This article is co-authored by Lindsay Sharma of Industry Ventures.
After a prolonged absence, investors more traditionally focused on the public markets have recently played an increasing role in venture capital. Over 50% of the current 108 unicorns (>$1B valuation) have been financed by public investors; while, 7 of the 9 “decacorns” (>$10B valuation) have institutional investment. It’s no secret why companies are increasingly drawn to this source of capital. Public-market investors have longer-term investment horizons, deeper pockets and, most importantly, different motivations and return targets than most VC firms. Many have cited public investors’ emergence in the asset class as an indicator that we may be in a period of “irrational exuberance,” with valuations soaring relative to historical precedents. While we would agree that we are in a valuation environment unlike any we have seen for 10+ years, we can also see why the emergence of public-market investors may be perfectly rational—as will be their eventual retreat.
Not the first time public investors showed interest
While the absence has been prolonged, this is not the first time public-market investors have actively participated in the VC market. Prior to the mid-’90s, the technology capital markets worked in very clear ways, with everyone playing their roles and getting their fair share of the gains. Venture funds were smaller and could only fund companies through the launch of products and early sales efforts. Once the sales model was proven, venture-backed companies were forced to tap the public markets for necessary growth capital. This meant that time to IPO was typically less than 5 years, and companies were going public with market caps of $125-250M—a far cry from today’s 7-10 -year journey.
As the tech markets moved onward and upward, both VCs and mutual funds increased in scale dramatically. In 1999, the VC community had invested over $40B of capital in investments, and mutual funds had expended AUM to over $6T (a growth of $5T since 1990). The ability of venture funds to privately finance their best companies, and the sheer scale of the public investors fundamentally changed the IPO landscape. In the wake of the market correction in 2001, the time to IPO nearly doubled, and mutual funds quickly sold out of their positions in private companies as they faced redemptions.
As recently as 2009, the NVCA was publicly concerned about the lack of interest in venture capital from public investors. How quickly things change. What has driven public investors back into the private markets? First, investors have accepted that the public offering has been transformed as IPO-ready companies choose to stay private longer, accessing growth capital through late-stage rounds. The average VC-backed IPO now raises close to $90M in capital prior to IPO, compared to $31M back in 1999. Much of the capital appreciation that used to accrue in the public markets is now accumulating while a company remains private. Second, in today’s environment with interest rates close to zero, public investors are hard-pressed to find many opportunities to drive outsized returns. As a result, public investors have dipped into the venture capital asset class.
Capital & Returns Shifting from Public to Private Markets
The increased competition to gain access to later-stage companies and pre-IPO rounds has driven up pricing, as public investors angle to get an allocation. Matthew Walsh, managing director in BAML’s Technology Equity Capital Markets team, has observed this trend, noting that “in low-interest rate environments, investors typically move out on the risk curve in search of return. Valuations of higher-risk asset classes, including private technology companies, have benefited. Many companies have taken advantage of the relatively inexpensive private capital and delayed an IPO. The resulting lack of tech IPOs has driven more public investors into the private markets, pushing valuations further.”
This surge in pricing has fueled bubble discussions and even drawn into question whether mutual funds and hedge funds have the required skills, context and motivations to be rational actors in the market. However, on a relative basis, their participation may in fact be quite rational. With time to IPO over 7 years and the average offering size less than $150M, if institutional investors want to gain access to a company’s rapid growth and build a meaningful position, they almost certainly have to get involved prior to IPO. Furthermore, public investors are measured by total annualized returns relative to benchmarks, not by an investment multiple and IRR. Therefore, what may be an irrational valuation to a venture investor may actually be quite rational to a public investor, especially when contextualized against the investor’s overall portfolio.
Have they been right?
It’s too early in the cycle to start calling winners and losers, but the data would suggest that the strategy has been more successful than the popular narrative would lead you to believe.
The average year-end gains for IPOs in 2013 and 2014 were 47% and 24%, respectively, greater than returns obtained from most other sources. It’s even higher in the more sizable IPOs, with an average return of 56% in IPOs with valuations greater than $1B. In 2014, 73% of the previous venture rounds were priced at a discount to IPO, resulting in even greater gains to those public investors who dared to invest in companies while they were still private.
Mutual funds and hedge funds go to great lengths to protect their downsides by primarily targeting later-stage private companies with revenue and real business models, where binary risk is limited. Furthermore, institutional and other late-stage investors have also started incorporating ratchets and other structures in high value transactions, which companies are willing to accept in order to join the unicorn club.
Box has been consistently highlighted as an example of what can go wrong in high-priced, late-stage deals. At face value, Series F participants priced the last private round at $20 per share, well north of their $14 IPO offering price. But according to the S-1, these investors in an IPO were guaranteed to convert at a share price of $20, and if the offering price was less, they would be granted that difference in additional shares, plus a 10% premium. At the stock price today of $17.50, without the ratchet, the Series F would have lost 12.5%. However, with the ratchet, the Series F investors converted into common stock at a 1.6 ratio and are now up 40% on their position.
Since private investments only constitute a small portion of an institutional investor’s fund, even if some of the unicorns are unable to go public or decline after IPO, the impact on overall fund performance is limited and the risk/reward trade-off is still in their favor.
How does this impact the VC landscape?
The VC investments that mutual funds are making have a limited impact on their overall fund performance, but the impact mutual funds are having on the VC landscape is far-reaching. The top mutual funds that are participating in late-stage funding have over $300B in AUM, and even a 1% allocation means $3B of additional funding flowing to late-stage companies. The success Fidelity, T. Rowe Price, and Blackrock have demonstrated by investing in the space in the past several years has driven increased interest among other mutual funds, with pre-IPO crossover volume increasing significantly in 2014 and 2015. The most obvious and acute impact these investors have had is on valuations. Late-stage valuations continue to grow as investors compete for access to transactions, with growth premiums outweighing any illiquidity discount. With the increased valuations and structured preference, the potential concern is whether many of these companies have given themselves little room for error when it comes to execution and potentially have priced themselves out of M&A exit opportunities.
When does the party stop?
It’s difficult to predict how this will end. However, there are several potential drivers that could steer institutional investors away from the private markets. Mutual funds have the liquidity and flexibility to chase outsized, risk-adjusted returns; so any relative market changes, such as an increase in interest rates, could result in better returns elsewhere. When the dot-com bubble popped, mutual funds exited the market as quickly as they entered. Absolute changes in late-stage, venture-backed businesses could also drive a shift, especially if revenue growth slows prior to an exit and requires continued external funding to sustain growth. This could quickly spiral if mutual funds continued to pull out, resulting in reduced growth capital available for companies at the moment they need it most.
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