VC’s New Denominator Effect

I remember during the financial crisis in 2008, a lot of people were talking about “the denominator effect”:

An asset-allocation problem called the “denominator effect” is forcing the selloff of billions in private equity and alternative investments.

-Fortune Magazine

In a nutshell: Stocks and bonds plunged in value but private equity and venture capital didn’t (because they aren’t “marked-to-market” the same way). The end result is that endowments and their ilk were holding a much larger fraction of PE/VC assets than they should.

So to get back down to their target percentage of PE/VC, portfolio managers had to sell some off. Fast forward to today, the public markets have roared back so those problems are a forgotten memory.

But there’s a new denominator effect on the horizon in venture capital and one which will start to get more attention in the near future.

When investors of VC funds (LPs) evaluate performance in the near term, they focus on total value. So with the rapid expansion in late stage valuations, a lot of investors are sitting pretty and feeling good about the numbers. In his recent LP newsletter, Josh Kopelman sounds the alarm to make sure the investors in First Round Capital understand what the numbers mean:

While we are happy with (most of) our funds’ performances, we want to stress that most of the valuation increases are “unrealized”, and until these companies end up in the “realized” column (through IPO, M&A or secondary sales) the valuations are just paper increases…and in today’s market we are seeing companies raise follow-on financing rounds at much higher prices than we have seen before.

“Unrealized” valuation increases means that shares of company that First Round owns in their portfolio have increased in value. They haven’t made any real money on them yet. This is the new “denominator effect” in venture capital, where unrealized value has grown so fast (thanks to the rapid rise of unicorn valuations), its ratio to actual, realized gains are skewed.

The optimistic expectation is that all that unrealized value gets transformed into realized value and the venture asset class performs really well for several years. The conservative expectation is that some of that unrealized value will transform into realized value but some of it will also get marked down.

What’s the reality we should expect in the future? Getting back to Josh Kopelman, he supports the latter expectation, as he ends his LP letter with:

we expect that several of our portfolio companies will end up being marked down over time (with many potentially being written off entirely).

That’s most likely how our denominator effect will deflate.

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