2019: Year of the Unicorn?
With global investor confidence tempered by the US-China trade war, Brexit, the upcoming US elections, and other geo-political issues around the world – IPOs are having a hard time taking off. There were 1,115 initial public offerings (IPOs) of companies around the world in 2019, taking into count the ones postponed or called off. However, even this “inflated” figure falls 19% short of the 1,383 in 2018. To provide another reference point, North America saw only 160 IPOs in the past year, less than half as many as the amount at the onset of the DotCom bubble in 1999. However, while the picture appears grim for the market as a whole, one class of firms is reaping ever larger rewards: an increasing number of startup firms are reaching high private valuations and attracting special attention from public investors. About 25 of the IPOs that went to market this year in the United States were of unicorns – startups privately valued at $1 billion or more. However, this number was still less than the projected 38. And this was despite some of the companies that are typically synonymous with “unicorn” moving to public markets in 2019: Uber, Lyft, Peloton Interactive, and Beyond Meat.
The value of unicorns is dictated by private firms who invest during series funding. For most of the recent unicorns, their value lies in their growth-proposition for private and institutional investors: promising high returns in the long run to compensate for losses in the short-run growth period. Most of them were once considered “disruptors” in high-growth, competitive markets such as technology and healthcare, but are struggling to extend their honeymoon period of prioritizing revenue growth over profits. Backed by venture capital and private equity investors, they continue to burn through piles of cash to retain their customers and break into new markets. They were able to meet the mounting pressure of providing returns to investors, however, through dividend recapitalization measures – borrowing in the market to fund dividends – in a low interest rate environment where credit is cheap and easily available. As a result, private equity and venture capital have been rushing the gates to every upcoming unicorn, injecting cash into any firm showing even the slightest promise of future profitability. Private investors have also been plagued with the kind of optimism public investors are skeptical of; since they cannot hedge their bets against the investee company like the latter, they bet on their large cash infusions to help the unicorn beat the market. This investing behavior also generates negative externalities in driving smaller competitors out of the market or leaving them fighting for scraps, even if they may have had have better management or operating efficiency.
Moreover, unicorns lure cheap capital investment by offering preferred stock that come without voting rights, but with liquidation preferences and ratchet options that protect the value of equity against the failure of the company. When the company publishes financials before going public, the common stock issued is valued in the same way as this preferred stock, making the overall valuation inflated. Early public investors are drawn to these unicorns due to initial valuation and touted revenue growth potential, but in 2019 it was evident that they lost their appetite for companies without a clear path to profitability as many large unicorns dipped below their initial offer price within a short while of trading, or, even worse, were issued at lower than expected prices. Newly public tech companies, usually the poster children of investment growth, shed an aggregate of $1.7 billion in value of shares by year-end. Investors in 2020 are set to refocus on businesses with a sustainable value-chains and more realizable growth propositions, not buying into the private equity bubble. A stricter regulatory framework for unicorn IPOs has been on the horizon for a long time, and mounting public investor pressure will likely accelerate its adoption. Investors must have unfettered access to standardized financials and ownership structures of companies going public in order to prevent any information asymmetry.
The wildly over-valued We Company was perhaps 2019’s most high-profile and dramatic unicorn failure, losing almost all $47 billion of valuation pre-IPO and eventually calling off going public altogether. We’s primary investor, SoftBank’s Vision Fund, owned about a third of its stock in a multi-class voting structure, and had invested $10.65 billion which was largely written down when the company’s IPO plan went bust. The We Company’s debacle also tells another cautionary tale: unicorns frequently mislead public investors on their growth prospects and earnings by reporting side-by-side non-GAAP metrics that inflate their earnings potential. Getting creative with their metrics, management of We painted a much rosier picture of operating margins and asset ownership than was the case, using the “Community-Adjusted EBITDA” measure. Furthermore, We is not SoftBank’s only failure. The supermassive venture capital fund, backed by Saudi Arabia’s sovereign fund and existing tech giants, failed to do substantial due diligence on many of its 88 investees, of which more than a few are now raising glitches – leading to a $6.5 billion loss reported by Softbank Investment Group in the third quarter of 2017.
Cheap capital has never been more easily available, and it has allowed private equity investors to take on higher risk investments in companies with shakier fundamentals. Private equity still boasts up to $2 trillion of uninvested capital and has increased leverage multiples to record levels. Market commentators have described a positive economic outlook for 2020, optimistic that investors will learn from the mistakes of 2019. Furthermore, geo-political instabilities also increase the likelihood of markets re-adjusting to bearish outlooks, which threaten this current pattern of high risk investing of cheap capital. Private equity and venture capital are witnessing a bubble that is due to pop sooner than expected, and the diversified risk would mean it has the potential to hurt the whole economy.
Written By Yashwini Sodhani, Undergraduate Economics Student
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