How economic events weigh on early stage investing
By Robert Whitby-Smith, Partner at Albion Capital
In late 2021, the huge monetary stimulus since 2009 met a stronger economy and rising energy prices, triggering rising inflation and interest rates. Now we have the horrific attack on Ukraine – the duration and extent of which is unknown. Sadly a humanitarian crisis, further acceleration of inflation and an economic slowdown in Europe are certainties.
How does this backdrop impact early stage investing?
Lower growth doesn’t always mean lower performance
When it comes to looking at history as a guide, the regulatory mantra that ‘past performance is not a guide to the future’ rings true. At Albion Capital we have experienced three flavours of recession (the dotcom crash, the financial crisis, and the pandemic) which impacted early stage tech investing in different ways. In the financial crisis, we saw portfolio company revenue growth stall for a year as enterprises froze their budgets and then growth bounced back.
By contrast during the pandemic, the top 15 companies in our portfolio of b2b software and healthcare saw their aggregate annualised revenue grow c.80% to over £110m in the 12 months to March 2021. However, we are mindful the next recession will have a different flavour, possibly involving stagflation not felt in the UK since the 1970s.
Our focus on sectors undergoing structural change and in companies delivering mission critical products provides a degree of insulation from economic disruption.
The themes we focus on are: digital risk, data/AI, digital health and fintech. For example, an ageing population drives structural growth of the healthcare market and as providers and patients witness the significant benefits of digital health (both to outcomes, convenience and efficiency), digital health provision will receive a greater share of an expanding market. And as an example of mission critical services, whilst British Airways might ground its planes, it can't turn off its cybersecurity.
Albion’s working assumption is that central banks are able to contain inflation
How does a rising level of inflation impact our investing? Since the biggest cost in software companies is people, wage inflation means building software becomes more expensive. This needs to be factored into our investment appraisal. However so long as rising inflation is contained by central banks, it will not change the fundamental attractiveness of mission critical b2b software and the ability to rapidly grow high margin recurring revenues.
The tech stock sell-off
Growth stocks, including quoted tech, are sensitive to interest rates and this change in outlook hit the quoted tech sector hard. In the last six months, revenue multiples of quoted b2b software companies have fallen around 40%. This fall will influence valuations in the private markets. Lower valuations will likely mean lower exit prices, other things being equal, but as we operate evergreen funds we are not under pressure to exit in soft markets. And lower valuations also mean lower entry prices.
However, a more important point is that the key to delivering strong early stage tech returns is less about what the public markets are doing at exit and more about growth. Early stage companies have the potential to scale by orders of magnitude. For example, if a software company scales its revenue from say £1m to £100m, as long as this is done in a capital efficient manner and investors have not overpaid, there are likely to be exciting returns for investors.
The most important thing to get right in early stage tech investing is to back amazing founders and empower them to transform the world for the better.