Venture Capital Valuation Confusion

How real are the nosebleed high implied venture capital valuations being tossed around? For example, Pinterest raised $370 million which gave it an implied value of $11 billion. Snapchat has an implied $15 billion value following an Alibaba investment. The number of “pre-IPO” venture capital backed firms with implied values exceeding $1 billion (AKA unicorns) has increased from under 50 last year to almost 80 this year. My suspicion many of these implied values are “funny money” i.e. not real.

What passes for valuation in venture capital is really relative pricing based on what someone else paid for something similar, which could be wrong. This is especially true in today’s environment where investors are driven more by FOMO (fear of missing out) than reason. Implied value is at best a proxy for market value and is often misleading. Implied value is determined by dividing an investor’s dollar investment by the proposed ownership percentage the investor receives. For example if you will receive 10% of the firm for a $10 million investment, then the implied value is $100 million.

Looks simple, but there are serious complications to consider including the following:

1)     The ownership percentage is a negotiated item reflecting relative bargaining positions and not a traditional market price. Comparables used to substantiate declining ownership percentages can result in an overvaluation when the comps themselves are overvalued.  Venture firms flush with newly raised capital have reduced bargaining power with potential issuers. Thus, they are accepting smaller ownership percentages which inflate implied values.

2)     A reality check is needed to justify the implied price. This can be estimated by determining the future performance required to justify the price paid. The aggressive future performance estimates, currently exceeding 15X+ next year revenues, are often based on continued assumed weak competition due to first mover or network effects which are as elusive as merger related synergies. Thus, the needed future performance is becoming more difficult to achieve.

3)     Beware of receiving different terms. Venture firms usually invest in preferred not common stock. Liquidation preference (AKA the ratchet) differences in preferred stock can impact real values and are often ignored in implied valuations. These liquidation preferences allow the holder to receive more shares upon a liquidation event (e.g. a sale or IPO) if the price received upon that event is below their investing value. This gives certain investors an in-effect look back re-pricing option, which is valuable and needs to be considered when pricing an investment. Warren Buffett refuses to invest in situations when he is not pari passu with other investors and so should you.

4)     Limited financial information, due diligence and issuer financial infrastructure increases the risk of error or worse yet-fraud for pre-IPO unicorns. Also, there is no guaranty of an IPO; hence the investments are illiquid. Holding a minority position in a non public firm is a potentially unpleasant experience. Even if there is an IPO, it may be at a lower than expected price, which can trigger a ratchet.

      You can only accurately value your venture capital investment twice-once when you make it and once when you exit. Relying on implied values going in can lead to some nasty surprises when exiting the investment. The implied values for many unicorns may not be real.

J

Merger Waves: Are Private Firms Different?

We've talked quite a bit in these posts about merger waves. Previous research finds differential results for firms that merge before, during and after a merger wave in their industry.  Today's post links to new research that finds interesting results regarding how public and private firms participate in merger waves  and the resulting (and different) outcomes. The article, is entitled, "Private and Public Merger Waves" and is authored by Vojislav Maksimovic, Gordon M. Phillips and Liu Yang.  The abstract is below.

                                   Private and Public Merger Waves

Abstract:      

We examine the participation of public and private firms in merger waves and productivity outcomes. We show that public firms participate more than private firms as buyers and sellers of assets and their participation is more cyclical. Public firms are affected more by credit spreads and aggregate market valuation. Public firm transactions are also impacted positively by their stock market valuations and liquidity. Public firm acquisitions realize higher gains in productivity, particularly when their transactions occur on-the-wave and when their firms' stock is liquid and highly valued. We show that our results are not just driven by the fact that public firms have better access to capital. Using productivity data from early in the firm's life, we find that better private firms subsequently select to become public and that these initial conditions predict higher participation in asset purchases and sales five and more years later.

The complete paper can be downloaded here.

All the best,

Ralph

Warren Buffett and Conglomerates

Berkshire Hathaway is a difficult to understand conglomerate with a collection of unrelated businesses ranging from candy to insurance. Conglomerates suffer a well deserved discount from their pure play peers. Consulting firms like BCG and Marakon estimate the discount as high as 10% in normal times. The discount is based on the following factors:

1)     Poor focus leading to inefficiencies including: a) high head office overhead; b) cross subsidies from cash positive SBUs to cash deficient units; and c) poor capital allocation decisions. Conglomerates mimic capital markets, but on a less efficient basis.

2)     Weak Fit: conglomerates are usually not the best owners of all their SBUs. Managers must not only manage well enough to earn their cost of capital; they also earn more than an alternative owner who can extract synergies from related operations.

These forces underlie the wave of proposed spinoffs by firms such as Hewlett Packard, EBay and Yahoo.  Yet Warren Buffett claims Berkshire’s collection of businesses are worth more under their corporate umbrella than as standalone entities. He bases this on the following:

1)     He can move capital efficiently and on a tax efficient basis among the various units. This is premised on his being a better capital allocator than capital markets. This may be true for him, but probably questionable for other mere mortals.

2)     Spinoffs are frowned upon as the “spin-or” does not receive any premium. There is no premium, however, because, the “spin-or’s” shareholder still own the spun SBU just is a different form.

3)     Berkshire has very low overhead-at least for now.

Well, how can you dispute his success? The success, however, has some question marks associated with it. Consider:

1)     Buffett used to measure Berkshire’s by the growth in book value per share compared to the S&P 500. Unfortunately, Berkshire’s performance by that measure has lagged the S&P index for 5 of the last 6 years. Consequently, he switched metrics to comparing Berkshire market value changes compared to the S&P index.

2)     He justifies the change as better reflecting the significant change in his business model from owning minority positions in liquid public securities (70%+  of business 20 years ago) to owning and operating large business today (70%+ of the current business now).

Perhaps, the conglomerate curse is catching up with Berkshire as it marches down the conglomerate path. Buffett’s superior individual skills may slow the onset of “conglomeratism”. Nonetheless, I doubt that even the Oracle can stave off its effects forever. That may be why he saw it necessary to explain why the conglomerate model makes sense for Berkshire in his annual shareholder letter this year.

Berkshire is unlikely to spin-off any divisions while Buffett remains CEO. My guess is that the pressure to break-up will mount once he gone. It seems that the advantages of the conglomerate model are more evident to those who run them, than to customers, employees and investors.

J

Arbs - Smart, Influential, or Both?

Consider several interesting, stylized facts about the role of arbitrageurs in acquisitions:

• Once a firm is in play, the new shareholder base is likely to be the arbitrageurs as existing shareholders sell out to lock in the jump in price surrounding the announcement of the deal and avoid the risk of deal failure.
• Arbs make a living taking this risk of deal failure.
• Most arbs don't try to predict who will be a target but take a position after a deal has been announced
• The risk profile of arbs is very low - arbs hedge their positions to minimize as much risk as possible.   In a stock deal, for example, they might go short the acquiring firm and go long the target, locking in the spread between the post announcement price and the offered price - usually a few percent.
• Arbs favor the rapid completion of a deal and when deals close quickly the few percent gained in the spread becomes a very high return when annualized.
• Arbs can lose their shirt if a deal collapses or they are not properly hedged.
• Arbs tend to earn superior returns around acquisitions.

So lets take the last point.  It has been known that arbitrageurs can earn abnormal returns around mergers.  What hasn't been clear is why.  There are two theories - one that arbs play a passive role and the other that they play an active role in facilitating deal completion.

The passive theory is that arbs are better at predicting deal success - studying the dynamics of a deal, the positions of the players and the likely regulatory positions.  They then take a position when the odds are in their favor.

The active theory is that arbs actually influence the outcome of a deal - that their shareholdings help tip the balance of power and facilitate deal completion.

In that article below, published in the Journal of Financial Economics co-author Jim Hsieh and I find evidence supporting both theories.  The abstract is below.  A copy of the published article is available through the link above.  A copy of the working paper is available here.

Determinants and Implications of Arbitrage Holdings in Acquisitions

Abstract:      

This study investigates arbitrage activities and their impact on acquisitions. The literature contains arguments for both passive and active roles of arbitrageurs during the takeover process. Larcker and Lys (1987) suggest that arbitrageurs are passive, having superior ability to predict offer success. Cornelli and Li (2002) and Gomes (2001) model arbitrageurs as active, influencing the terms and outcome of offers. We find evidence supporting both arguments. Using a simultaneous-equations framework to recognize endogeneity, we analyze 608 acquisition bids over the 1992-1999 period. Consistent with the passive arbitrage argument, the change in arbitrage holdings is greater in successful offers. However, changes in arbitrage holdings are also shown to be an important determinant of the probability of success, bid premia, and arbitrage returns. In addition, the change in arbitrage holdings is positively associated with both revision returns and the occurrence of subsequent bids within one year after initial bids are terminated. Overall, we find that merger arbitrageurs play an important role in the market for corporate control.

All the best,

Ralph

Finance Debt Fetish?

The go-to recommendation from many consultants and academics is to lever up your firm to increase your tax shield, lower your WACC and fend off activists. This approach may fit for some mature firms. It is, however, less well suited for other firms.

A useful approach to setting debt policy as reflected in a firm’s actual or implied debt rating is based on a firm’s life cycle. Consider the following:

1)     Early and growth stage firms: most of their value is reflected in growth opportunities from assets not yet in place. They have negative free cash flow due to operating losses, high business risk and high CAPEX. Hence they need flexibility to complete their investment plan and maintain access to capital. Such firms have high financial distress costs. Furthermore, they have limited taxable income i.e. tax shields have limited value. Such firms should and do have low debt levels.

2)     Mature firms: generate more cash than they can profitably invest due to high operating income and reduced investment needs. Business risk has decreased and the need for financial flexibility is low as is business risk. Additionally, they have high taxable income in need of tax shields. Finally, agency/incentive issues become prominent regarding investment allocations. In these circumstances, increasing debt makes sense. Witness the “old” tech firms like Apple that have pressured by activist to increase debt level to reduce the risk of misallocated capital. Also confirmed by consumer non durable firms which spend time on tax planning, including use of debt related tax shields, to reduce their tax burden.

3)     Declining firms: here the emphasis shifts from value creation and taxes to value transfers among the firm’s various claimants. Debt holders, often purchasing the debt in the secondary market at a discount, are looking to squeeze-out shareholders and gain control of the firm’s assets in a disguised bargain purchase. Equity holders are seeking to protect their interests. The Caesar’s Palace’s bankruptcy has highlighted questionable transfers by PE firm Apollo to shield assets from creditors.

In addition to life cycle and taxes there are other reasons firms may favor debt. These include:

1)     Information asymmetry discount (AKA Pecking Order Theory ): debt is a contractual obligation v equity which is a residual claim. Hence, there is more informational uncertainty regarding equity, and equity investors require a higher discount to induce them to commit. Managers recognize this fact and exhaust internal funds and debt capacity before issuing additional equity.

2)     Ownership/Control: maintaining ownership and control (ownership v earnings dilution) is very important for private and smaller closely held public firms. Thus, equity is not a preferred funding instrument.

3)     Discipline: agency issues arise whenever management’s interests diverge from shareholders. Debt can provide the discipline needed to hold management’s feet to the fire. This is a driving force behind many LBOs (agency costs).

4)     Signaling: issuing equity for mature firms usually results in a stock price decline. Investors view the raise as a signal that future cash flows will be less than expected. Debt must be serviced (P&I). Management would not issue equity if they thought it was undervalued.  Conversely, management would not issue the debt unless it thought the firm could repay it.  Consequently, debt issues are viewed by investors as neutral.

5)     Value Transfers: see the declining firm discussion above. Creditors attempt to protect against this include seniority, security and covenants. Legal protections include substantive consolidation, fraudulent conveyance and equitable subordination.

The above framework can aid managers seeking to make capital structure decisions.

j