Fear the Walking (Dead) Unicorn

I posted several notes here, here and here trying to make sense of inflated late round technology valuations. My conclusion was the valuations were illusory rationalizations used to justify inflated prices. The private market valuation of these firms suffered from being unregulated, questionable accounting, lack of comparability due to differing provisions (e.g. liquidation preferences), and lack of short selling. The result is momentum based pricing driven by the optimism of the last investor. The number of previously rare unicorns (private firms with values exceeding $1B) increased to 124 in July of this year. Eventually, however, you run out of optimism when an event occurs causing investors to re-examine their assumptions and reduce their risk appetite leading to lower pricing. That something was the August correction.

You only really accurately value a private firm when you make the initial investment, and then when you exit. Exits had been delayed for many later stage tech firms. Only 14% of 2015 IPOs were tech related. The reasons (excuses?) given for the lack of tech IPOs was twofold. First, the founders did not want the hassle of public market scrutiny. Second, they did not need an IPO liquidity event because they could always do a “private IPO” (oxymoron?) by accessing private investor cash in subsequent financing rounds (at assumed higher valuation levels). Both reasons are nonsense.

In reality they wanted to avoid the evaluation of numerous hard-nosed investors both at the time of the IPO and the on-going trading-including short selling. You need a public market to get liquid; it is hard to access public markets at sky high prices.

Many tech founders and investors who confused bull market valuations for liquidity are now discovering the difference between paper and real liquidity. Over 40% of 2015 tech IPOs like Novo Cure are being priced near or below their last private financing round valuation. This fact has not gone unnoticed by private investors. They are balking at high implied valuations in later financing rounds forcing firms to accept lower values. For example, Blackrock which lead a prior $350M financing round for Dropbox has marked down its investment by 24%.

Pricing represents a short term belief in expected operating performance. Investors should gauge the gap between expectations and reality. This means not falling in love with stories about market growth and technology without considering how those factors translate into revenues and ultimately cash. 

This involves understanding the following:

1)     Market Characteristics: some markets have difficult characteristics making it difficult to yield superior returns. Use Porter's 5 forces framework as a starting point.

2)     Business Model: who will the firm achieve and maintain market share and pricing power when facing competitors, new entrants and substitutes?

3)     Execution: inept managers can negate attractive markets and credible business models.

If you claim this is hard because of profound uncertainty then recognize you are not investing. Rather you are speculating based on what you hope someone else will pay for the firm. This someone else can and does change his mind leading to wild price swings like those experienced this August. This in turn can turn your hoped for unicorns into unicorpses.

J

There They Go Again: Shareholder Distributions and Short Term-ism Rant

Blackrock’s Larry Fink is cautioning CEOs about giving in to activists. He suggests that CEOs are influenced by short term activists to increase shareholder distribution-dividends and repurchases. He prefers, and I agree, CEOs should first focus on investing their capital in new growth investments. This assumes of course that firms have positive NPV projects in which they can invest. This becomes more challenging the further we are into an economic recovery.  All too often CEOs feel the pressure to grow and the lure of size when the opportunities just are not there. This results in value destructive growth-both organic and over priced M&A. Not all CEOs are as skillful as Warren Buffett in making investment allocation decisions. Hence, not all CEOs can have Buffett’s zero payout policy.

Some firms simply have more cash than they can profitably reinvest given where they are in their life cycle. Firms should view distributions as a residual capital allocation decision involving the following:

1)     List all projects offering positive NPV

2)     Match opportunities with available internal resources -operating cash flow plus liquid resources

3)     If opportunities exceed internal resources, then raise external capital

4)     If opportunities are less than internal resources, then return the excess to shareholders

Shareholders can search market opportunities to redeploy their capital to higher valued use better than managers trying force the issue.

Next, Fink proposes a protective tax based mechanism to shield CEOs from dividend seeking activists by raising taxes on investments not held for at least 3 years. This would supposedly discourage short term actions. Again, he confuses an investor’s holding period with the market’s investment horizon. Capital markets are like time machines allowing investors to realize cash flows now by liquidating investments. Conversely, they can postpone consumption by increasing investments. The market price for each action is based on the same identical formula independent of the investor’s time horizon; namely the stock price is based on some estimate of future long term cash flow discounted for its risk. Efforts to penalize so called short term investors, however defined, will only reduce market liquidity and entrench management.

Value is created on the asset, left hand, side of the balance sheet by managers skillfully exploiting market opportunities. You cannot, however push on a string when the opportunities just are not there. Returning excess capital under those circumstances is not a sign of weak management, but of good stewardship. It is difficult to create value on the liability, right hand, side of the balance sheet. Nonetheless, you can destroy value by getting the right hand side wrong by being too stingy with dividends.

J