John Stepek asks whether the failure of some much-hyped IPOs signals the demise of the start-up private funding market
Public ownership is so 1990s. The real money these days is made before companies go public on the stock market. By raising funds in private markets, firms can grow, free from the pressures of quarterly reporting, regulation, tight scrutiny and demanding retail shareholders.
In the US, the number of listed companies has almost halved since peaking in 1996. It’s a trend that accelerated after the 2008 credit crunch saw interest rates collapse, making debt funding more attractive and easier to raise for entrepreneurs.
This is a key driving force behind the boom in the valuations of privately backed companies. The rise of start-ups backed by venture capitalists (VCs) and private equity firms has gifted us the term “unicorn” – an unlisted company valued at more than US$1 billion.
The idea is that investors get in early on the most exciting companies, which are usually technology-related, and the funds are used to grow the start-ups. Then backers “exit” – selling either to another private backer or by listing the company on the stock market (via an IPO – initial public offering), multiplying their initial investment.
At a time when interest rates are low and attractive returns hard to come by, this is an appealing story. Institutional investors and sophisticated private investors have queued up to get exposure to private equity and VC funds. According to data provider Prequin, cited by Bloomberg, the big players started 2020 with nearly US$1.5 trillion in “dry powder” (Wall Street jargon for “money sitting waiting to be invested”); a record.
However, the rush for unicorns suffered a reality check last year, as the venture end of the industry suffered an “annus horribilis”. Much-hyped IPOs, such as Uber, flopped when they came to market. The biggest disappointment came with We Work. The office space rental group was scheduled to go public last year, with its main investor, Japan’s Soft Bank, hoping it would list at a value of US$47 billion. In the end, the IPO had to be scrapped when it looked as though the most it could fetch would be well below US$10 billion. We Work founder and chief executive Adam Neumann left the company and Soft Bank had to step in with emergency funding.
So is this it for the boom in private markets? Not necessarily. Plenty of deals are still being done at exuberant valuations. Shuli Ren, for Bloomberg Businessweek, notes that, according to a recent study by Will Gornall and Ilya A Sterbulaev published in the Journal of Financial Economics, the average “unicorn” is still priced at 48 per cent above its fair value. With all that “dry powder” flooding into funds that need to invest it (you don’t pay VC and private equity fees to have them stick your money in a cash account), it’s hard to see the deal flow drying up any time soon.
What does it mean for your own money? You should be aware of two main points. If you are considering investing in private equity as an asset class, bear in mind that the estimated returns to private equity are quite possibly overhyped. Because companies aren’t traded in public markets, private equity valuations are more subjective than those of firms trading on the FTSE 100.
Reality check
A good example of the difficulty of valuing unlisted companies comes from Neil Woodford’s fund empire. His flagship fund was forced to stop investor withdrawals last year because he held too many stakes in unlisted companies that were impossible to sell at short notice for the valuations assigned to them. Since then, there have been several write-downs on the value of those firms, illustrating clearly that you only know what an asset is worth once you’ve managed to find a willing buyer for it.
The second point is more relevant if you are tempted to buy into any of the IPOs of the bigger VC-backed companies. The hefty valuations put on some of these firms in the private markets may not reflect reality. As the JFE study points out, many late-stage investors have protective clauses attached to their investments, which will compensate them if the IPO disappoints – protections that ordinary investors don’t have.
While there may not be a bursting of the unicorn bubble, any sensible investor should view it as a warning sign. When you invest in a sector characterised by high fees and a lack of transparency, someone involved in the process may well make out like a bandit – but it almost certainly won’t be you.
