November 8, 2019

Unicorns: Putting Things in Perspective

According to Merriam Webster Dictionary, the definition of a unicorn is:

  1. a) a mythical, usually white animal generally depicted with the body and head of a horse with long flowing mane and tail and a single often spiraled horn in the middle of the forehead
  2. b) or something unusual, rare, or unique

The term unicorn has a different meaning in the investment world. In the venture capital industry, a unicorn refers to any tech startup company that reaches a $1 billion dollar market value as determined by private or public investment. The term was originally coined by Aileen Lee, founder of Cowboy Ventures.

How did we get $1 billion dollar IPOs?

The Jumpstart Our Business Startups Act (the “JOBS Act”) of 2012 opened the door for private companies to gain access to more funding by increasing fourfold the threshold in the number of shareholders allowed before a company must go public. Prior to the bill’s passage, companies with more than $10 million in assets were required to become public reporting companies once they reached 500 shareholders of record; for example, Google was required to IPO in 2004 because it reached the 500-shareholder limit. Since the passing of the JOBS Act, that threshold has increased to 2,000 shareholders, making it possible for private companies to increase their funding sources. This in part allowed companies to raise more growth capital from more shareholders in the private markets before they had to file and release their financial information to the public — which arguably might judge companies by very different valuation metrics.

Alongside the regulatory and market dynamics, the cost of capital has never remained so low for so long, which has helped to infuse billions of new investment dollars into the venture capital ecosystem.

The shifting dynamics of public and private alignment of interest

With companies staying private longer, it has led to an outsized proportion of growth happening in the private markets. Furthermore, there seems to be a greater misalignment between what matters in the venture capital community and in the public marketplace. Uber, Lyft, and now WeWork, all considered multi-billion dollar favorites of venture capital, have hit very bumpy roads along their paths to the public markets. Uber has lost ~30% of its value since going public, and Lyft’s stock is down ~40% from their IPO price. WeWork pulled its IPO after their valuation dropped by more than 75%. The common theme among all of these companies is that, while their outsized growth numbers and massive addressable markets made them trendy and popular in the venture capital world, their lack of profitability devalues them in the eyes of investors in the public market.

The bottom line is with skyrocketing valuations being a continued theme in the venture capital realm, capital efficiency and earnings seem to have started to command some attention from investors, both public and private.

The measure of Free Cash Flow is important to a prospective investor because, among other indications, the metric shows how efficiently a company is using their cash to run the business. It also can reveal potential problems in the fundamentals of the business before they arise in the income statement.

The 2019 class of IPOs has included a number of high-profile unicorns like Uber and Lyft. Together, the unprofitable IPOs have already raised the most cash of any year since 2000.

Our approach to private markets

Some components of the private equity asset class have started to become overcapitalized — as we’ve seen from the lofty valued unicorn arena we have discussed. Our philosophy leads us away from these areas, toward less efficient parts of the market where we believe lie the greatest areas for opportunity: smaller, more niche areas that are less likely to be over-saturated with larger, institutional capital.

Our goal is to lead trends, not follow them, and so we seek out unique businesses. We look for companies that are carving out their own categories or creating new markets. We look for sector specialists and/or regional specialists, finding managers who have great talent and skill in their specific fields and know how to implement within a private equity structure. We focus on building strong industry relationships with groups and individuals that keep us apprised of prospective opportunities and can provide our clients with access to top-tier, exclusive private equity opportunities.

We also look for niche managers and products focused in thematic areas where we see opportunities for growth. We are particularly focused in areas of “what people need,” such as food/agriculture, water, resource efficiency, and life sciences/healthcare, as we believe that what humans need to survive are likely areas for rapid growth in the current environment.

In conclusion, our hope is to bring some context to the clashing information in the world of investing, and that by sharing some of our insights into the realm of private markets, we can provide our clients with the critical information they need to separate headlines from the practical reality.