Private equity, hedge funds and digital transformation

DANIEL O’DONNELL
GLOBAL HEAD OF CITI INVESTMENT MANAGEMENT ALTERNATIVES
JEFFREY LOCKE
GLOBAL HEAD OF PRIVATE EQUITY AND REAL ESTATE RESEARCH AND MANAGEMENT
MICHAEL STEIN
GLOBAL HEAD OF HEDGE FUND RESEARCH AND MANAGEMENT CITI INVESTMENT MANAGEMENT ALTERNATIVES

Deepening digitization

Digitalization equities have sold off along with many other secular growth themes in 2022. But we believe the long-term trend remains well intact and seek some exposure through certain alternative strategies.

Key takeaways

Valuations of digitalization-related companies have come under pressure amid the broad sell-off in public growth equities

We see many suitable clients with insufficient exposure to private equity and hedge funds

In digitalization-related private equity, we see potential opportunities in venture capital and growth equity strategies

We also favor long/short equity hedge fund strategies, where the market sell-off may be creating better entry points for skilled managers 

Digital technology is becoming ever more ubiquitous. But while we are surrounded by software, apps, artificial intelligence, robotics and the like, opportunities to invest in digitalization leaders present and future are much scarcer. Many companies and strategies are only available to a small minority of suitable investors who are willing and able to take on illiquidity, duration and other risks.

Private investing in digital

The venture capital and growth equity ecosystem is the financial engine of digital innovation. It channels money from sophisticated investors to the world’s most promising companies. Venture capital managers incubate companies from initial idea and product development through all their expansion stages, typically called early-stage to late-stage venture capital. Growth managers select from some of the most successful private technology companies and support significant scale expansion. This helps those firms to globalize, disrupt incumbents and potentially become public companies.

Although somewhat insulated from short-term economic shocks and equity market volatility, late-stage private companies have felt some impact amid the broad selloff in public growth equity. Exits have slowed: the first quarter of 2022 saw only 14 traditional initial public offerings (IPOs) completed, of which just five were technology companies.1

That said, deal-making activity and pricing has remained well above pre-2021 levels, albeit down from the peak levels of 2021. In the first quarter of 2022, $108.5bn of investment activity by venture capital and growth managers occurred, versus $131.9bn a year earlier. However, that quarter was still approximately 53% higher than the five-year average from 2017 to 2021, where the average quarterly deal activity was $71.0bn – figure 1.

 
Figure 1. Deal-making activity is still healthy
 
Chart shows US venture capital and growth equity deal activity by quarter. Source: Pitchbook, as of 31 Mar 2022.
 

Although a pricing reset is seen first in the pre-IPO sector, continued weakness in public technology markets such as the steep decline in software and software-as-a-service multiples will likely filter down to earlier stages of private investment.

At the earlier stages of corporate development, though, valuation is less important than factors such as total addressable market, product-market fit, market leadership and growth rate. Specifically, seeking to mitigate the technology risk inherent in new products and services, we focus on late-stage venture capital strategies in the broad technology and software sectors, where execution and product-market fit are the key drivers of returns.

Portfolio diversification opportunities in digitalization

While technology has helped drive equity markets higher in recent years, the sector is not a one-way street. Stark differences in corporate prospects can translate into wide divergences in equity performance.

Within the S&P 500 Technology Index, the average gap between first and third quartile returns for companies has been 37% over the past 5 years.2 This dispersion provides potential opportunities for long/short equity hedge funds, which buy shares they expect to rise and sell short those they expect to fall. Long/short strategies historically have had a lower sensitivity to market movements and thus add diversification potential to a portfolio.

Recent market declines have left digitalization company valuations looking more attractive. Price/sales multiples for the highest growth software firms – those whose revenues are increasing more than 30% annually – have fallen from a 2021 high of almost 35 to 11, as of 1 March 2022. This is despite their continued business growth and improving profitability.3 Globally, software represents 43% of technology capital expenditures.4

We believe that specialized managers can apply their analytical expertise to identify positions and then exploit high levels of equity market volatility to seek more favorable entry points.

How to invest in digitalization via private equity?

We observe that many suitable clients either lack enough exposure to private equity via venture capital and growth equity, as well as hedge funds or have none. Many of the same clients would also benefit from increased exposure to the unstoppable trend of digitalization. Such investors should compare their portfolios to the strategic asset allocation we customize for them using our own methodology. They should then consider ways to align them.

While today’s market environment is challenging for cutting-edge technology firms of every type, we also believe that it may create the conditions for strong returns and more efficient diversification going forward.


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1Pitchbook; Data as of 1 Apr 2022

2Bloomberg, as of 30 Dec 2021. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Past performance is no guarantee of future results. Real results may vary.

3Thomson Reuters; Data as of 1 Mar 2022.

4Gartner; Data as of April 2022