Monday, February 9, 2015

Venture Capital Pricing: Bubble or Something Else?

Trying to make sense of current VC pricing is a daunting task. The increased pricing is reflected in VC IRRs for the past year which exceeded 25% according to Prequin-exceeding those of PE for the first time this century. Consequently, fund raising is accelerating as investors chase yield. This is producing ever higher pricing multiples. Is it a bubble, a recovery or something different?

My thoughts, which focus primarily on the ecommerce segment, are as follows:

1)     There are only three ways to profit from ecommerce. Either you sell devices like Apple, sell goods or services such as EBay or Angie’s Page, or sell advertising –Facebook.
2)     The implicit assumption for investors is competition is weak due to something like network effects-hence the need to raise lots of money, invest it quickly and get big quick. Investors flock to the industry and its participants creating a momentum pricing effect lifting pricing multiples-a virtuous circle.
3)     Wild changes in pricing occur once evidence accumulates that the competitive advantage period is unrealistic. Investors are reintroduced to Porter's  five forces which eventually impact industry profitability.
4)     Investors recognize they misread market signals and have misallocated capital, and begin to curtail investments. This triggers a reverse momentum or vicious circle.

Investor errors are understandable given the lack of operating history or clear business model for these firms. The impact of seemingly small changes in investor estimates can have a major valuation effect:

1)     Simple earnings calculation model: P=E/(r-g) were E is a horizon value earnings estimate, r is the risk factor and g is estimated growth.
2)     P/E ratio is then equal to 1/(r-g). If we assume (r-g) =2 at the beginning of the investment then the P/E ratio is 50. If (r-g) increases to 4 due to a combination of changes in r and g then the P/E ratio falls to 25 resulting in a massive value change.
3)     The change in estimated growth, g, is probably the greatest wildcard. Over estimating growth (AKA under estimating competition) results in investors over paying for growth and reduces their margin of safety when something causes a reassessment.
4)     VC markets, especially early stage, are by no means as efficient as established markets. Thus, the price is not always right. Even in efficient markets the price is not always right. Rather, it means it is difficult to exploit any perceived errors.

The above volatility is characteristic of investors “shooting in the dark” given the lack of operating histories and clear business models for many of these new firms-leap of faith investing. Warren Buffet calls this speculation and not investing-different strokes for different folks I guess.  Until new information arrives, investors are left following technical demand factors (e.g. momentum which is heavily dependent on the amount of new capital raised) and guesswork. Momentum and guessing are prone to error and wild corrections as the mean reversion impact of the Five Forces kick-in.

So, keep your safety belts fastened and do not bet the ranch. The path for now is up, but how long this lasts is unknown. When it changes things will get bumpy as is characteristic of the creative destructive process of economic progress.


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