Liquidity Concerns in a World of Excess Capital
Flipping the common notion of liquidity crises on its head, venture capital (VC) investors may face systemic risk from an abundance of capital, not a lack.
Historically low interest rates and almighty valuations in the public financial markets, are channelling huge flows of capital into illiquid venture capital investments. Mixed in with fraud, and market manipulation(?), this could spell disaster for shareholders.
VC FUNDING
Private markets have historically been an avenue for superior returns, for investors who have been willing to tie up their funds for a little longer than usual. Thanks to the lack of market pricing for companies on a day to day basis, shareholder transactions are harder to conduct, as aspiring investors have to contact, and then negotiate the sale of the shares with the existing owners, that is, if the owner will even pick up the phone. The flow of funds in and out of a market is referred to as liquidity, or illiquidity (the absence of fund flows). The inflow of funds into capital markets usually creates high liquidity, as each existing shareholder has the chance to sell their share to the new investors. The same cannot be said for venture capital.
The inflow of funds in private markets is not an inflow of liquidity. Existing investors see none of this new capital, and cannot use it to exit positions. Instead, the inflow of funds is the marginal pricing, that ticks up paper valuations. This paper mark up (in share price) then often justifies the behaviour of investors, who begin making dumb decisions on the basis of higher valuations. Despite the lack of liquidity, funds keep coming, especially into US growth equity where the magnitude of funds in these illiquid investments is then creating a leverage effect. In short, the demand for limited investments accelerates valuations, but leaves investors holding the bomb, should valuations take a turn.
PREFERENCE STACKS & ZOMBIE SHARES
A little bit of explanation regarding the structure of venture capital investments wouldn’t go astray here. Term sheets are commonly used by large VC funds, which outline the terms the fund will invest on, with it being not unusual for funds to demand preference shares, as opposed to common equity. The preference stack (preferred equity) sits on top of the common equity, so preferred shareholders get paid before common investors. When the preferred shareholders are the ones writing a $200 million cheque, and saying “your price, my terms,” you risk getting complicated exits where the preferred shareholder may be getting 60% of the exit, rather than 20%.
How does this happen? Let’s suppose the VC fund is investing $200 million in preferred shares at a $1bn post valuation. The term sheets shows the founders have agreed on the $1bn valuation, but the VC fund is guaranteed a 3x return on investment upon the sale of the company. Now this isn’t a problem if the company increases to say, $3bn in value — the VC fund will receive $600 million, and all other shareholders will receive their share of the remaining $2.4bn. But, if the valuation remains at $1bn, then you get a situation where the VC fund will receive $600 million of the sale, leaving only $400 million left for the remaining investors. Should the valuation drop, then the situation has the potential to wipe out the common shareholders stack entirely.
The concept of zombie shares is the result of what has just been described through preference stacks. In a sentence, Zombie shares are being created from a lot of money going in at very high prices, that has caused marked-up paper prices that investors will never see to fruition due to the illiquidity created by excessive valuations.
SOFTBANK & LEGAL MARKET MANIPULATION(?)
When Mark Andressen of the VC firm Andressen Horowitz said, “ it doesn’t really matter what price you invest, because in any given year, there are only really 10 companies that you want to be in, and price [you pay] won’t matter because the returns will be huge,” he put his foot in it, so to speak. The statement from one of venture capital’s heavyweights, is effectively a hall pass for excess valuations. Unfortunately for other VCs, overfunding start-ups isn’t a great way to bolster their success. The biggest problem is that although 10 companies per year may provide such gigantic returns that price doesn’t matter, i.e. buying into Facebook when it’s already valued at $1bn, the biggest trouble is finding which ones are eligible. The sensible investor then has to maintain price discipline to avoid sinking the ship on a shoddy pick. That is, unless they have the capital to create there own success. Enter Softbank.
The $100bn Vision fund run by Softbank is reported to have generated an average 44% IRR per year since 2000, a feat that seems almost unbelievable given the size of funds. And, it might well be. Softbank’s parent company is said to be heavily indebted, while the fund is the preferred investor of the Saudi pension fund. The collaboration of these forces understandably creates huge pressure on the Softbank management team, who are held responsible for maintaining the survival of both their investments, and the fund itself. Hence why it’s not all that surprising that Softbank has been shown to invest in companies that they can reinvest in later. Their history of reinvestment is theorised to be done to inflate the value of their holdings, allowing them to show paper returns against their equity holdings, providing collateral to a massively indebted parent company. Their preferred status and size as investors means their company valuations are used as a reference point for smaller investors trying to join in the companies, giving them the ability to control company valuation in subsequent funding rounds.
Whether or not we can consider Softbanks tactics as market manipulation is outside the scope of this article.
However, there is little doubt caution must be practiced when placing venture investments. The over prominence of funds in US venture capital has created worrisome conditions, where excess funding has leveraged companies, increasing the risk of valuations going to zero in subsequent revaluations, when operations don’t pan out as planned.
