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How Unicorns got Stripped Bare by the IPO Reality Check

Mispriced, opaque private ventures no longer fulfill the tough requirements of initial public offerings (IPOs). The WeWork and Uber bubbles teach us how zero interest rates create too much capital that chases too few sound ventures.

Myret Zaki

Deutsche Version

Myret Zaki

Myret Zaki started in 1997 as a junior analyst in a Geneva private bank where she learnt the basics of equity research, before joining the daily newspaper «Le Temps» in 2001, where she was in charge of the finance section for 9 years. When the financial crisis broke in 2008, she wrote the investigative book «UBS, am Rande des Abgrunds» (originally published in French as «UBS, les dessous d'un scandale»), for which she received the Schweizer Journalist prize. She joined «Bilan» magazine in 2010 where she became Chief Editor from 2014 to 2019. Between 2010 and 2016, she wrote three other bestselling books, about Swiss banking secrecy, the end of the Dollar reserve status, and the rise of the shadow banking system. She has a Political Science Bachelor from the American University in Cairo and an MBA from the Business School of Lausanne. She is now a freelance columnist and a consultant in influencer and opinion leader strategies.
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Once upon a time, in private equity land, there was a beautiful unicorn valued at 47 bn $, when in fact it was hardly worth 3 bn. Its charming CEO, its millennial-friendly aesthetics, and the blind trust of the Softbank emperor made everyone in the empire believe the unicorn was a tech-savvy company instead of a common office-space provider. The charming CEO, dreaming of a fortune, would impersonate a tech aristocrat instead of the real estate bourgeois he really was.

But a fairy called fair value was observing it all from afar; she hated lies, self-dealing and misstatements. So one day she ripped beautiful unicorn and charming CEO of their deceptive disguise, revealing an unvarnished, indebted and mismanaged company. The populace filled the streets and jeered at the deceitful unicorn, giving it less than one-third of the value the emperor had claimed for it. The emperor was naked and put to shame. «Unicorn» has now just become another name for doubtful valuation.

Fantasy valuation

You might have recognized the reference to the recent debacle of WeWork, one of the strongest convictions of the giant venture fund Softbank, and one of its greatest failures. This case and others like Uber, which made it to listing but lost 33% after its debut, and Lyft, down almost 40% from its IPO price, or Tesla’s long losing streak and mysterious income disclosures, raise serious questions about the way valuations are done in the private market universe.

In the last decade, the success of Google, Apple, Facebook and Amazon (the «GAFA»), which managed to build highly profitable models, created such a technology hype that any sense of judgement got lost in the private equity and venture capital sphere. Mega-financings of new ventures like WeWork, Uber and Slack, unchallenged by independent expertise, dolled up by opaque accounting, made them so overvalued that they couldn’t pass a reality check or – for WeWork – fulfill the requirements necessary for an actual market listing.

At the height of the WeWork scandal, many news articles entertained us with anecdotes about the eccentricities of WeWork founder Adam Neuman, and the 10 bn $ commitment he got scribbled in a limo after a 30-minute pitch to Softbank’s CEO, Masayoshi Son. But few articles analyzed how investors can avoid these bad trips in the future by holding their fund accountable for disastrous investment decisions and making sure that consistent valuation techniques are applied to portfolio companies.

Disappointing post IPO-performance

The performance of unicorns (start-up companies valued at more than 1 bn. $) since their IPO is a cruel witness to these irrational valuations. Since 2017, unicorns with a market cap of 5 bn or more have been very poor performers post-IPO. Seven out of ten have delivered negative returns, according to Forbes:

<strong>Source: Forbes, October 7, 2019</strong>

Source: Forbes, October 7, 2019

Exuberance is not exclusive to private equity and venture capital. Prices have been going up in all asset classes, thanks to cheap money by the Federal Reserve. But private equity happens to be particularly leveraged and opaque, and the front runners become rich at the expense of IPO investors. Conflicted valuations and accounting tend to misrepresent the risks of these leveraged bets. Uber, for instance, was valued over 68 bn $ by its financial backers. But after its May IPO, its public market valuation fell to 48 bn.

Low interest rates fuel speculation

The speculative frenzy we’ve seen is not surprising. Markets are communicating vessels. As ultra-low interest rates made fixed income unattractive, much of the investor hype was channelled into private equity. Debt became too cheap to worry about, and the amount of cheap money exceeded sound investment opportunities. At some point, funds like Softbank stopped doing their math and switched into pure speculation mode.

The WeWork case tells us that Softbank managers chose to ignore the basics of valuation. The sector ratios should have sounded the alarm bell: sector price/EBITDA multiples of 11 have become higher than their pre-2007 crisis levels (8.9x). Private equity deals display a 30% premium to listed companies. Leverage stands at 6 to 9 times debt/EBITDA on average. Had the Fed raised interest rates fast this year, a sure-fire crash would have ensued. These high ratios are no longer justified by performance: if we average things out over five years, private equity as an asset class has underperformed the Russell 2000 small cap index by 1% and the S&P 500 by 1.5% per year.

True to form, private equity valuation is by nature subjective and has to rely on scenario analysis; getting the fair value right, i.e. the hypothetical selling price, is more difficult than it is for listed stocks. But in the case of WeWork, it would have required to stick humbly to a sales multiple comparison with its direct competitor, office provider IWG (formerly Regus). In that case – and many financial media rang the alarm bell – WeWork’s equity value would never have exceeded 3 bn $.

Growing valuation gap

The phenomenal valuation gap between 47 and 3 bn $, and previous startup exaggerations have hurt market sentiment. IPO buyers no longer subscribe to sky-high valuations and overvalued unicorns run a growing risk of failing to place their shares at the announced prices. Due to this growing valuation gap between private and public, private equity exit volumes haven’t shown any growth since 2015.

Reduced public investor appetite for unicorns could result in fewer IPOs in the future. This is a good thing, as it will force valuations to self-correct and firms to take on less debt. The average private equity deal is currently 65% debt financed, which is very high and vulnerable to rising interest rates; and with borrowed money so cheap, there are no incentives to make sure investments fund productive ventures.

Another telling indicator is that even large corporations are no longer willing buyers of unicorns, as no major deal such as Facebook’s acquisition of WhatsApp has taken place lately. A big company would rather develop the technology internally than buy a startup at these inflated prices.

Opacity and bad governance is what needs to change. While a publicly listed company has to be valued independently and provide transparent, faithful accounting to regulators, private equity firms are the ones who decide the valuations of their own portfolio companies. How is that possible?

Questionable valuation techniques

PE firms simply cannot be judge and jury. Both the funding firm and the startup have a vested interest in bidding up the price too high. One usually believes that the «market» is valuing the unicorn higher, but it is actually just the firm bidding against itself in the successive financing rounds (a certain Mr. Charles Ponzi invented this strategy in the 20s).

The startup CEO’s interest is to exit at the highest price, and the fund wants to mark up its investment and book a return. That is when complacency comes in and arrangements to accounting are made. We aren’t supposed to take debt above 6x EBITDA? No worries, funding partners allow startups to be creative with the definition of EBITDA so that «one-time» costs and other items are removed to get a more convenient «pro forma» EBITDA.

IPO-window is closing

So much complacency jeopardizes the future performance of these companies, whose losses are subsidized and whose founders are spoiled at the expense of investors. Such situations seldom happen with listed equities. In private equity, inefficiencies and arbitrage opportunities are still too high, attracting speculators, as it takes years rather than minutes for bad management to be discovered.

Well, the private equity bubble has actually burst. We just didn’t see it happen in a big way because interest rates are still artificially low. But what we see is that a big chunk of capital is now stuck in mispriced private markets, with little hope to be offloaded onto the IPO markets, as the window of opportunity is closing: the public grew aware that these opaque offerings can only underperform.