The Resilience and Flexibility of Equity Capital Markets
Equity Capital Markets See a Shift in Investor Demand
While growth equity investors still have substantial amounts of dry powder, companies looking for outside capital should realize that current investments are not like 2020 and 2021 when the macroeconomic climate was strong. To combat the higher cost of borrowing, increase in economic concerns, and a tougher LP (limited partners) fundraising climate going forward, growth equity firms and their investment committees have adapted to address the new quantitative tightening era. A few noticeable changes in the market for 2023 growth equity investments are evident:
- Shift towards more mature companies with proven, defensive business models: Growth investors are seeking stable growth coupled with a track record of (or clear path to) profitability. With the economic effects of the Federal Reserve’s tightening cycle yet to be seen, investors are looking for stress-tested business models that can provide sufficient returns in multiple economic scenarios. As an example, Capstone has found that business services companies with steady growth have been attracting capital in lieu of higher-volatility technology companies in the past 12 months.
- Uptick in down-rounds for certain pandemic-favored companies: This year, some of the most-high profile, late-stage names have seen retrenchment in valuations. Payments darling Stripe closed a $6.9 billion fundraise in March at a $50 billion valuation (down 50% from two years prior). Grocery-delivery firm Instacart internally adjusted its valuation to $12 billion in February—an upward revision from December 2022 but still ~70% below its last publicly-priced valuation in March 2021, according to an exclusive article by The Information.1 More broadly, median valuation for growth equity to date in 2023 is down 46% from the 2021 full-year level.
- Increase in use of structure: Private markets benefit from the structural flexibility that can be utilized, and investors have continued to rely on structured investments as a means of protecting against downside risk in 2023. For companies looking to raise equity, structured equity has also been utilized to avoid moving forward with a priced “down-round” amid falling valuations.
Structured Equity as an Alternative to Traditional Growth Equity
To address current dynamics in equity capital markets, structured equity can be an effective tool for companies to achieve the quantum of proceeds and valuation desired for a successful raise. There are two different types of “structured equity” deals, and in each case, the profile of the company and the type of investor are very different. The first type of deal features traditional structured equity as a lower cost of capital alternative to traditional growth equity and is for companies with strong positive cash flow. Below are key considerations for companies considering a traditional structured equity deal as an alternative to a traditional growth equity raise.
Traditional Structured Equity vs. Traditional Growth Equity
Source: Capstone Partners
- Traditional structured equity: Capstone defines “Traditional” Structured Equity as a hybrid security in which the investor accepts a lower return threshold in exchange for downside protection.
For companies with strong positive cash flow (double-digit EBITDA, and mainly outside of the Technology sector) that are considering raising equity capital, structured equity can be a good alternative to traditional equity given it is much less dilutive. Furthermore, structured equity can be a means of preserving valuation and gives companies more time before conducting their next “priced” round. The most common structure is a redeemable preferred security with warrant coverage that is typically two-thirds less dilutive than a traditional equity deal. The return threshold for these types of structured deals is typically in the mid-teens on an IRR (internal rate of return) basis. The investor base for structured equity deals consists of special situation funds and credit funds.
Many larger asset managers, hedge funds and private equity (PE) firms also have separate funds dedicated to structured equity investing. Capstone has intimate knowledge of the structured equity investor universe due to our extensive experience in space.
Structured Equity Investor Universe
Source: Capstone Partners
The different groups of structured equity investors typically target varying levels of return profiles, governance, and operational involvement, with a summary shown below.
Differences in Structured Equity Investors
*Multiple on invested capital
Source: Capstone Partners
- Structured equity used by growth investors: The second type of structured equity is used by growth investors to mitigate near-term investment uncertainty, in which the return hurdle for the equity investor is the same as for any growth equity investor (25%+ plus). In these cases, traditional growth investors may add stricter terms to convertible preferred investments as a means of protecting downside risk. Structure can be included in a convertible preferred investment in multiple ways so that the growth investor can achieve the return hurdle of 25%+ IRR while protecting downside risk:
- Participating preferred feature: Rather than using a traditional convertible security, investors may ask for participating preferred stock, which allows the investor to receive the face amount of investment amount at exit, in addition to proceeds based on equity ownership. This “double-dip” feature contrasts with a traditional convertible security in which an investor is entitled to receive the face value investment amount, or their equity ownership at exit.
- Increase in liquidation preference. Typically, convertible preferred investors are entitled to 1.0x their capital at exit if not converted to common. For further downside protection, investors may increase this to 1.5x, 2.0x, etc.
- Additional capital tranche: Ability for investor to deploy more capital if certain financial milestones are achieved.
- Valuation ratchet feature: Allows investor to adjust valuation of investment if certain performance milestones are not met.
Growth Equity Investor Universe
Source: Capstone Partners
What’s Next for Private Markets?
One year into the downturn in the equity markets, private companies that survived the volatility may be considering what their long-term strategy for success looks like:
- What comes after months of prioritizing stabilization and preserving valuations?
- Is now the time to sell or consider an equity raise?
- What do investors currently prioritize?
Despite volatility in the broader equity markets, growth equity and traditional private equity investors have been assessing their portfolios and using excess capital to take advantage of new market opportunities—albeit through the lens of a new supply/demand dynamic. Following the “FOMO” market of 2020 and 2021, the equity market dislocation that began with the Fed’s most recent tightening cycle has reshuffled the rules of private market investing. Thankfully for investors, dry powder levels have never been as high, with North American growth equity funds currently sitting on an estimated $474 billion. When factoring in buyout funds, total North American dry powder is more than $1 trillion, according to Preqin.
Despite the turbulence in public equities and mergers and acquisitions (M&A) to date in 2023, growth equity investments into late-stage private companies have been tracking with levels seen in 2019, with first-half growth investments, totaling $70.2 billion or 61% of 2019’s full-year total.
While 2023 has lagged 2020 to 2022 in terms of deal value, there have been a number of high-profile deals announced and more than 530 closed transactions (52% of 2019’s total figure).
The durability of the late-stage private market has also been apparent when comparing it to new initial public offerings (IPOs) and follow-on offerings. During the 2020-2021 period, as public investors’ appetite for new issuances seemed endless, many late-stage companies opted for public exit instead of seeking late-stage private funding, with many more already-public companies deciding to conduct follow-on offerings. In 2020 and 2021, IPOs and follow-on offerings totaled $290.0 billion and $324.1 billion, respectively. The prevalence of reverse mergers with Special Purpose Acquisition Companies (SPACs) also took share away from companies that otherwise would have stayed private for longer, with 275+ North American companies going public via SPAC merger in 2020 and 2021.
In 2023, IPOs became more common than in 2022 but have largely been relegated to higher-quality, mature businesses in select industries such as Consumer, Energy, and Industrials as well as those in the more-unique Biotech sector. Despite strong receptivity to recent IPOs, it is unclear how many companies are planning to go public in the near-term.
This has provided the opportunity for private markets—once again—to act as a source of capital for mature private companies requiring primary/secondary liquidity who otherwise would have exited to the public markets. In the robust years leading up to 2021, public issuance volume greatly outstripped private capital formation for growth companies, while the trend reversed in 2022 and into 2023.
This trend has seemingly been driven by record amounts of excess available capital in the market and a shift in investors who have flocked towards lower-risk, more mature companies. We believe that much of this growth is due to companies pursuing private capital raises in lieu of full exit strategies planned before the public equity slowdown. While plenty of companies have tapped the private markets for primary liquidity, transactions that include a portion of the capital raised used for liquidity for existing shareholders (secondary capital) have remained stable. We believe most institutional investors are comfortable partially cashing out existing owners under the right circumstances, which was not in favor several years ago. For entrepreneurs and owners of private companies, selling a minority stake today may arguably be the best tactic to increase valuation and return capital over a three-to-four-year period without a full exit. Any dilution resulting from selling equity today is often offset by growing value in the medium term, increasing proceeds to original owners.
Though deals are being completed for the highest quality companies, the equity capital raising environment for most companies remains more difficult than it has been in the past two years. We believe founder-backed and sponsor-owned companies who have made the shift from capital raising independently to working with an advisor are now better accessing investors and benefitting most from the current climate.
Capstone anticipates that there will be a steady flow in equity capital raising in the coming months, particularly in areas that have been active since the public equity market dislocation in mid-2022 (i.e., Healthcare IT, Cybersecurity, Supply Chain, etc.). We believe that non-traditional investors are looking for mature companies to partner with in late-stage or structured equity transactions. With a significant amount of dry powder available in the market, companies who hope to improve valuation before they sell are well-positioned to do so by taking advantage of the current investment climate. With the fundraising climate continuing to process deals with the new-found complexity of 2022 and 2023, companies who pick the right advisor are in the best position to ensure a successful raise with the right structure for shareholders, management, and employees.
To receive additional insights into the trends featured in our Equity Capital Markets Update and the current fundraising environment, please contact our Equity Capital Markets team.
The Information, “In Reversal, Instacart Hikes Its Valuation 18%,” https://www.theinformation.com/articles/in-reversal-instacart-hikes-its-valuation-18," accessed July 27, 2023.
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