The PE Cure and the PE Trap
It’s almost impossible to talk about private equity these days without mentioning ‘Uber’. From being a no-namer a little more than four years ago, Uber has grown to become the largest unicorn (privately held company with a valuation of over $1 billion) in the world, with a valuation of north of a whopping $50 billion. It would have been unthinkable as recently as 10 years ago for a privately held company to be valued anything close to what Uber is valued at today.
Yet, Uber chooses not to go public, because going public involves a lot of hassles, most notably, having to comply with increased regulatory and financial reporting requirements. Further, going public requires the company to pay a lot of attention to the short and medium term to reward its shareholders. Staying private allows Uber to undertake massive expansion campaigns (through investors’ money) and scale up operations for the long-term, without being worried about quarterly results. This translates to a rapid expansion in valuation, which would be highly improbable if the company were listed and closely scrutinized by shareholders and analysts. Uber was valued at $18 billion in June 2014, and in July 2015, it raised funding at $51 billion. It’s hard to think of any publicly listed stock that grew 3x in valuation in one year. So when you find yourself (like Uber does) in a heating market and you’re under pressure to raise funds, simply don’t go public, just raise PE money and enhance valuation a lot more before you ultimately IPO. That is what I’m referring to as ‘the PE cure’ — the relief that PE funds provide.
Of course, PE firms expect a more than reasonable compensation for the risk they are taking. The conditions of investments by the firms which have invested in Uber are not known, but a ‘liquidation preference’ is fairly common — that is, that the PE investor will get x times its money back before the founders and the management get anything in equity returns. In some circumstances, PE investors successfully negotiate for a ‘participating liquidation preference’, which allows them to get back not only x times their investment, but also then to participate in sharing the proceeds of the remaining amount (in short, double-dipping). But that’s not the PE trap that I’m referring to — a PE firm does not have much leverage when it’s a late investor in an already hot company such as Uber, so I’d not imagine that the terms of their investment are too onerous.
The trap I’m referring to is the one that PE investors themselves may be falling into. It’s common for PE investors to envisage a 10x return on their investment in 5 years. If you’re investing at $50 billion, and you want to make 10x return in 5 years, that means Uber would have to be valued at $510 billion in 5 years’ time. Only Apple today has a valuation north of $500 billion. There seems to be some sort of a ceiling for companies, that you can’t just go on and accumulate infinite value, and so, it’s unreasonable to expect that Uber would continue its meteoric rise for too long. Competition inevitably sets in (think of the numerous competitors Uber already has), market saturates, technology changes (what if people don’t use cars much in the coming few years), among other potential causes for a slowdown.
For the first time, probably ever, we’re seeing companies receive an ‘illiquidity premium’ on their valuation, instead of a discount. This begs the question — what will be the exit for these investors? Will it still be an IPO? Will it be a controlled stake sale to smaller and smaller parties? Will it be a large M&A transaction? Or will the companies accumulate enough reserves that they actually buy back the shares they issue to the investors? My bet is the controlled stake sale to smaller parties. With further fin-tech innovations, it is not inconceivable that an individual buys 100 shares of Uber from Sequoia in a secondary purchase, completely by-passing the formal stock exchange system. In short, the future may hold for us a blurring of the lines of what’s private and what’s public. But for now, though, PE investors seem to be placing very large bets without a clear exit strategy.