WARREN BUHAI: Overdressed unlisted assets stripped naked as world eyes interest rates

When investors woke up to the fact that Silicon Valley Bank’s (SVB) business model was a leveraged play on the flow of venture capital into loss-making technology companies, it started a US regional bank “crisis”. In many ways the events surrounding SVB point to the fragility of unicorns — unlisted companies with valuations of more than $1bn. 

Private markets have exploded over the past two decades. Private equity and venture capital funds have attracted enormous quantities of assets from investors keen to harvest what has become known as the “illiquidity premium”. This is the additional return investors should rationally require to invest in assets that cannot be easily converted to cash.

Private markets also give institutional investors and wealthy individuals exposure to new or yet-to-be-listed technology platforms, and a world of innovators deploying smart tech to capture huge market opportunities.

Paradoxically, unlisted assets are also sought-after because it is hard to calculate their worth. Unlike listed shares, the market typically only “discovers” the value of equity in a private company every couple of years when the company raises fresh capital or is sold or listed.

Unicorns, as the name suggests, were once a rare breed. There were fewer than 50 in 2013, but by Q3 2019 there were 404 in the world, with a combined valuation of $1.3-trillion. Excessive monetary stimulus by central banks in response to Covid-19 turbocharged their growth. Today there are 1,207 unicorns with a combined value of $3.8-trillion. To put this number in context, there are now fewer than 2,000 listed US companies with a market capitalisation of over $1bn, including some former unicorns that listed in the past three years.

Correction

There are several indicators that private asset valuations are too high, but the correction is only beginning slowly. The first is the percentage of new companies listing in the US with negative earnings. This percentage has remained at 75% or above for the past six years, an unprecedented sequence since the 1980s. 

The second indicator is the performance of the shares of newly listed unprofitable companies. Shares falling below their initial public offering (IPO) prices indicated that private markets have become disconnected from public markets. Only 22% of US IPOs over the past 12 months have produced a positive return, and the median return of those IPOs is minus 38%, compared with the S&P 500 return of minus 8%.

Of the five largest unicorns that have held IPOs since 2019, (Didi Chuxing, WeWork, Airbnb, Grab and DoorDash), only one has delivered a positive return since listing (Airbnb), though it has fallen 43% from its high. The shares of the other four are down 70% on average since their IPOs (all data up to end-March 2023). 

Our third indicator is valuations of unlisted companies, where there are mixed signals from the US IPO market (to get a sense of how private valuations translate into public markets). Looking at the price-to-sales multiples of US IPOs on their first day of trading, there were two conspicuous periods of exuberance. In the dot-com era of the late 1990s, when technology companies dominated new listings, the median multiple peaked in the 40-times to 50-times range.

In the current cycle valuations have been elevated for longer than in the late 1990s’ cycle, but the median tech IPO multiple has already fallen to six times in 2022, whereas the median multiple for all IPO listings rocketed to 902 times in 2022. This appears partly to reflect the low number of US IPOs in 2022.

It also reflects the low level of sales, on average, relative to the valuation they were able to capture on the first day of listing. This is a continued warning sign that the market’s appetite for speculative investment has not completely disappeared, even though the cost of capital has continued to normalise.

Precarious position

The obvious question for private market issuers and investors is whether the normalisation of listed equity valuations will feed back into private markets, and if so how quickly and with what consequences.

Markets are in a precarious position given the uncertain outlook on inflation and the path of interest rates. While there has been a retreat in certain observable valuations, this may be just the tip of the iceberg of capital misallocation. Investors who fell into the arms of the private markets in haste, fearful of missing out on promised low volatility, uncorrelated returns, may now be repenting.

As interest rates rise, these investors find themselves trapped in an overvalued and illiquid asset class. That’s bad news if rates stay higher for longer than expected, as the clock is ticking on those cash-burning business models.

• Buhai is senior portfolio manager at Stanlib.