One of the major roles of equity markets is to supply capital to young and growing businesses. In recent years, however, companies have relied much more on private capital in the form of venture capital for growth finance. For this reason, they have been coming public much later in their life cycles, particularly in the US.
The current year was expected to see a huge flood of venture capital funded businesses list for the first time as venture capital could no longer support these loss-making businesses at the scale they had reached. Examples such as Uber, Lyft and WeWork spring to mind.
All has not gone to plan, however. Public markets have been much less forgiving of high valuations for loss-making businesses, particularly where there is no obvious path to profitability. This culminated in the spectacular failure of the WeWork float, a privately financed serviced office provider that somehow expected a valuation of around $50bn. WeWork’s business model is to lease office space and sublet it in small open plan offices. Its hoped for valuation, and indeed the valuation that private equity had been financing it, was similar to the value the property market would apply to the freehold interest in the same properties. In essence, the venture capital backers believed that renting a building and subletting it at a loss had somehow created more value than simply owning that same building.
That and other bubbles now seems to have burst. It seems to have inflated as a result of excess demand for alternative assets, with low correlation and high returns, combined with a scarcity of large-scale opportunities to invest in truly attractive new business ventures. This rush into private equity investment dragged in a number of high profile but otherwise inexperienced investors such as Japan’s Softbank and others. With more money to invest than the available universe, valuations of private companies now appear to be materially higher than public companies.
It is probably not just too much money seeking too few opportunities that has led to this situation. Another feature of private equity is the fact that only the buyers set the price. In situations where only one fund is providing the new capital, the price will be the buyer’s price. Often the buyer will have an incentive to set a higher price than before, thus proving its valuation of existing investments.
In public companies, once the flotation has taken place both buyers and sellers set the price, this is a much harsher environment. Although short sellers are often maligned, they perform a risky and important role in ensuring valuations reflect all views not just those with a vested interest in rising prices. Only public markets have this feature.
Whether the current meltdown of recent IPOs will have broader economic implications is not clear. What is clear is that the vast amounts raised by recent VC funds is not likely to be repeated. We can also be fairly sure that much of this money has been squandered on projects with little or no prospect of creating long term value. However, even if we assume that all money that has recently been invested in VC funds has been wasted, its impact on overall economic activity its relatively small.
We think the more likely impact will be on financial markets. We have for some time been expecting a more discerning market, one that is less willing to pay high valuations for sales growth, irrespective of profitability. For this reason, we are more focussed on quality growth businesses with high margins and established business models.
The value of stock market investments will fluctuate and investors may not get back the original amount invested.
Forecasts are not reliable indicators of future performance.
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Source for information: Miton as at 31/10/2019 unless otherwise stated.
The views expressed are those of the fund manager at the time of writing and are subject to change without notice. They are not necessarily the views of Miton and do not constitute investment advice.
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