The views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk.
Portfolio manager Matt Witheiler joins host Thomas Mucha to discuss the outlook for private equity markets, from changing performance measures to the influence of AI.
2:00 Career arc
4:25 State of the venture capital market
8:30 Macro indicators that could affect private equity
10:00 Increasing importance of distributions-to-paid-in
12:30 How valuations affect investment approach
15:15 Opportunities arising from AI
18:40 Effect of AI policy and government spending on innovation
22:00 Best practices for venture capital investing
25:00 Example of how we source and evaluate deals
MATT WITHEILER: So the kind of final stage of grief is upon us and the acceptance is that the world doesn’t look like it looked in 2020 through 2022 and isn’t gonna look that way anytime soon. And so with this kind of acceptance phase hitting in, there’s been a more constructive posture from the companies’ perspective. Capital is available for those companies. And so I believe we’re really entering a potentially productive period for both deployments as well as returns in the venture capital world.
THOMAS MUCHA: Today’s topic is private equity markets and the late-stage market in particular. Activity here rebounded in 2023 from an abysmal ’22. Prices also normalized and some degree of sanity has returned. So what’s ahead for venture capital for 2024? Here to dive into that subject is one of the best people for the job, Matt Witheiler, a portfolio manager and deal lead for consumer and technology sectors at Wellington, focused on late-stage venture capital. He’s an expert on the late-stage PE market and spent several years as an early-stage venture capital investor as well. So Matt, I’m excited to talk to you today. Thanks for being here on WellSaid.
MATT WITHEILER: Thank you so much for having me. I’m excited for this conversation.
THOMAS MUCHA: All right, let’s start with your career arc. What brought you to Wellington? And what are some of the key lessons that you brought with you to Wellington?
MATT WITHEILER: When I was in college, I helped start a consumer Internet site, so kinda got the entrepreneurial bug at that point and helped run that business through my college career and left there when I graduated. The company continued to operate, but I left and went to a large technology company and actually became an operator at that technology company for just about three and a half years as a product manager, where I was in charge of developing new technology. I left there to actually go to business school, and when I was in business school, I actually thought with near certainty that I was gonna start a company out of business school. In fact, a friend and myself created a business plan in my second year of business school and we went around and tried to raise money behind the idea, and funnily enough we both got the same feedback as we went to go pitch various investors about this idea, and that feedback was our idea was not so good but maybe we would be interested in coming to work at the firm to learn a little bit more about how to develop a good idea. And so I guess I became a accidental venture capitalist by taking the opportunity to say, “Okay, I’ll go to a venture capital firm and kind of learn about what it takes to be a great operator and a great entrepreneur, and then take those learnings to the company that I would start.” And fast forward to 16-something years later and I’m still a VC. Ultimately, I came to Wellington from the early-stage firm that I was at previously because I just became convinced that there was a change in the market and that as companies were staying private longer, there was a really interesting opportunity to partner with those companies both from a capital perspective as well as from an experience perspective to help them get ready to be great public companies, and ultimately decided that Wellington was the best place to actually practice that art because of the unique capabilities we have both as a large asset manager as well as with the very collaborative culture we have as a firm.
THOMAS MUCHA: Yeah, you anticipated my question there. It was what attracted you to Wellington? So it’s that breadth of resources, that breadth of research, the expertise we have in bringing companies to market.
MATT WITHEILER: It’s a combination of all of those things plus what is maybe a little bit more tactical, but also was important in my decision-making to come here, which is we decided to invest in these private companies out of dedicated funds. And so that allows us to continue to invest through cycles as opposed to being reactive to where the market is at a particular point of time.
THOMAS MUCHA: Long-term focus.
MATT WITHEILER: Long-term focus, exactly.
THOMAS MUCHA: All right, Matt, what’s the state of the overall venture capital market? You know, with interest rates holding steady, potentially coming down, valuations and deal activity normalizing. Is there less dry powder in many cases? What do we expect in 2024?
MATT WITHEILER: Reflecting on kind of how the past couple years have gone, we’ve really, since late ’21, been through what I’d characterize as kind of the five stages of grief in the venture capital market. And it really started with the classic denial. Back in late ’21, early ’22, as the public market corrected, a lot of companies on the late-stage private side where I focus were in denial around the fact that the market was changing. And that persisted for maybe a quarter or two, and then we kinda entered in the first half of ’22 kind of the anger period where investors and companies were really unwilling to face the new valuation environment. And in the back half of ’22 and early ’23, we saw companies in the bargaining phase of the five stages of grief really attempt to put rounds together while punting on valuation. So we saw a lot of structure. We saw a lot of ways where companies were trying to delay the inevitable around the valuation reset. Most recently, we entered the depression phase, which is really characterized by avoidance. There just wasn’t much activity in the late-stage private market. Companies weren’t raising and so people just did not wanna face the new reality and really tried to punt on doing anything because of this kind of depression that fell across the market. And then most recently, we began to see glimmers of hope that acceptance is here. So the kind of final stage of grief is upon us and the acceptance is that the world doesn’t look like it looked in 2020 through 2022 and isn’t gonna look that way anytime soon. And so with this kind of acceptance phase hitting in, there’s been a more constructive posture from the companies’ perspective. Capital is available for those companies. And so I believe we’re really entering a potentially productive period for both deployments as well as returns in the venture capital world.
THOMAS MUCHA: Does that framework apply to the IPO market as well in 2024? I mean, how do you expect that to develop?
MATT WITHEILER: I think there was many similarities with how the public market went through the same kind of coping mechanisms, if you will. And I think if you looked most recently, we’ve really come to the acceptance phase most recently in the public market with kind of four tech IPOs or private IPOs in the past couple of months, those four being Arm, Instacart, Clavio, and Birkenstock. And I think while the consensus is that these failed -- that’s kinda the popular opinion -- given that they all broke deal price at some point post their issuements. I take a different point of view, and that point of view is that really none of ’em imploded, and when you look at how they traded, yes, some of them or all of them did break issuance price, but it’s not like they fell by 50 percent. They were off maybe 5 or 10 percent at their lows. And all of those companies are north of seven billion dollars in market cap, so these aren’t small companies that are testing the water and going out and not being successful. These have been pretty big IPOs. And so I think that when you look at that, the market’s actually more constructive than maybe popular opinion would be, and that I think that trend will likely continue. I think that in the first half of this year -- 2024 -- we’ll see continued slow but steady return to the IPO markets.
THOMAS MUCHA: What are some of the signs you look for in determining that path?
MATT WITHEILER: Well, I think the most interesting analysis we did is that if you look back over the past nearly 50 years of IPO issuance activity, the issuance volumes tends to collapse -- meaning IPO windows close -- for, on average, kind of one to three years, and in 2024, we’re entering the third year of this closing. And so I’d expect the market to continue to gradually reopen over the next six months or so, and undoubtedly there’ll be noise around the election. But I do think that the market will continue to be constructive on a new issuance standpoint.
THOMAS MUCHA: All right, Matt. Besides interest rates, which obviously affect financing costs for late-stage companies, what other macro indicators matter most to this market?
MATT WITHEILER: This is a really cop-out answer, so I apologize, but I think in general, the economy. And I think really two aspects are gonna drive the venture capital activity and the exit activity in 2024, and I think those are, one, how the consumer reacts this year, and two, how software spending reacts this year. So on the consumer front, I think the question is are we gonna enter a full-blown recession? Are we gonna have a soft landing? How resilient will the consumer be? And on the software side, how are companies adjusting software budgets and hiring plans in light of the macro slowdown? And I think we’re seeing signs of both the consumer as well as the technology spend environment being maybe on a slight upswing -- at least, maybe not continuing to fall at the rate it was through all of 2023 -- and so I feel encouraged about that. But those are really the two things that I think will drive investment activity in 2024.
THOMAS MUCHA: So you’re watching consumer confidence, consumer spending, capex spending?
MATT WITHEILER: Exactly, all of those things, and then as well just the hiring environment at software companies and at companies in general because many private software companies utilize seat-based models where the more employees you have using the tool, the more you’re paying for it. And so we saw a lot of cuts in 2023 from an employee headcount perspective. In 2024, will that trend continue? Or will that, be replaced by more employee growth?
THOMAS MUCHA: Right, Matt, I wanna dig a little into some of the details of this market, and one measure of fund performance that’s been gaining favor among investors -- particularly amid the slowdown in distributions -- is distributions to paid-in or DPI with the long-used internal rate of return -- IRR -- falling to the wayside. So tell us about that and what you think is driving this shift.
MATT WITHEILER: I think there’re really two primary dynamics that are driving this. I think the first one is that as companies stay private longer -- and the data suggests that they are -- venture funds have been progressively slower and slower to generate returns. When we last looked at this, over 40 percent of IT venture capital firms were still active after 15 years. And so from a client perspective, seeing strong distributions earlier -- DPI earlier -- is increasingly important for everything from J-curve mitigation to certainty of returns. So I think that’s one big bucket of what’s driving the trend towards DPI. I think the second thing that’s driving that trend is that many fund-level performance metrics are impacted by internal marks, and those internal marks are based on hypothetical valuations of what a company would be worth at any given point in time. And those marks, which are primarily driven by public comps, were at bubble levels in 2020 through 2022, and as a result, it can make metrics like TVPI and IRR look spectacularly good. But on the opposite end of that, when valuations correct, since these marks are generally more art than science, it can be tempting for private investors to be slow to mark down those positions. DPI, on the other hand, doesn’t lie. It reflects the realized returns that investors have received, and it’s -- in my opinion -- kind of the truest performance measure that’s out there. And so those two trends are really two things that are driving the move toward more DPI-focused investment.
THOMAS MUCHA: Do you think that’ll continue in 2024?
MATT WITHEILER: I do think it’ll continue in 2024 ’cause I think what investors in the asset class will see is they’ll see a lot of funds that showed spectacular TVPI and IRR performance in 2020, 2021, 2022. You’ll see those continue to come down. And so there will be more and more of an emphasis not on what did those pretend marks look like, but were you able to realize those investments during the period where valuations were extended?
THOMAS MUCHA: Makes sense. So Matt, the tech sector pulled back from its sky-high valuations last year. How did the extraordinarily rich valuations for tech companies affect your universe?
MATT WITHEILER: It made getting deals done extraordinarily hard is how I’d characterize it, and the reason for that is because the late-stage private market that we invest in typically takes their cues from the public market when it comes to valuations. And what that meant is that -- take 2021 as an example -- when public software companies were at all-time highs from a revenue-multiple perspective, each private company wanted to go out and raise at multiples that were at least as high as those public companies, if not higher, because maybe they were growing faster or they tried to convince themselves that their TAM was bigger or whatnot. And so the valuations got very extended, and for us that made getting deals done extraordinarily hard because we never took the point of view that those multiples were sustainable, and so we never bought into the fever -- meaning that we saw lots of great companies that we were excited about and would’ve liked to have invested in, but only at prices that were dramatically lower than where they were actually getting done at. And so that just made the environment for investing and deploying for us more challenging.
THOMAS MUCHA: Given that challenging environment, where do you and your team see attractive opportunities or challenges across early or later stages next year?
MATT WITHEILER: I think we have the benefit of investing in technology out of the funds, and technology companies, whether they’re consumer or health care or financial or enterprise software, are continuing to grow because technology is continuing to become an increasing part of GDP. And so if you believe that backdrop, then you should believe that there’s secular growth in the categories that venture capital is generally active in. And so within that backdrop, we’re seeing momentum across multiple areas. If you take consumer, for instance, the technology trends there are really driving the move away from retail and towards e-commerce, and that’s something that’s happened over the last 20 years, but that momentum is continuing and the amount of technology-led disruption in the consumer is continuing to increase. Or if you take enterprise software as another example, there are categories like cybersecurity, where there’s resilient budgets on the customer side, and a continued need for innovation. And so I think across the spectrum, there is continuing to be explosive momentum in technology-led transformation that’s really highlighted by the activity in artificial intelligence and ML.
THOMAS MUCHA: Yeah, let’s dig into that now. You’re obviously closely watching the landscape for AI and machine learning. So what do you think investors should expect from the private side in terms of innovation and opportunity, as well as there’s risks out there, some of which markets may not yet fully appreciate. So how do you assess this landscape?
MATT WITHEILER: Let me start by saying that we believe that the hype around AI is real and justifiable. We believe it will be a major driver of technology transformation over the coming years, over the coming decade. As we break down the space, we bucket AI companies and ML companies -- machine learning companies -- into infrastructure companies -- which are those that are enabling the ecosystem, model companies -- which are the ones developing artificial intelligence models, and applications -- which are those that are using AI inside of their own system or platform. And we believe all three categories -- the infrastructure, the model companies, and the app companies -- will continue to see robust growth in the coming years. I think what’s maybe most interesting today from my perspective is just how early all these companies are. On the private side, I can probably count on maybe one hand the number of artificial intelligence companies that are at this scale -- that are operating at this scale.
THOMAS MUCHA: So it’s early.
MATT WITHEILER: It’s really early, and despite the large valuations and incredibly large rounds that are happening in the space, most of the companies are actually late-stage in name or fund only. They’re not late-stage from a revenue or momentum perspective.
THOMAS MUCHA: Well, the AI space is something that I also pay a lot of attention to, given its importance to geopolitics, how it’s changing military power, military doctrines, how it’s influencing economic power at the national level, how it’s fueling all kinds of institution and policy changes from both economic and national security perspectives. So to your mind, Matt, what are the key aspects of accelerating great-power competition on emerging tech -- you mentioned cybersecurity before -- or other investable areas in this rapidly evolving space?
MATT WITHEILER: Well, I think what’s interesting is maybe how the bifurcation of technology development will progress in very sensitive categories like artificial intelligence. If you take a historic point of view of kind of technology disruption and how that permeates the globe, generally what you see is you see one platform company expanding horizontally across the entire globe. And I think what’s -- what’s interesting about more sensitive areas like artificial intelligence, like cybersecurity, like you mentioned before -- I think what’s most interesting is, are we gonna see a bifurcation in how the technology is developed and ultimately deployed based on what region you’re in? And that is pretty different than how technology-led disruption has occurred in the past. And so you can maybe point parallels to kind of how the cloud evolved, where you have a number of dominant cloud players here in the US who are maybe different than the dominant cloud players in Asia. And will AI, as an example, develop in a similar way, where the technologies that are leading edge here in the United States, for instance, be different than the technologies that are developed and ultimately leading edge in parts of Asia?
THOMAS MUCHA: What do you think? Does the national security focus threaten innovation in this sector?
MATT WITHEILER: I think it does. I think innovation could be or would be potentially higher without this bifurcation or without this artificial wall that potentially is being put in place. I do think that in general, it will slow down potentially the pace of AI disruption. That being said, I think that given the momentum and given the potential of the category, it’s just gonna slow down the pace potentially. It’s not really going to abate it or prevent it from becoming dominant either here or internationally.
THOMAS MUCHA: So I spend a lot of time on Capitol Hill talking to lawmakers. AI, of course, is a major focus of their conversations. I get the sense that they’re at the very, let’s say, early stages of understanding the implications. How do you think about the policy environment going from here, particularly given the makeup of the Congress and who’s looking at these things?
MATT WITHEILER: I think that the policy environment will be woefully behind where it needs to be, or perhaps where it should be when it comes to AI. And it’s driven simply by the fact that, one, the pace of innovation in AI is unbelievably fast. And two, the technology knowledge you have to have to fully appreciate and understand not just what the outcomes of this stuff is, but what’s actually happening, you have to be a PhD. You have to be a specialist to really understand this. And so you combine those two things -- it’s moving really fast and it’s really hard to understand -- and I think unfortunately, that means that policy will probably be meaningfully behind where it potentially could be to influence the outcome of AI.
THOMAS MUCHA: Yeah. What I find to be really interesting in this area is the bifurcation of domestic economy uses versus military uses. And the signals that I get from policymakers is because China’s pushing so hard, because Russia’s pushing so hard, because other actors around the world -- and non-state actors -- are pushing so hard in the national security space, there’s more of a hands-off approach on the national security side. Do you see that coming through in your conversations with these companies?
MATT WITHEILER: We do, and we see it definitively in the types of companies in AI that are getting financing. We see companies in sectors that historically have been really hard for venture capital or for private investing to be active in -- things like defense -- you’re seeing that there’s more and more activity in that category from a private company investing standpoint. And 10 or 15 years ago, that wasn’t a thing. There was no way to access the massive billions of dollars that are spent on defense as a venture investor, and over the past couple of years, that’s really changed. And I think that’ll continue.
THOMAS MUCHA: I think that’ll continue too, But I think there’s been a change in policymaker attitudes towards the technology given the great-power demands of this. Do you think the government can do this successfully? Can the Pentagon move quickly in this space?
MATT WITHEILER: I think the answer is actually yes, because innovation and capabilities will flow to where the dollars are, and there’s a lot of dollars accessible to that customer. And so I do think that they will be successful in driving AI and tech-led disruption via AI across the Department of Defense, as an example.
THOMAS MUCHA: Now, Matt, given the market’s high-return expectations, why do you think valuation discipline is so important in late-stage investing? And in your opinion, what are some best practices, whether for deal sourcing, capital deployment, and generally, you know, looking past the hype of this market?
MATT WITHEILER: Let me take a 10,000-foot view in answering this question. And when I take that view, I think there’re really four things that one has to do to be a strong investor in the late-stage private market, and those four things are, one, you have to find the best companies. Two, you have to do the best, most effective diligence on those companies. Three, you have to pay the right prices. And four, you have to know when to get out. You have to know when to manage your exits. So let me just tick through all four of those. On the finding the best companies, there are a variety of ways to source to find those opportunities, and for us, what we found to be the most effective mechanism is leveraging our deep connections with the earlier-stage venture capital community, investors who need firms like Wellington to come into their companies, both from a capital perspective as well as from an experience and expertise perspective in helping their companies get ready to go public. The next thing that we have to do is we have to do the best diligence on those companies. And so once you find a deal, you have to do the best work in analyzing that deal and coming to a determination on will it be a successful long-term public company or not? And how do we manage that here at Wellington? We manage that by leveraging the nearly 3,000 employees that we have who are incredibly talented individuals who I call colleagues, and those colleagues are deep experts across all the sectors we invest in across the private platform. The third thing we have to do, to your point, is pay the right price, and once we see something we like, once we’ve done the diligence, we’ve found the company, how do we figure out what to pay? And the answer is we don’t have to do it inside of a vacuum. I don’t have to sit in my office and hypothesize around what a 20-percent EBITDA-margin software business growing 30 percent will price like when it goes public ’cause I can walk down the hall and ask somebody who’s been answering that question for decades. The fourth thing that we have to do, once we’ve found the company, done the diligence, paid the right price is know when to get out -- manage our distributions. And apropos our DPI discussion, if we don’t know when to realize our investments, we may not be able to generate the best or most compelling outcome for our clients. And so knowing what we think a business is worth in relation to where it’s trading once it’s public is really critical as part of our process. And how do we manage that? And the answer is, you guessed it, by leveraging the internal platform that we have and the 90 years of experience we have as a firm buying and selling public securities.
THOMAS MUCHA: All right, so with that research ecosystem, expertise ecosystem that we have here at Wellington, can you share an example that shows how you think about sourcing and evaluating deals?
MATT WITHEILER: Yeah, absolutely. I have in mind one of our consumer businesses. And the arc of relationship with the consumer business that I’m thinking of was actually quite long, which is pretty typical for most of the investments that we do. And we initially were introduced by an earlier-stage investor, so got the introduction around eight years in advance of actually investing in the business. And we looked at the opportunity, actually two separate times looked at investing, and the first time we looked at it, it was a little bit too early for us, and so we chose not to invest. But we continued to develop the relationship with the entrepreneur because it was in a category that we liked. Second time we looked at it, we ultimately did not invest as well, and that time it was more because of where the company was from its metrics perspective. The metrics weren’t where we thought that they should be. And so continued to develop the relationship, again, because we like the business, we like the entrepreneur, we like the TAM and the category they’re operating in. And so fast forward to literally seven years after first meeting them, the company actually was anticipating going public via a de-SPAC-ing event, and instead of going public via the SPAC decided to call us up and say, “Hey, we’ve spent time in the past. We’ve been impressed with how you have engaged with us and the experience and expertise you’ve been able to offer. Would you be interested in investing?” And so third time’s the charm. Did more work on the business and liked what we saw this time, both around the scale of the business as well as the metrics, which were massively different than the last time we looked at the company. And so we were able to lean on the coverage of the public market teams and their deep knowledge and deep relationships in the category to determine if the company that we were evaluating had long-term prospects as a standalone public company or not. And ultimately came to the determination that, yes, they did, and that we were quite excited about those long-term prospects. So we made the investment and, again, similar to how we operate with many of our businesses, once we made the investment, we didn’t go away and hope that the business did well. We deeply engaged with the company. And so that includes everything from helping the company think about timing to go public to bringing in some of our public investors to help provide feedback on the company’s test-the-water or potential roadshow presentation. And so really just continuing to add value not just as we diligence the business, but as the company gets ready to ultimately go public.
THOMAS MUCHA: So relationships, patience, collaboration. You put all those things together and you have an opportunity.
MATT WITHEILER: You said it much clearer than I could have.
THOMAS MUCHA: Once again, Matt Witheiler, portfolio manager and deal lead for consumer and technology sectors at Wellington. Thanks for joining us on WellSaid.
MATT WITHEILER: Thanks so much.
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Views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk. Podcast produced January 2024.
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