It’s the revenue, I promise!

Investors and portfolio company leaders need to focus on organic revenue growth as the North Star navigates current economic headwinds. Funds that fail to do so risk uncomfortable conversations with limited partners (LPs) that they’re not used to having.

1. Public company valuations have declined in the wake of the S&P 500, losing 21% of its value in H1 2022. This effect is spilling over into private company valuations and it’s preventing investors from exiting on attractive terms. Public listings have all but evaporated — an exit-to-investment ratio of 0.32x not seen since the Great Recession of 2008-09 leaves the door open to secondary exits and sales to strategic investors. 
2. Declining valuations, coupled with the fastest rise in interest rates we’ve seen in 20 years, are making it more expensive for companies to raise equity and debt to fund growth. 
3. The most rapidly rising inflation we’ve seen in 40 years and rising labor costs are putting pressure on companies’ cost structures.
4. The growing risk of recession, now at a 40% probability of occurring in the next 12 months, is reducing spend and slowing sales cycles as companies batten down the hatches.

How to Maximize Free Cash Flow

Not all boats will rise with the tide in today’s turbulent economic environment. To make progress despite strong headwinds, leaders can’t sit idle. They can do one or more of three things to maximize free cash flow, a reliable indicator of value creation.

1. Defer investment.

Kicking the can down the road on planned investments is the easiest way to increase free cash flow, and the most controllable. It’s also a foolproof way to slow growth. A lot of companies will elect to do this despite mounting research that shows organizations that double down on investing in turbulent times emerge on a faster trajectory.

2. Cut costs.

Cutting costs is not a silver bullet, because, as Ruth Porat is quoted as saying, “You can’t cost-cut your way to greatness.” It may be as controllable as deferring investments, but it’s not easy to do. Many companies miss the opportunity to be strategic about it. They cut costs by X% across the board instead of cutting where it matters less — they did so in areas where they merely need to be “good enough” to compete while investing in the capabilities that differentiate them.

3. Grow revenue.

It’s critical to success, but it’s also the least controllable in the near term. A lot of companies trying to hit quarterly targets will not lean into the opportunity and elect to cut costs and defer investments instead. The ones who do create the opportunity to leave their competitors in their wake.

Companies that double down on revenue growth, win. What applies to all companies, applies most of all to venture capital and private equity-backed portfolio companies. PE and VC funds have generated returns exceeding 30% IRR on average in the last three years, according to Pitchbook. The problem is that a lot of portfolio companies’ valuation only exists on paper and is not crystallized in reality. 

Monetize Existing Clients and Win New Customers

Accelerating organic revenue growth is simple, but it’s not easy. To monetize existing clients and win new customers, there are a lot of moving parts to get right.

1. Monetize existing clients.

Doing more business with existing customers is a foolproof way to grow. Companies need to build muscle in four areas.

1. Turn around unprofitable customers, or stop trading with them. That does not happen without the right incentives for leaders.
2. Improve customer retention.
3. Get better at cross- and up-selling.
4. Manage price. Fortunately, inflation can help.

2. Win new customers.

In  B2B, by the time a prospective customer wants to talk to you, they have conducted 80% of their buying decision process online, according to Gartner. Companies who work within this new paradigm, and make the most of opportunities to add value across the customer buyer journey, are setting themselves up for success.

To that end, companies need to get better at three things.

1. Improve the volume, quality, and cost-effectiveness of lead generation efforts. B2B companies in particular have an opportunity to stand out, by getting really good at below-the-line and content marketing that answers customer questions during their buying journey, rather than focus on self-promotion.
2. Improve the close rates of customers they attract.
3. Launch new products and services to attract new customers, and increase the share of wallet. The loop is closed with client monetization.

3. Making the moving parts work together.

Having strong marketing, sales, and customer success functions across the organization helps but is not sufficient — the key (although difficult) is to interlock those functions. Improving the performance of the sales funnel by 5% (in absolute terms) at every step of the customer’s buying journey has the potential to deliver 300% revenue growth! This requires having three functions that row in the same direction, and to the same drumbeat, rather than at cross purposes.

This entails getting four things right:

1. Target the same industries.
2. Work off of the same ideal customer profile.
3. Agree on marketing and sales qualified lead attributes and management.
4. Adopt robust governance that measures conversion rates and helps revenue operations leaders pinpoint where the weakest chain in the link lies.

Executives who run portfolio operations for investors, and those who lead portfolio companies, need to figure out which portfolio companies can accelerate growth in the current headwinds on their own, and which ones need help. After all, they can’t leave a company behind without running the risk of souring the returns of their entire fund.

In a nutshell, funds that do not create material value through organic revenue growth are setting themselves up for uncomfortable conversations with LPs.

Supporting Evidence

• War for Talent: In the last 12 months, the U.S. economy gained 6.4 million new jobs and unemployment has fallen back to its pre-pandemic level of 3.6%, according to the Bureau of Labor Statistics. Industries such as technology, manufacturing, and some service industries are experiencing labor shortages, exacerbating wage increase demands. In technology, many workers are asking for increases of 20% or more according to the Wall Street Journal. (12% year-on-year in April 2022).
• Rising interest rates: To counter spiraling inflation, the Federal Reserve lifted interest rates by 0.75 % in June 2022, the third hike this year and the largest in almost 20 years. Another 0.75% hike is expected in July, followed by 0.5% in September according to Reuters.
• Rising risk of recession: The risk of the U.S. experiencing a recession in the next 12 months is rising, with the probability pegged at 40% according to S&P Global.

Declining valuations and rising interest rates are getting in the way of companies’ ability to raise equity and debt financing to fund organic and inorganic growth plans, and of investor exits on attractive terms.

• Late-stage valuations dropped by 27% in Q1 2022 according to Pitchbook. For example, Klarna, the Swedish Buy Now Play Later fintech, is in the process of raising money on a $6.7Bn valuation when it raised funds last year on a $46Bn valuation, according to Reuters.
• Private equity exit count and value have reduced by 57% between Q4 2021 and Q1 2022. Public listings have all but evaporated, with an exit-to-investment ratio of 0.32x, not seen since the Great Recession of 2008-09, according to Pitchbook.

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