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.
J
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