Unicorrection
We’ve had a correction in Unicorn financing that has trickled throughout venture capital. A lot of people lost jobs, opportunity and wealth. You could say this began with the creation of a the secondary market for private equity, and the dust on Chris Sacca’s spurs. But the correction began with Fidelity’s very public markdown of Unicorn valuations, with questionable motivations that I don’t think have been questioned. The heart of this bubble pop wasn’t a RIP Good Times deck, but by public market actors trading semi-privately in the very currency that popped.
If you flash back ~ten years ago, secondary sales of stock in venture backed companies were rare. It was a buy and hold until acquisition of going public opportunity. For founders, employees and investors. Startups then disrupted this, like SecondMarket. And also some investors started to recognize that giving a little liquidity to founders who were proving out a company’s value might be a good thing. Let them take a little money off the table so they have some basis to not think they need to go take some other risk, and it really aligns a VC with a founder to create long term maximized value.
You see, most founders are pretty dirt poor and trying to change that. And the average VC might be, but let’s say has a different risk profile. They both work with someone else’s money to get there. Founders have a couple shots at it, sequentially. And if they get one to go well they win big. VCs are spreading it across the roulette table and have lots of shots at it. Founders play a game mostly of skill, and this is where my gambling analogy breaks down, while VCs play games of other people’s skill, largely. Oh, and the information. This is what they call an asynchronous market. Where one side supposedly has more information (they gal selling stock in they company they founded has more than the dude buying). Reams of research of have been done by venture associations that seem to be based in Nevada to help that buy side make better decisions in that golden moment of buy or naught.
But it boils down to this. Venture is the most inefficient market left. Nobody really knows what they are doing, and if they say they do it’s a lie with intent. Nobody knows what the real value of anything is, all they can do is to point to the intention someone else had. Or what they settled on. And this is done with less actors and more prone to manipulation, so it’s the intent of others that ends up ruling the day. Unless you are really building something where you can say no to someone. A lot. Consistently. Not just the VC’s who’s primary job it is to say no. Or the founders/execs who create by saying yes until they get to the point where they say no enough until they say one big fucking yes. Then everyone says yes yes yes. This is not a metaphor for sex. This is the way value gets created in the valley. World famous value.
When this value is world famous everyone wants a part of it. Public markets and IPOs have been the rightful home for it, and what leads companies to be as close to be as good actors in the world as they are capable of. But something cut off the startups in ascendance to their righteous IPO enlightenment. Trades
A more well known example of secondary markets getting ahead of the IPO market was when Chris Sacca was buying up employee shares of Twitter, and then started to get leverage from investment banks to do it. It’s a great arbitrage. You’ve got a media darling hard startup at the mezzanine stage. Lots of employees who feel they have created value and are ready to lock some of it in. And buyers who would love to get in before that IPO pop. Sacca made a lot of money for him, investment banks and the high net worth individuals that trade in the currency of favor. Buying low and scarce, selling high and scarce. Might be a little hard for management to manage, but up to this point, I think everything in venture land is cool.
Somewhere a dude with a deck said to the institutional investors that they should get into the offer before the initial public offer. Not as LPs. As direct investors. And they could take mutual fund mom and pop funds to get in before that pop. And they did. More money than god suddenly became available for the companies that could justify they were on the track to go public. Someone who had kids and read fairy tale stories, but more importantly knew that what they did at work was becoming that weird, coined the term Unicorn. They story got a lead actor driving supporting actors around town for free and we were off to the races. Justify a $1B valuation on paper? You are in the cheap money club, where terms be damned, everything goes up and to the right.
But then there was the markdown. Fidelity, with whom I have an IRA somehow but have never pitched, marked down the value of some Unicorns like Zenefits, Dropbox, MongoDB, and Snapchat. This had a chilling effect, but first it’s important to understand the non-valley stuff in this sentence means. When a public market actor owns a security, they need to mark-to-market the value of the investment on a daily basis. Fidelity invested in some private companies before they theoretically went public from it’s Growth Fund that largely invests in blue chip publicly traded companies and needed to report on the performance of said fund. But these private companies don’t have minute by minute price setting. They did this starting in July 2015, with it being disclosed in November 2015.
What followed was a massive correction in private equity valuations, all the way down to the initial seed market. The bar got progressively higher to raise rounds, and valuations crammed down, at all stages. Every investor rightfully worried about the round after theirs. Made sense when the last round before public was crammed by Fidelity, and most of the few IPOs went through the window instead of the holding pattern that feels like a victory lap, underperformed. The next Uber (in an alternative reality) couldn’t raise their first $500k.
But why? Not because US consumer or enterprise spending wasn’t doing great. Not because US equity markets where companies weren’t doing great (today they are in an all time high). China had it’s first big test to growth and other parts of the world still in malaise. But there wasn’t anything stopping the growth of free consumer apps, consumers paying for apps, enterprises trying and spending on shit. Well, there was the fact that there was so much funding for noise and ads and competition. But in the market that matters that creates instead of betting on value, not much had happened.
In April 2016, 9 months later, what we find happened is that Fidelity bought some stock in SpaceX on the secondary market and as a result marked up its value. They marked it up again in February for reasons we don’t know yet. And we don’t know how or why they marked down all the other companies. Other mutual funds are marking up and down companies they have stakes in. There isn’t a Chinese Wall like in regulated public markets were research issues buy or sell recommendations, and the other side of the house does trading around it. Not that that wall is Chinese, or exists, but at least it sounds like America is great and the average investor isn’t being manipulated.
So my concern is if heretofore regulated public institutional investors manipulated the market prices of Unicorns to their favor. Either picking winners by creating information or selecting it, perhaps activating their Sharky terms of the investments they made? From what I can gather Fidelity is one of the best actors, which is perhaps why their actions had such a broad effect, but I don’t understand why this hasn’t been looked into.
And these new price signals from public actors been overweighed in private markets? VC values used to lag the NASDAQ by one year. Has the long term investment industry gotten short, at least in thinking? How will private and public markets align, when not around exit value?
I believe there was a glut of capital at the unicorn and seed stage, and valuations needed a correction. This one was far healthier than past ones. Generally a good deflation. But the heart of the bubble seems corrupt and unreported, and good private market actors have had trouble adapting. We may in a new world where public market volatility is more closely correlated with the private market, but the first fat tail sent everything into too much contango. I don’t think the story of this bubble and it’s deflation has been told, or that the above is it, and I can’t wait to read it.
After a little feedback, to the above, here’s some clarification…
This is all about an unnatural mix of public and private markets. Mutual funds rightly are required to mark to market the value of their investments. Private equity is largely illiquid by nature, and the mechanisms for valuation can vary. And the new actors in at least this one case are setting the value by making a trade. The SEC, is looking at how to regulate this space, and that may even mean getting private companies to disclose financials:
“There’s a lot of excitement about the unicorns, and some concerns that have been raised in that space,” SEC Chairwoman Mary Jo White told a conference in January. “Individual investors … may get very excited from an article or a blog and invest their money, and so you worry about them not getting sufficient or accurate information.”
Private investors and management could also worry about regulate risk. And if they sold stock to a public investor, how that investor might trade in the illiquid secondary market to their own broader advantage.
This correction was clearly a first and over-reaction to a new dynamic in private equity with public investor participation. Markdowns and ups to come will likely not have as broad of an impact. It may mean that late stage financing will trend towards being an Over the Counter (OTC) market with greater regulation.
But really, these Unicorns should just go public anyway.
Postscript
VC Stuart Peterson after having a monumental exit with Stemcentrx, took a shot at Fidelity’s markdown:
What bothered him about Fidelity was its nearly 38 percent markdown of its estimate of Stemcentrx’s valuation earlier this year. The mutual fund giant led the company’s last round in the fall which valued it at about $5 billion.
But another large mutual fund investor in Stemcentrx didn’t mark down the company and is looking more prescient today.
“When Fidelity made the markdown a few months ago, I thought about writing an open letter and offering to buy Fidelity’s $40 million in stock at a $5 billion valuation. I figured they would have no interest in that, though,” Peterson said.
He predicted that now that the stock market has been recovering, there will be headlines coming this year about private market valuations rising, too.
“I think they are trying to be as independent as possible but I think they have taken it to a level that is nonsensical. It’s just wrong. I don’t know what the solution is but that’s not the solution,” he complained.
“Fidelity marked us down 40% while we were trending upwards,” Slingerland told me, noting that he was told the decision was driven purely by an audit committee and that the portfolio manager didn’t agree. (A Fidelity executive talks about its private tech investing here.)
“It is insane to have an audit committee determine your valuation,” he added, saying the writedown earlier this year caused anxiety among multiple parties that had been interested in acquiring Stemcentrx. “The assumption [with a writedown] is that the investors know something. They didn’t.”
And then, Fidelity marked up in March:
Fidelity wrote up the value of software firm Domo Inc. by 68% after marking it down 29% in February. Stemcentrx Inc., the cancer-drug maker that AbbVie Inc. said this past week that it was acquired for up to $9.8 billion, was marked up 61%, back to the value Fidelity paid for the shares in August.
…Cloudera Inc. and Nutanix Inc., each up about 20%, as well as storage firm Dropbox Inc., up 14%. Fidelity marked up ad-technology company AppNexus Inc. and software firm MongoDB Inc. over 20%. All five of those companies’ values are still down overall since December, due to prior markdowns in January and February.
T. Rowe Price Group Inc. marked down most of its investments in closely held technology companies for the month of March, including Uber Technologies Inc. and Dropbox.
At least 13 startups have one or more mutual funds marking their stakes at below the price the funds paid, according to The Wall Street Journal’s Startup Stock Tracker. Still, many have delivered big gains to the funds, including Uber Technologies and Airbnb Inc.
…Those investors receive the current net asset value for the mutual-fund shares when they buy or sell. If, for instance, the fund firm holds the valuation of an illiquid startup steady despite a rapid decline in the overall market, the net asset value of the fund might be artificially high. That would benefit those trading out of the fund at the expense of those buying in.
