Unicorns revisited: reaching new levels of irrational exuberance

We warned of the fragility of the unicorns (unlisted companies with valuations over $1 billion) in our first take in 2019. Today the potential for sizeable corrections in unlisted assets looks even greater. Misallocated capital is likely to be destroyed as business models based on a historically low cost of capital are repriced.

Warren Buhai

Senior Portfolio Manager

Key takeouts

Covid-19-related monetary and fiscal stimulus has fuelled bull markets in risk assets. Private markets have boomed on a combination of abundant liquidity, investor appetite for an apparently less volatile asset class and the emergence of high-profile, capital-hungry start-ups.
Enormous inflows into private markets have tripled the herd of new unicorns since 2019.
After 15 years of historically cheap money, central banks are finally normalizing interest rates to fight inflation. Risk asset valuations should rationally decline to reflect the impact of higher discount rates on the present value of future cashflows. We are starting to discover how this will play out as liquidity dries up.
This will cause a negative wealth effect, which is one of the indirect ways for central banks to reduce consumer confidence and ultimately consumer spending, to fight against inflation.

When investors woke up to the fact that Silicon Valley Bank (SVB)’s business model was a leveraged play on the flow of venture capital into loss-making technology companies, it kicked off the ongoing US regional bank “crisis”. SVB has highlighted the fragility of unicorns, which we first raised in an article four years ago.

In that article, we discussed the financial markets’ appetite for cash-burning technology businesses and negative-yielding government debt as the world drowned in central bank-sponsored liquidity, click here to read the full article.

Describing the four years since we published that piece as ‘eventful’ would be the understatement of the century. We have seen:

the first global pandemic in over a century
the steepest bear market in the history of US equities
the largest monetary stimulus in US history
the steepest recovery to new highs in the history of the US equity market
a negative oil futures price for the first time in US history
the first conventional war in Europe since 1945
the highest inflation in over four decades
the steepest US interest rate hiking cycle in over four decades
the second- and third-largest bank failures in US history.

Will they ever learn?

It was impossible to forecast the pandemic, but the way that governments and central banks reacted was far more predictable. It was reminiscent of what we were writing about in late 2019: extravagant fiscal and monetary stimulus, apparently aimed at keeping risk assets buoyant, while ignoring the possible long-term consequences.

Governments and central banks were initially applauded for coming to the rescue of households and businesses dislocated by the Covid-19 lockdown. They managed to head off a savage recession at best, or a depression at worst. But ‘no good deed goes unpunished’. The world is currently enduring a major unintended consequence of their efforts: the biggest wave of inflation for forty years. Central banks, conditioned by recent decades of globalization to see the world as a structurally disinflationary place, initially characterized inflation as the ‘transitory’ effect of Covid-19-related supply chain disruption. Ironically, they failed to spot the effect of their own monetary and fiscal medicine. Prices were rising due to increasing demand for goods, as well as temporarily reduced supply.

We warned about the risks of policy change two years ago (Read full article here). By the time it became clear that the economy had been over-stimulated, the US Federal Reserve (Fed) found itself behind the curve. To re-anchor inflationary expectations, it was forced into a steeper rate hiking cycle than the financial system had seen for over 40 years. Interest rates are a pretty blunt instrument for fine-tuning the sprawling US economy and hikes only take effect months later. A popular saying is that the Fed will tighten ‘until something breaks’. We have seen these upsets in the past (see our behavioural cost of capital Chart 2 below), so now we are wondering: ‘What are they going to break this time?’

From TINA to TARA

It has been a rollercoaster few years for the cost of capital. At the end of 2020, the absolute value of government bonds in the world offering a negative yield reached a new high of $17.8 trillion. Then central banks’ belatedly aggressive rate hikes last year plunged global bond markets into one of their deepest bear markets in recorded history.

The positive result was that most of the negative-yielding debt available for investment was eradicated, finally making bonds an alternative asset class again for multi-asset investors. It has taken a long time to move away from the endless talk of the “TINA” (There Is No Alternative) option of investing only in equities (listed or unlisted), to the “TARA” (There Are Reasonable Alternatives) world we have reached after a brutal drawdown year for both major asset classes, equities and bonds.

Equities get a valuation wake-up call

Apart from positively resetting bond valuations, rising bond yields have also had an impact on equity valuations. It became clear in recent years that falling risk-free rates increased the valuation that investors were willing to pay for certain assets. The most conspicuous examples are the big technology platform companies that have come to dominate the technology landscape over the past 20 years in the US and China.

The dramatic increase in the valuation of these businesses at least made mathematical sense. The further in the future that cashflow is expected, the greater the change in its present value for a given change in prevailing interest rates. Another way to think about this ‘Time Value of Money’ concept is to ask what you would pay today for an IOU promising you $100 in one year’s time. Rationally, you should be willing to pay no more than the amount you would need to put in your bank savings account today for it to grow to $100 in a year’s time. If the interest rate on your savings account fell, you would have to increase the amount on deposit, and you would be willing to pay more for that $100 IOU. Due to the effects of compounding, this dynamic is magnified when the IOU is payable in five or more years’ time. In short, the longer the term of the IOU, the greater the change in its value to you when interest rates move.

Many of the world’s favourite tech stocks are loss-making today, which means that the profits and dividends that their shareholders are looking forward to will occur much further into the future than those of a regular, profitable member of the S&P 500. This conceptual approach turbocharged the valuation of technology stocks as interest rates and related bond yields collapsed to the lowest levels in recorded history. This dynamic works in both directions, of course. A rapid rise in the discount rate crushes the present value of future cashflows, and thereby the valuation of companies promising investors far-off riches.

The table below depicts the impact of a rising discount rate (which is synonymous with the return that an investor would demand) on the present value (‘Today’s Value’ in the table) of $1 000 received in five, 10 or 20 years from now. As explained above, growth companies, like the big technology platform companies, offer more of their value in the distant future, as investors expect them to grow their cash flows for many years above the nominal growth rate of the economy. This contrasts with traditional lower growth companies, such as consumer staples, which tend to grow at a lower annual rate but more consistently, so more of their value resides in earlier years.

As you can see above, a five percentage point increase in the discount rate (the same as the Fed’s overall increase in rates so far in this hiking cycle), cuts the present value of Year Five cashflow by 20%, Year 10 cash flow by 37% and Year 20 cash flow by 60%. Conversely, when rates fall, the table above can be read from right to left: the present value of longer-term cash flows can easily double in value. This was demonstrated by the valuations of many growth assets in 2020 and 2021, when central banks slashed rates in response to the system shock of the Covid-19 pandemic.

It made sense for equity markets to correct while interest rates were rising sharply in 2022. Similarly, the market’s rebound since October 2022 implies that investors expect central banks to start cutting rates before too long. Falling inflation is the most obvious reason for central banks to reverse course, but equity bulls also take confidence from a structural narrative: that a financialized world, awash with debt, simply cannot bear higher rates for any period of time. Central banks’ independence may be constitutionally guaranteed, but they still rely on political consent. They are unlikely to survive if they create too much pain to society and imperil state finances. Lower rates are not always the starting pistol for a runaway equity bull market, however. If central banks have to cut because of a recession or systemic risk reasons, then associated falling earnings could negate much of the benefit of a lower discount rate.

The modern “attraction” of unlisted assets

This brings us to private markets, awareness of which has exploded over the last 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 term refers to the additional return which investors should rationally require to invest in assets that cannot be easily converted to cash. Private markets also give institutional investors and ultra-high net worth individuals exposure to new or yet-to-be-listed technology platforms we use every day 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 what they are worth. Unlike listed shares, whose price is visible at any moment in the day, 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 ultimately sold or listed. In what may be seen as an act of willing self-deception, investors somehow interpret this to mean that unlisted assets have lower volatility than listed assets and therefore better risk-adjusted returns (all else being equal). Until investors actually have to sell their interests, they can merely mark them to market using their own assumptions (like students marking their own tests!) without considering current liquidity, credit or business cycle conditions.

What’s happened to the unicorns?

As a reminder, ‘unicorn’ was a term coined in 2013 to describe an unlisted company valued at a minimum of $1 billion. As the name suggests, they were a rare breed (fewer than 50 in 2013), but in a world awash with central bank liquidity, investors were obliged to embrace risk to achieve returns. The Private Equity/Venture Capital (VC) industry was ready to help. By Q3 2019, there were 404 unicorns in the world with a combined valuation of $1.3 trillion. Excessive monetary stimulus by central banks in response to a one-in-a-hundred-year event (Covid-19) turbocharged this growth. Since early 2020, unicorns have tripled in number and size. Today there are 1 207 unicorns with a combined value of $3.8 trillion! To put this number in context, there are currently fewer than 2 000 listed US companies with a market capitalisation of over $1 billion, including some former unicorns that listed in the past three years.

In our previous article about unicorns, we wondered when investors would lose their enthusiasm for pouring capital into loss-making companies. We looked at previous cycles for indicators that the bubble might be bursting.

Firstly, we looked at the percentage of new companies listing in the US with negative earnings (refer to Chart 4 below). While the previous dot-com bubble highs were matched in 2018, this percentage has remained at 75% or above for the past six years, an unprecedented sequence since the 1980s! The other interesting difference in this cycle compared with the dot-com bubble is that investors are apparently happy to invest in the IPOs (Initial Public Offerings – when new companies get listed) of unprofitable companies in a range of industrial sectors, not just technology, as they did in the tech bubble of the late 1990s (remember Pets.com).

The second indicator we considered was the performance of the shares of newly-listed unprofitable companies. Our thinking was that shares falling below their IPO prices indicated that private markets have become disconnected from public markets, and that private market participants have become captive to the many incentives to keep valuations rising through sequential capital raising rounds from Series A to Series B, C and D and then to IPO. A lukewarm response from public equity investors sends a chill through the entire ecosystem of private investors, since an IPO is the ultimate realisation of the value which has allegedly been created on the company’s journey through private ownership.

On that indicator, recent data does not paint a positive picture. Only 22% of US IPOs over the past 12 months have produced a positive return, and the median return of those IPOs is -38% compared with the S&P500 return of -8%. If we focus on the five largest unicorns, we identified in our original article in 2019 that have subsequently IPO’d (DiDi Chuxing, WeWork, Airbnb, Grab and DoorDash), only one has delivered a positive return since listing (Airbnb), although 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 31 March 2023).

The biggest losers tell the story of the private market’s changing passions. The award for greatest value destruction goes to Rivian, the electric carmaker which held the largest IPO in 2021. The company has lost $54 billion in market cap since its debut, when it was briefly valued at more than GM and Ford combined. In second place is Coinbase, which debuted on Nasdaq in April 2021. Since then, the cryptocurrency platform has shed over $41 billion in market cap and is down 84% from its first-day closing price.

A few years ago, Goldman Sachs created an index specifically to track the performance of listed non-profitable technology companies, a category which would have welcomed many of the unicorns of recent years as they listed. The boost that this cohort of companies received from the excessive monetary stimulus is apparent in Chart 5 below. What is also instructive is how that huge performance boost during the pandemic has all been given back, as the tide of monetary stimulus has turned over the past year because central banks are fighting inflation.

Some other pertinent facts are that global venture capital funding was down 35% in 2022 to $415 billion after a record 2021, while unicorns born in Q4 2022 have fallen by a massive 86% year-on-year. Despite these big falls, deal volume in the venture capital world was only down 4% year-on-year in 2022. We may infer that valuations are becoming more realistic as the cost of capital normalises after more than a decade of extraordinarily low interest rates. This was our third indicator, i.e. valuations of unlisted companies, where we found some mixed signals from the IPO market in the US (to get a sense of how private valuations translate into public markets).

Chart 6 below depicts the price-to-sales multiples of US IPOs on their first day of trading (we cannot use the more traditional price-to-earnings multiple because so few of the companies listing were profitable). The chart reveals two conspicuous periods of exuberance. In the dot-com era of the late 1990s, when technology companies dominated the new listings landscape, you can see that the median multiple peaked in the 40-50x range. In the current cycle, valuations have been elevated for longer than in the late 1990s cycle, however, the median tech IPO multiple has already fallen to 6x in 2022, whereas the median multiple for all IPO listings has rocketed off the chart (to 902x last year). This appears partly to be a reflection of the low number of US IPOs in 2022, as well as a reflection of the very 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.

We are reminded of the exasperation of Scott McNeely, CEO of dot-com bubble darling Sun Microsystems, contemplating in 2002 the assumptions required to justify Sun’s 10x price to sales multiple when the share price peaked at $64. He said: “Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?” Three years later Sun’s shares were trading at $5. Today there are 36 companies in the S&P500 index trading at over 10 times price to sales. This is half the number so richly valued at the all-time peak of the S&P500 in January 2022, but still more than the 29 such companies at the peak of the dot-com bubble!

The inevitable venture capital write-downs

The obvious question for private market issuers and investors is whether the normalization of listed equity valuations will feed back into private markets, and if so, how quickly and with what consequences. As discussed above, the private investment ecosystem actually thrived on the lack of price discovery. That works in the upcycle, when VC funds are turning investors away and loss-making businesses can raise multiple rounds of capital. Once the cycle turns, however, the weakness in the private markets model is revealed: companies forced to raise fresh capital are forced to do so at lower valuation than previously (the hated ‘down round’) and the very opacity of asset valuations accelerates and amplifies the investors’ journey from greed to fear. Business models feted as world-dominators look fanciful in hindsight, and investment committees ask themselves” ‘What were we thinking?’

For evidence that the seasons are turning for venture capital, look no further than the pronouncements of investors themselves. VC funds do not advertise their mistakes, so by the time they do, the transmission of those lower public valuations is probably well under way.

Tiger Global Management (“Tiger”) was founded in 2001 by Chase Coleman III, a well-known protégé of 1980s hedge fund legend Julian Robertson. Tiger grew its venture capital activity aggressively in 2021, doing more than a deal a day (more than any other US investment firm). Tiger markets itself as a technology-focused hedge fund that includes a portfolio of privately-held “growth” companies exceeding $40 billion.

When the monetary tightening cycle began last year, listed valuations dropped. This fed into private markets. Shares of tech companies that trade privately plummeted in value, with discounts from around 30% to 40% to as much as 80% compared with valuations from earlier fundraisings. The Financial Times reported in March this year that Tiger marked down the value of its investments in private companies by about 33% across its venture-capital funds in 2022, erasing $23 billion in value from Tiger’s giant holdings of start-ups around the globe.

“[We] underestimated the impact of rising inflation,” wrote Tiger in an investors’ letter, and it admitted it had “overestimated the sustainability of Covid-driven growth tailwinds for software and internet-enabled businesses”. Observers wonder whether Tiger has been sufficiently conservative in its private market write-downs, considering that the value of its investment in listed technology companies fell by more than 50% last year.

SoftBank’s famous Vision Fund is the world’s largest technology-focused venture capital fund, and it became synonymous with mega-cap tech investments at the centre of the private markets bubble. It also epitomised the, sometimes unhealthy, alignment of interests between funds and founders. Based on CEO Masayoshi Son’s glittering track record of investing in technology, Softbank attracted $100 billion of assets to the Vision Fund, much of which came from sovereign wealth funds in the Middle East. Scale is great for management fees but creates problems too. To deploy that quantum of capital, Softbank needed to find visionary entrepreneurs with global domination in mind and a massive appetite for capital. WeWork was the result.

As with Tiger, SoftBank marked down its private investments between April and December 2022 by about 30%, less than the 50% drop in its publicly-traded holdings.

Potentially a long way to go

Times may change but human nature does not. We can debate the rights and wrongs of the tidal wave of liquidity that central banks have unleashed over the last fifteen years but investors have proved once again that, to paraphrase the fateful words of Citigroup CEO Chuck Prince, when the music starts playing they will get up to dance and will keep dancing until it stops. To add some colour to the metaphor, as at every party with a punch bowl, decision-making tends to deteriorate as the evening progresses! And, when it’s a good party, people are also slow to leave. So it is taking time for positions to be unwound, especially with drinks being served by central banks as revellers head to the door in dribs and drabs.

The greed-fear continuum can be relied upon, but every cycle has unique characteristics. The current cycle has been exacerbated by a boom in online trading by citizens locked down at home with stimulus cheques to spend. Some consequences were predictable (a savage re-rating of household names in technology) and some less so (Wall Street Bets’ mob of vigilante short-squeezers). We would have expected institutional investors to show a little more self-control as valuations parted company with rational thought, but even the best of them are keen to forget the last few years. In August last year Masayoshi Son publicly apologised for the Vision Fund’s self-destructive focus on unicorns and stepped down from running the group’s day-to-day operations.

Four years ago, we wrote an article warning about the risk that excessive liquidity would inflate the valuations of illiquid and opaque investments in loss-making businesses. Today it is possible that markets are in an even more 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. It should be remembered that in fighting high inflation, central banks, using only their blunt interest rate adjustment tool, need to reduce consumer confidence. Lower consumer confidence ultimately results in reduced consumer spending, bringing demand more in line with supply and achieving the goal of lower inflation.

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 at leisure. As interest rates rise, these investors find themselves trapped in an illiquid asset class, the valuation of which reveals itself to be a leveraged play on the liquidity cycle. This is bad news for valuations when rates go up, but good news if the promise of big secular change, like AI advances, helps them to grow fast enough to counter the rising cost of capital. It is even worse news if rates stay higher for longer than expected, as the clock is ticking on those cash-burning business models.