July 22, 2022

Square Peg Investor Letter Half Report 30 June 2022

We are publishing our half year letter that we sent to our investors last week. The letter reflects our views on what is happening in markets right now, and how we are responding.

Paul Bassat

July 22, 2022

Square Peg Investor Letter Half Report 30 June 2022

We are publishing our half year letter that we sent to our investors last week. The letter reflects our views on what is happening in markets right now, and how we are responding.

Paul Bassat

Dear Investor

We started Square Peg in 2012 and for the past 10 years we have had the wind at our back.  We have seen enormous value creation from startups, and this has been magnified by extremely strong markets. It is also important to take actions and make decisions that increase the likelihood of serendipitous outcomes occurring, and we have done that. We believe the outcomes we have achieved are due to a combination of strong markets combined with a dedicated and focused team that has made great investment decisions. We are proud of our achievements, but it would be fundamentally dishonest for us to ignore the role of good fortune.

Based on our updated 30 June valuations, we have achieved a net IRR of 32% aggregated across all our funds since inception. Most importantly, we have returned substantial capital to you. We have now returned $582m across 11 different exits at an IRR of 42%. No Australian founded technology venture fund (past or present) has had as many exits or returned as much capital as we have and that is one of the things that we are most proud of.

We are now entering a tougher phase for early-stage technology markets, as well as the potential for a major economic slowdown. We don't know its duration or severity, but we believe we are very well prepared as we work through the next period. We are well prepared in terms of the quality of our portfolio, our mindset, and the quality of our team. We are also in the fortunate position of investing from two brand new funds. Provided we are patient, disciplined, and make good investment decisions, Fund 4 and Opportunities Fund 2 will be strong performing funds. We expect the next few years to be a great time to be deploying capital into early-stage technology companies, and we couldn't be more excited about the opportunity set in our chosen markets.

With the high degree of uncertainty in markets, we have taken proactive steps to be conservative in our portfolio valuations. We continue to apply IPEV Guidelines which are regarded as global best practice and take a market valuation-based approach. As a reflection of the uncertain market environment, we have adopted a general provision for future write-downs across a number of our funds. Further detail on the provisions and changes to the valuations of individual holdings is provided in the respective fund specific updates sections of this report.

Before we move on, it is worth reflecting on what we have got wrong over the last year. We either knew, or should have known, that we were in the very late stages of an incredibly buoyant market. In hindsight, our pace of investing should have been slower than it was. We had sufficient visibility to exit a number of positions and return substantial capital to you, however it was cognitive dissonance that prevented us from slowing down our cadence of new and follow-on investing. The argument that we were much less aggressive than most of our peers is not an argument that has much relevance.

We feel good about the companies that we invested in during 2021 (both new investments and follow-on investments) and believe that we didn't compromise on quality. However, valuations were higher than they should have been and inevitably that will impact returns on those investments. We have been reflecting on this and remain committed to learning from our mistakes.

We are currently in a period of high uncertainty and there is a wide gap between the bull case and the bear case outcome over the next couple of years. Like every other business, we need to have a plan. However, we need to hold our views lightly and be flexible and agile as the facts become clearer.

What is our current thinking on the period ahead?

The first lens is our existing portfolio. Over time, outcomes bifurcate for early-stage technology companies. The great companies compound year after year and become remarkable businesses. Today, we have 7 companies in our portfolio that have annualised revenue exceeding $100m and in many other cases there are businesses fast approaching this level. In most cases we invested in these businesses at a pre revenue stage, or when they had very little revenue.

Whilst some of our best performing portfolio companies may be impacted in the short term by a slowdown in the broader economy, the coming period will also be an incredible period to create value. Talent markets will become more favourable for employers, great companies will more easily be able to attract and retain amazing talent, competitors will either disappear or become more rational, and founders will be able to focus on long term value creation. If you are a startup with a great business and strong balance sheet, then you should be relishing the next few years. We are lucky to have a significant number of these in our portfolio.

The critical point is the distinction between fundamental creation of value and how markets value businesses. We know that in our universe of early-stage technology investing, markets can be prone to periods of excessive enthusiasm and excessive despair, our focus is always on fundamental creation of value.

Every startup begins with a vision of building a remarkable business and we choose to invest in companies because we believe each one of them has a realistic path to building something amazing. In most cases things don’t go exactly to plan. In some cases, the outcome is a good but not great company while in other cases the outcome is a failure of the business and a write-off of our investment. These situations are painful for the founders and teams and painful for us (and you) as investors.

One of the features of the last couple of years is that businesses that haven't been meeting expectations have still been able to raise external capital and continue to fund themselves. The failure rate in our portfolio has been remarkably low for a number of years, and this is not sustainable. The next two years will see a higher failure rate and in some cases we (and our co investors) will need to make the difficult decision of which businesses we can't continue to support. This is a decision we have had to make on numerous occasions in the past, but the frequency of these decisions will increase over the coming period. We will assess each situation dispassionately but also with a high level of transparency and empathy towards the founders.

Let's turn from our existing portfolio to what this slowdown means for our investment activities. Firstly, there is a lag in private markets, and it will take some time for valuations to fully adjust, and the likelihood is they will ultimately overshoot on the downside. We have already seen valuations move fairly substantially but there is further to go in this process. As a result, we have slowed the cadence of investing in both new and existing portfolio companies. We believe this is the right decision given the high level of uncertainty right now. To be clear, we are still very much open for business. We will keep backing new and existing founders that are doing amazing things.

We expect to see a slower period of exit activity over the next couple of years. IPO markets are closed and whilst trade buyers are likely to step back in, valuations will be compressed. As long as the best performing portfolio companies are creating value in the meantime, then we are not concerned. However, we want to set the expectation that we are unlikely to return capital at the same rate over the next couple of years.

It is also worth reflecting on things that will and won't change over the next few years. Firstly, many of our peers will exit the market for one reason or another and we probably won't see as many of the mega funds as we have seen over the last few years. In particular, we will see a lot of non-traditional early-stage investors exit the market.  We will also see greater capital efficiency from startups and, as a consequence, it is likely that Fund 4 will invest in a greater number of portfolio companies than our earlier funds.

What won't change is how we run our business. Venture capital is not a business where you get rich on management fees, and that is especially true in our case where we believe the right strategy is to invest across multiple geographies and build a remarkable team. Our approach to building our business will not change over the next couple of years, and we are committed to maintaining a long-term mindset. Our investment in a world class team increases our likelihood of backing the best businesses and that in turn maximises the likelihood of delivering great outcomes for you, and for us. Alignment and a long-term mindset are critical. We have made lots of mistakes but every decision we have made has been based on alignment, a desire to build an enduring business and integrity.

Some other things won't change. Firstly, the desire of a large cohort of people to start businesses is not a phenomenon that is about to disappear. Nor will the desire of lots of people to join these startups. The rewards (both tangible and intangible) that people get from founding or joining high growth startups is remarkable. More and more people are wanting to arc their career in this direction. The rise of the startup as a global phenomenon, and not just limited to certain geographies, is a profoundly exciting event of the past decade and the long-term secular trend is unambiguous.

We believe we have the right team executing the right strategy and with the right mindset and we couldn't be more excited about the next decade that lies ahead. Great companies are best able to differentiate themselves in difficult environments. That is true of our best performing portfolio companies, and we hope it is equally true of ourselves.

Thank you for your support!

We are grateful to all of our Limited Partners for your incredible support, and we are extremely excited to welcome all of our new partners into our new venture funds. 

All amounts are in USD unless otherwise stated.

Square Peg Investment Overview