Published September 2020
In 2019, unicorn companies — those that are worth at least $1 billion — started to lose their luster. Ride-sharing giant Uber initially aimed to go public at a $120 billion valuation, but eventually settled for a value of $82 billion. At the writing of this article, its market cap hovers around $60 billion. In remarkably similar fashion, shared-office provider WeWork‘s $47 billion private valuation drove widespread skepticism, leading to a failed IPO. After a series of adjustments, its valuation has since plummeted to a mere $2.9 billion.
Despite these valuation fiascos, the situation this year is quite different. With interest rates at record low levels and the Federal Reserve continuing its asset purchases, there is an overabundance of capital that has propped up asset values. However, this will not be valid across all sectors, as some will continue to bear significant business challenges from Covid-19.
According to parent company SoftBank, WeWork’s latest devaluation is partly the result of the Covid-19 pandemic, which has affected earnings across the economy. The current pandemic has resulted in weak transaction volumes, striking at the heart of certain sectors in certain areas in the FinTech sector. Sectors related to travel are hit particularly hard, with private equity firm Carlyle Group pulling out from a planned $450 million investment into AMEX’s travel agency business.
Many payment companies have transaction-based business models, with transactional growth dependent on large marketing expenditures. A survey conducted by Rosenblatt Securities in October 2019 revealed that investors expected a prolonged market slowdown to significantly affect global FinTech unicorns, driving down average valuations by about 15%. The valuation of UK challenger bank Monzo already fell by 40% to $1.5 billion in May due to the pandemic, with others scrambling to secure emergency funding while avoiding a cut to valuations.
Public Markdowns and Private Markups
In some cases, the economic downturn has even revealed significant accounting fraud. To continue driving higher valuations, some companies have resorted to financial engineering with the hopes that growth will eventually plug the financial holes. China’s Luckin Coffee, once valued at $12.5 billion, disclosed the fabrication of sales to the tune of $310 million. It has since been delisted on NASDAQ and current market cap stands at a paltry $350 million. Revelations of an accounting scandal by German company Wirecard triggered a precipitous decline in the markets, culminating in its bankruptcy. The payment processing company is currently trading at a market cap below $1 billion, a stark contrast to its peak of $28 billion two years ago.
Given the intense scrutiny of public companies, it is no surprise many companies prefer to remain private. In the past, Tesla CEO Elon Musk has lamented about public pressure to focus on its quarterly numbers, leading up to his 2018 attempt to take the company private. However, private equity valuations can continue to be inflated with less regulatory and public scrutiny, with WeWork being a prime example.
Some have already sounded the alarms about sky-high private valuations. A recent paper titled “Squaring Venture Capital Valuations with Reality”, published by the Journal of Financial Economics, concluded that private investors pay a premium of about 48% to access investment opportunities. Since 2012, private equity dry powder, or uncalled capital, has grown significantly to a record high of $2.5 trillion across all fund types in December 2019. With a great deal of capital chasing investment opportunities, it is no surprise that private valuations get distorted upwards, some less justified than others.
To understand how private valuations will fare in the post-WeWork and post-Covid-19 era, there is a need to understand the rise of the bubble and its association with historical bubbles. As highlighted in books such as Nobel-prize winning economist Robert Shiller’s “Narrative Economics,” narratives can influence the actions of market agents, ultimately driving bubbles or causing panics. A more recent book by economists David Kirsch and Brent Goldfarb, titled “Bubbles and Crashes,” investigated the root cause of technological bubbles over the past 150 years, emphasizing the role of narratives in many of these episodes.
Differing Narratives: Pre-Covid and Post-Covid
The narrative of new technologies has the potential to drive a valuation bubble. The valuation of these emerging technologies depends on how much investors believe in the vision, the imagination of use-cases and the business model. In SoftBank’s case, their $100 billion Vision Fund invested heavily into the sharing economy, a key narrative of “the future of work.” However, this narrative is supported by a model of high volume, low margins. To get to high levels of profitability, companies need to spend their way into new markets and rapidly drive up adoption. Amazon and Alibaba grew to scale, eventually becoming extremely profitable, but others like eToys met its demise in the dot-com bust.
eToys exemplified the Get Big Fast approach back in the late 1990s, with CEO Toby Lenk outlining his strategy by “losing money fast on purpose, to build our brand.” Back then, the overarching narrative was that the nascent internet would make online sales more convenient and efficient to brick-and-mortar businesses. While that was valid, the valuations of dot-com startups increasingly got out-of-touch with reality, culminating in the 2000 crash. In 2019, many SoftBank-sponsored companies found themselves in a similar situation, but this time many were stopped at the IPO gates. Those that raced to go public found relatively weak public appetites for their offerings.
In public markets, the tech-heavy NASDAQ could be an interesting comparison to the dot-com bubble. Since its 29% decline back in March, it has not only recovered completely but also gone on to challenge new highs since June. The S&P 500 has also repeated the feat in August. Many of the listed companies benefit from the current Covid-19 narratives: “work from home” has driven up expectations of higher SaaS (Software-as-a-Service) adoption, while “stay at home” has boosted the bottom line of online retailers and other consumer web services. An anomaly is Tesla, whose stock soared in recent months despite not fitting into these narratives, possibly benefitting from the positive sentiments of the market.
From the macro-level, there is also the Quantitative Easing (QE) narrative that supports the soaring public markets. With interest rates near zero levels, it is tempting to put the new capital to work in the stock markets. Even though markets are climbing quickly, there are plenty who still want to ride on the momentum, even against the advice of their financial advisors. While this macro factor is important to consider, a deeper analysis is beyond the scope of this article. Regardless, the plausibility of this narrative can be sufficient cause to drive significant asset price inflation.
To summarize the points so far, the nature of the industry would drive differing narratives that would have various impacts on the valuations. FinTech and sharing economy companies that have narratives that depend on the “classic Get Big Fast” approach have and will likely continue to suffer in the near-term, especially if physical interactions are important.
On the other hand, enterprise software and sizeable online consumer platforms (e-commerce, streaming platforms, etc.) have narratives that are favorable in the post-Covid-19 era, propelling their valuations further in the QE era. There is also a third category of companies that focuses on long-term R&D in fields like autonomous driving or space travel. These companies may not be generating revenue yet, but may not be incompatible with the post-Covid-19 era.
Every market that has a narrative, will inevitably have strong speculative potential. The more plausible the narrative is, the more likely retail investors will participate. These investors tend to lack experience in the markets, with many ending up buying at premium prices.
Two Tech Trajectories
Companies that are expected to thrive in the post-Covid-19 era will likely continue to benefit from private equity dry powder and an escalating QE policy. SaaS and other cloud-related companies will continue to benefit from the ongoing cloud transition, while online platforms like Amazon and Netflix will continue to grow their market share in a winner-takes-all situation.
Growth in these companies remain optimistic and will likely reflect in rising market valuations, though an eventual dot-com style crash is not beyond imagination in a certain future. Ironically, the Covid-19 recession could have slowed growth to more sustainable levels before going up the next leg, but it has instead created a stronger growth narrative.
In contrast, companies that will only achieve high profitability levels after getting to massive scale will continue to face difficulties. SoftBank has slashed billions of value from its investments, many of which are in this category. For other privately-held companies, there could be a desire to get acquired at reasonable prices before things get worse (Payments company Galileo was recently acquired by SoFi at $1.2 billion).
The continued strength of tech stocks could significantly widen the gap between an expected sale price and another company’s acquisition offer. In that case, companies may prefer to delay their exit, rather than receiving an undesirable value. However, a massive collapse in the markets (either the burst of a bubble or exogeneous shocks in the economy) could trigger a series of panic sales at substantial discounts, adding on to the backlog of companies that already plan to sell.
Despite the seemingly high valuations of many unicorns, there seems to be little sign of a hard landing in the near future. While some companies may lose billions in value, many others will continue to thrive in favorable market conditions.
The narrative-speculative value seems to be fairly muted at the moment, likely due to two reasons. Firstly, SaaS companies and B2B software trends can be more difficult to understand for retail investors, compared to consumer-facing companies. Secondly, these investors are pre-occupied with surviving the pandemic and do not necessarily have spare emotional or the financial capacity to invest. Despite that, we need to monitor how the economy recovers and how this impacts the entry of more retail investors (through trading platforms such as Robinhood) that drive up speculative activity.
The Federal Reserve has pledged to keep interest rates near zero through 2022, which can be helpful for market stability. However, should a perfect storm of circumstances arise, as had happened in past bubbles, the markets could decline heavily. A black swan event like this would then have the potential to ignite a hard landing across all parts of the parts of the capital markets.
 Kirsch, David and Goldfarb, Brent, Bubbles and Crashes: The Boom and Bust of Technological Innovation.