Why our approach works in the market?

Over the course of last year, sentiment in the venture industry underwent a seismic shift. While public valuations had already been under pressure for a prolonged period of time –the EMCloud Index had dropped 68% from an implied valuation of 17.6x EV/NTM revenue in early 2021 to 5.8x EV/NTM revenue by the end of 2Q22– private market funding remained healthy until mid-2022.

The ripple effects of inflation and the subsequent high-interest rate environment eventually caught up with theventure funding landscape in the latter half of 2022,triggering a sharp contraction in deal-making activitiesand compelling founders to rethink their growthstrategies

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From “growth-at-all-cost” to“survive-at-all-cost”

While most founders entered 2022 expecting the preceding growth market to continue – a February 2022 survey by OpenView amongst 3,000 start-up executives found that 100% of respondents were expecting to grow headcount that year with the majority of respondents (56%) expecting strong growth of over 40% -, sentiment shifted quickly as the big reset of 2022 sent a shockwave through the venture capital landscape.

Founder optimism that had been exuberant at the beginning of the year quickly morphed into discussions surrounding cost reductions, workforce downsizing, and the careful management of cash runways. It became increasingly apparent that capital would no longer be as abundant as it had been during the boom years of 2020-21, leading to hundreds of tech companies having to let go of thousands of people quarter by quarter.

In a noteworthy shift, the focus on runway has temporarily started to supersede the pursuit of growth as the guiding KPI for many startups. What's intriguing about this shift is that many companies made cost-cutting decisions irrespective of their cash reserves, suggesting that the industry is preparing for a prolonged period of change and not just be reacting to a temporary drought in funding. This theory is further underscored by the substantial layoffs witnessed with in tech giants known for their profitability—think Alphabet, Meta, and Microsoft.

The tech sector is undoubtedly in a recalibration phase following an extended period of exuberant expansion. This entails a deliberate adjustment of operational scale in pursuit of a more balanced, more capital efficient approach to growth to thrive in an environment where financial resources are no longer limitless.

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The dawn of a VC buyer’s market?

The funding landscape for founders is likely to remain challenging throughout 2023. Faced with an environment of subdued valuations and investor caution, many startups have deferred their fundraising efforts, opting to wait for more favorable conditions as long as their cash balance permits. This has created a substantial backlog that looms as we approach the second half of 2023 and ultimately 2024.

Although dry powder remains at historically high levels, this impending congestion poses substantial challenges for startups not leading the charge in efficient growth within their peer group. Regrettably, for many, reaching their fundraising targets may prove elusive, thus driving (strategic) M&A activity and potentially ushering in another wave of significant workforce reductions.

For investors, the upcoming 12 months are likely to offer an enticing investment environment. Valuations seem to have stabilized after converging towards and eventually dropping below long-term means. The average company in the EMCloud Index is currently trading at approximately 6.1x EV/NTM revenue, well below its 5-, 10-, and 20-year averages.

Our holistic investment approach

With the overall market putting stronger emphasis on fundamentals, which is closely related to HPE's long-term belief on sustainable growth, HPE is well positioned with decades of investing and operating experience in sourcing, analysing, and building sustainable growth companies. HPE is well-known in the market for following a long-term strategy around the following: selection, valuation, value creation and optimizing for exits.

1. Selection

HPE targets technology companies with recurring revenues and high-margin business models that are growing in a capital-efficient manner and have a clear path to profitability. The recurring nature of business provides predictability which in turn provides downside protection, while investment returns arise from capitalising on further growth opportunities.

High gross margins, typically >70%, allow companies to fund their operating expenses while continuing to invest their profits in further growth. This is also why it is so critical to have good cost controls, as discipline on cost on OPEX helps fund further sustainable growth without having to access additional outside capital.

2. Valuation

A strong investment return starts with entry-valuation discipline. HPE targets companies that have high-growth and value creation potential, where we can add value and where the founders and management teams recognise the value of the partnership with HPE. This usually leads to a reasonable entry value that works for both parties.

We prefer simplicity in the structure without the complexities often seen in other strategies. This is often appreciated by entrepreneurs as a valuable component of our investment and gives us the opportunity to invest in a high-growth company at a reasonable price.

3. Value Creation

HPE has a value creation playbook that includes many tools and knowledge that we provide to our portfolio companies as they make the journey from typically around€10m in revenue upon our investment to over €100m in revenue or more upon our exit. The challenges they face during that period are distinctly different than the earlier stages or those of a more mature company.

Our playbook revolves around the goal of creating such growth in a very capital efficient manner, while optimising the position of the company in the market and optimizing the value. Key ingredients include optimising and growth and product strategy, building a world class team to surround the founders and or CEOs, designing and adjusting the organisation to support growth at scale.

What we are particularly proud of is our specialty to achieve these important steps in professionalising the company without losing the fast moving, entrepreneurial, innovative, culture that made it successful in the first place and that we can do this while maintaining and growing the relationship with the founders of the business, which is a core goal of the firm. In the end, HPE wants to be known in the market to have a founder-friendly approach that delivers top quality companies that are equally attractive to IPO investors or potential acquirers.

3. Optimizing for Exit

The ultimate goal of HPE’s investment strategy is to deliver high-quality assets to potential buyers or IPO investors. This is not limited to a final polishing of theP&L and balance sheet and governance structure, as some may assume. Rather, our efforts focus on a range of initiatives and characteristics that define a high-quality asset. These include revenue and cost predictability, customer satisfaction, strong portfolios of market-leading products, world class management teams, good governance and responsible stewardship of people and planet.

With our knowledge of the technology buyer community and extensive technology IPO experience, we know how to guide a company to a great outcome, benefiting all shareholders, including the founders. And that journey starts on day one.

As we like to say, we begin with the end in mind.

We believe strongly in the value of our investment strategy, and we are seeing others understand how and why it works so well. With expertise and experience in our sector and specialist stage, we are proud to be leading the way for growth equity sector and stage specialists across Europe and the world.