples, 2016-2023

Having this information and perspective gives everyone a clearer picture about any individual moment of the market, and prepares us to look for the best opportunities at both high and low moments – and, for example, to know how to react when an asset that we expected to appreciate by more than 100% in two years finds itself once again valued at the same initial price, even though the company has had solid growth.

At moments of greater retraction, the rules by which companies are valued become more conservative: the multiples paid on the indicators of a business become much lower, and the terms and conditions become much more favorable to investors.

Valuation is always a consequence of two interacting sets of factors:
(a) expectations for future pricing of the asset in question, and
(b) the effects of the current moment in the market.

If there were simple ratios for conversions of the various factors this would all be easy.

But the challenge is that the scales of all these ratios change. And these changes influence not only the middle part of the journey, with the pricing of subsequent rounds – possibly making the appreciation of an asset slower than expected, though this can be reversed – but also the strategy, method, and pricing of an exit.

Analyzing this aspect is especially important at moments such as the present one in the world market, when large players have taken advantage of the recent years of plentiful capital to capitalize themselves, and even have no immediate need for cash, so that they are now well placed to make acquisitions – further encouraged by the fact that many assets have a more attractive valuation than they did in previous cycles.

The importance of terms and conditions

For the investor, keeping a close eye on the effects of the scenario as a whole in the venture capital market highlights the importance of seeking the best moments for allocating funds – and the conclusion that, especially at times of higher valuations, it is important to negotiate terms that compensate for entry under conditions that are not ideal, so as to guarantee that solid results will still be possible when there is a change in the overall scenario.

One case that strongly demonstrates the importance of understanding how to position oneself in accordance with this variability of cycles is our investment in Exact Sales, which was acquired in June of this year by RD Station (of the TOTVS Group), for R$ 51 million. Our decision to invest in this sales software startup was in 2019. At the time, we saw a good entry opportunity in a market with great potential, and a good team of entrepreneurs. We drew up a scenario in which, if they delivered everything they were planning, the entry price point would not make much difference, because the potential return would be very significant.

This analysis led us to invest in the company with a ‘premium’ that represented this view in the valuation, but also made us seek protections in the event that the situation at exit turned out not to be as exponential as we were expecting.

Since the date of our initial investment, the business grew by a factor of 3x. This was not bad – especially with the market situation that happened shortly after our investment – but it was far from the growth of 20x that we had projected. In other words, this was a situation in what we at Astella describe as “the Messy Middle”. And it did indeed turn out that, at the time of exit, the terms and conditions were important in protecting our investment.

This is just one of many examples of the importance for investors of understanding the effects that the variations in economic cycles can have on the profitability of their portfolios.

Global analyses of benchmarks, such as those made by Cambridge Associates, tend to show that the crops of investments made after moments of crisis have better profitability for investors than those constructed at moments of greater hype in the market.

Here at Astella, this continuous observation of economic cycles is a fundamental part of our strategy. We seek to position ourselves to create a portfolio that will enable us to make the most of not only the more bull-market moments but also periods of retraction.

Another thing that makes this aspect of management more challenging today is how fast things now tend to change. Instead of cycles of years, we are now sometimes seeing economic conditions change completely in a matter of months. There is a clear example of this in the indicators since the Covid-19 pandemic. In the second and third quarters of 2020, the scenario looked very adverse for VC investments, with funds and companies holding onto their cash resources to the maximum. However a turnaround came soon after. In the last quarter of 2020 and over the whole of 2021 we saw an unexpected high, with prices that many people thought were unsustainable.

This phase of extreme highs was reversed – sharply – in 2022, with the increase in interest rates in the US market, and all the consequences for tech investments, catalyzed by the failure of Silicon Valley Bank. What we are seeing now is a slow recovery, with some volume deals in both investment and M&A returning, although it is still far from having the intensity of the huge rounds of two years ago:

_{(Grey) 1st half – volume of investments (US$ million)  
(Black) 2nd half – volume of investments (US$ million)
(Pink) Number of deals}

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The important role of VC in M&A outcomes

The exit is one of the great moments of an investment. And this is one reason why a VC fund can play an important supporting role in M&A negotiations.

Traditionally, in the venture capital funnel 50 of each 100 investments return a negative result (total loss of the investment, or the need to sell the stake for less than the fund paid for it); another 42 give a return of more than 1x (important results for the overall functioning of the fund); and 8 are outliers, with returns above 10x – the choices that compensate for all the other investments.

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The great challenge in the role of venture capital in relation to M&A is in monitoring this central tranche of the market – about 40% of all companies. This is where we need to dedicate maximum attention, since well-tied-up terms and conditions, and a fair negotiation, can make a lot of difference in the result offered to investors.

Among the factors making this central part of the market important is the support that the fund needs to give to the founder.

However much the entrepreneur may know that, statistically, the chance of his being in the 8% that constitute the top of the pyramid is slim, he or she will rarely have imagined any other outcome. Thus, helping a founder see that an M&A transaction might be the best way forward for their business, and that this is not a demerit for their track record as an entrepreneur, is a first fundamental step that can have an impact for the rest of the negotiation.

In a second phase, we enter with our experience. It’s very probable that for the founders, this will be the first time they are selling a company that they have created to someone else. Experienced VC funds, though, have been through this several times and know both the potential traps of the process and also the points where it is possible to be more inflexible to achieve better conditions. Without this support, it’s common for a negotiation to get stuck on some mere question of pride, or on account of some detail that really makes no difference in practice at the end of the day.

Finally, there is the importance of our role in ensuring that the transaction is also important for the fund, ensuring a role that brings return for our investors – in line with our aims all the way from our initial choice of startups to include in our portfolio, and the terms that we accepted to enter each one of these businesses.

At the end of the day, there is the basic truth that the work of a venture capital fund is very strongly based on people.

However much such factors as economic cycles, market moments and valuation of the business have their influence, it is the presence of a missionary entrepreneur that makes startups become more attractive for M&A transactions – and which, when that moment arrives, cause the negotiation to result in the best possible return for all those involved.

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