Unicorn markdowns widely misunderstood

Likely to precipitate bursting of the bubble rather than presage it

Are we witnessing the popping of the most recent tech bubble?

Over the past few days there has been much discussion of large investors like Fidelity Investments marking down their holdings in “unicorn” startups like Snapchat, Dropbox, Zenefits and Blue Bottle. Widely followed tech publications [Techcrunch] have been forecasting the popping of the tech bubble for a few months now, but even mainstream news outlets [ Wall Street Journal, Vanity Fair] have used the news of Fidelity’s markdowns to call the end of soaring valuations.

However, the markdowns are likely an artefact of traditional portfolio valuation reporting methods rather than a logical outcome of the bubble popping; the widespread misinterpretation may actually cause the popping of the bubble rather than presage it.

The typical investment vehicle participating in these mega-rounds of equity is usually set up as a mutual fund, hedge-fund, private-equity fund, family office or sovereign wealth fund. Fund managers have to report the “market” value of their holdings to their investors on a periodic basis (by law in most jurisdictions). These funds increasingly include both private and public companies. The public/listed securities in the portfolio are very easy to account for since their market valuations are readily available from the exchanges. However, private market holdings (like positions in Uber and Dropbox) are much more complicated to report on — and those of us who are caught up in quarterly and annual reporting activities have long realized that this is as much art as science.

How does a markdown come about?

Without getting too detailed or specific, the typical private market portfolio is put through a valuation exercise that (in very general terms) goes as follows:

  1. Generate forward and backward looking financial metrics, sometimes presented as scenarios (base, upside and downside cases) for Revenue, EBITDA, Net Income, Free Cash Flows, etc.
  2. Look at comparable companies (listed/public company metrics) and comparable transactions (equity investments and M&A activity); despite imperfect information in some cases, develop estimates of the range, high, low, mean, and median multiples of financial metrics that drove these valuations
  3. Applying ranges of the multiples from comparable companies in (2) to the metrics in (1) above, come up with a reasonable valuation range.
  4. Then pick one value in the range that you would report as the value of your holdings

Note that all the steps above are fraught with subjectivity: both in choices of comparable companies, and in choices of the final value reported across a large range of possible valuations. And reporting a valuation for a private company holding is just half the story.

Behold the auditors

Most funds are audited by an independent auditor — sometimes more than once depending on how the vehicles are structured. They question both the quantitative elements of valuation ranges reported and the investment professional’s subjective view of how the company is doing.

A markdown can happen for several reasons:

  1. The comparables went down in value
  2. Conservatism has moved the fund manager’s estimate lower down in the range
  3. There has been a material change in the operating performance of the company
Across the board markdowns in recent times indicate (to me) that it is more of (1) and/or (2) rather than (3).

So why does the spate of markdowns matter?

With holdings like SnapChat (or any private company for that matter), there are certain accepted practices as part of the valuation process. For example, most auditors will allow you to maintain the price you paid as the “carried at cost” value since that was the most recent “market” transaction that determined a price. But the period for which an auditor will allow you to use your own price as the “market” value does vary.

In negotiated market deals it is possible that an investor pays at the high end of possible valuation ranges but a more conservative view of the same metrics emerges as the security is held past the initial “carried at cost” period. Based on the subjectivity highlighted above, you can end up at a significantly lower valuation of a private company even if nothing materially changed at the company. The most sensitive elements of this change are public market comparables and the investment professionals’ own sentiments — how conservative they want to be.

Auditor guidance tends to be guided by “precedents”. This is where the markdowns can become a self-reinforcing spiral since subsequent rounds at other unicorns will now reference these markdowns which in turn will drive down comparables based valuations in other company holdings.

In my view, we are probably at the tail end of a bubble. But it behooves all of us to be aware about why large institutional investors do what they do so we can make informed decisions about how to react to news so we do not hasten the inevitable.

Note: I am not affiliated with any of the funds or companies referenced in this post and all statements about valuations and valuation methods are generalizations to make a point. All opinions are my own and personal.

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