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Venture Capital – There is Something Strange in the Neighbourhood

Investing into Venture Capital could not be further away from the focus of this blog. We are aiming to squeeze out returns from unloved and obscure companies that are trading substantially below their liquidation value and do not require growth or other forms of significant outperformance versus their current status quo to drive our return. If we were writing a blog about venture capital investing we would be looking for the next hot ticket and making investments on the basis of blue sky visions often with no expectation of profitable operations in the near or medium term.

Neither strategy is better (in our opinion) and there are some fantastically successful venture capital investors whose track records rival those of great value investors both in terms of returns but also longevity and consistency of performance. So whilst we would be absolutely awful deploying our capital in VC investments there have been a couple of interesting things we have recently been reading around the VC space that we wanted to highlight and discuss.

1. Andreessen Horowitz Presentation on US Tech Funding

Andreessen Horowitz – US Tech Funding.pdf

Whilst Andreessen Horowitz was only founded in 2009 its cofounders Marc Andreessen and Ben Horowitz were very well known VC investors in their own right prior to joining forces and founding this firm. Today it manages $4bn of capital and is known for playing in the mature end of the market at one point owning four of the highest valued privately held social media companies at the time (Facebook, Groupon, Twitter and Zynga).

This is a great thought provoking presentation whose central argument is that all the recent activity and investor interest in technology companies is not comparable to the tech bubble that occurred in the early 2000s. Core to their argument are the following points:

  1. Whilst tech indices are growing in value this is being driven by earnings and not multiple expansion
  2. You have not seen anywhere near the public market listing frenzy that we experienced in the early 2000s
  3. There has been a step change in the size of the market that tech companies are addressing (internet usage and smart phones). To highlight this they provide an interesting metric of tech funding by person online (this does remind us of the Wall Street research analyst folly during the 2000s bubble of inventing new valuation metrics such as “number of eye ball valuation metrics.”)
  4. US ecommerce and online advertising has increased 15x since 1999 and represents a significant addressable market from an economic standpoint
  5. We have not seen the same surge in VC funding that you saw in the 2000s bubble (lower funding also as a % of US tech GDP vs the previous bubble)
  6. The large fundraising rounds get a lot of focus but the majority of the capital deployed is in smaller companies where it has gotten cheaper to start a new venture

Away from the core theme the presenters also focus on trying to explain the “unicorn” phenomenon in VC (a unicorn is a private company with valuation in excess of $1bn). They make an interesting point that the time to IPO for successful tech start-ups is now substantially longer than in the early 2000s. The presentation also makes a compelling case that today tech IPOs have been delayed or even replaced by private funding rounds and imply that the risk of a bubble is lower as these funding rounds are focused on later stage companies. The big gap in the presentation is that they do not prove that there is not a bubble in the privately funded VC companies as they make their argument for why there has been a shift from the public to private market capital as a source of VC funding.

The biggest question the presentation left us with is whether a bubble has occurred in the private capital markets focused solely on the large capital rounds as institutional, sovereign and corporate investors struggle to deploy enough capital into “attractive” opportunities in this low inflation environment. There are two pages that sum up the key part that is missing in their defence of a tech bubble: (i) “Yes there is more funding for larger deals” (p22), and; (ii) “But this is just a rebalancing from IPOs” (p23). The problem with their arguments about tech contribution being flat as a % of GDP and other metrics about the step change in size of the industry is illustrated on p60 where they show that only $212bn out of a total market value of $3,085bn is represented by unicorns, just 6.9%. It is not inconceivable that irrational exuberance has crept into this part of the market.

The one metric we would love to see that would go a long way to evaluating whether we are in fact seeing a bubble in the unicorn VC deals is a comparison of p/e multiples by funding round to the p/e of the listed companies during the early 2000s bubble similar to what is shown on p7 (our guess is this is difficult to compile due to the private nature of all of these unicorns)

This is probably unfair given the quality of presentation and the thought behind it but after reading it we could not help but be reminded of one of our favourite investing quotes:

When people are saying: “this time it is different” grab your wallet and walk carefully toward the door. History never precisely repeats, but it does rhyme.”

Jesse Livermore

2. The Increasingly Crowded Unicorn Club

The Increasingly Crowded Unicorn Club

Not much to say here (particularly as we do not know over half these companies) other that as always a picture tells a thousand words.

3. The Square IPO

Deal Book – Square, Facing a Chilly Market, Persists in Pursuing I.P.O

In the context of the thought process that the Horowitz piece began we thought this article and process was very interesting for two reasons.

First you are seeing the public markets require a 35% valuation discount to the last private market capital raise valuation in order to get the IPO away.

Second there is another hidden source of losses / potential excess valuation in private VC funding which is the existence of different economic rights for later stage investors such as shares with liquidation preferences or in the case of the square anti-dilution ratchets.

Now a disciple would say that point two is fine as these rights are typically only given to late stage investors and even if there is dilution of early stage investors on a monetisation event they will be making out like bandits regardless. However, given the furious pace of funding rounds we wonder whether there will be some late stage investors who subscribed at similar valuations but get disproportionally hurt in a downdraft as they find themselves sitting on the wrong chair from an anti-dilution perspective when the music stops.

Conclusion

To be clear we are not advocating for the existence of a bubble in late stage / unicorn VC deals, our knowledge and data is simply too skin deep to make any conclusions either way. However, it is always useful to take a critical look at other investment classes as well as your own and ask which offers the best value and risk/return.

Would be great to hear other people’s opinion on VC and any good data they have come across on valuations.

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