One part of the financial industry that has eaten up a disproportionate amount of headlines in the last few years are IPOs and private equity. Seemingly every week a new, fast growing company makes its debut on the public markets with some having eye-popping share price movements in the market. It’s important to be aware of these companies and the private equity industry as a whole because they do have a ripple effect across the business landscape.
A term that may be heard in tandem with IPOs or venture capital is “Unicorn”. A Unicorn is a private company that is valued at over $1 Billion. A common theme amongst most of these high flying “Unicorns” is that they are fueled by debt and low interest rates. Interest rates are near their historical lows with the ten year government bond yielding sub 2%. Historically, interest rates tend to mean revert over long periods and although difficult to predict, the current interest rate landscape will not stay the same forever. A low cost of capital is the single biggest factor driving absurd private company valuations. Fast growing startups need low interest rates to use cheap debt to fuel their cash burning operations in the hope that they can grow fast enough and take enough market share that they can eventually be profitable (or sell their shares to public investors through an IPO). This dynamic acts almost like a land grab with several cash burning companies trying to acquire customers at any cost. The below graphic is from Crunchbase News showing the profitability, or lack thereof, of recent IPOs.
The recent WeWork fiasco is a perfect example of the hazards that come with investing in high flying unprofitable companies. WeWork is a real estate company that provides shared workspaces for technology startups and services. WeWork, until a week ago, was led by their notoriously erratic founder, Adam Neumann. Less than six months ago WeWork was valued at over $40 Billion in a round of private funding and the financial headlines were filled with stories of the company’s intention to go public as one of the largest IPOs ever. Flash forward to today and it has been revealed that the company was one week away from running out of cash if they did not get another round of emergency liquidity injected from its largest investor, Softbank. On top of the emergency cash to keep the company afloat, founder Adam Neumann was removed and given a $1.7 Billion exit package to leave the company. Keep in mind this is a company that has yet to earn a profit and private investors were weeks away from unloading their shares of the company onto the public market for a price that was totally disconnected from what could be considered even close to reasonable. It is also a noticeable pattern when unprofitable Unicorns try to cash out while the market is elevated, and confidence is high. The graphic below shows WeWork’s valuation through several rounds of funding before the founder’s exit and the IPO was called off which obviously hurt the company’s value even more.
Cheap debt is also fuel for the private equity markets that specialize in these non-publicly traded companies. Private equity firms use large amounts of debt to purchase private companies, typically strap the company with a lot of debt to fund growth projects, with the intent to sell the company for a profit to either private or public investors. This practice can make large amounts of money if executed properly. Private equity deal making has soared to its highest level since the financial crisis. A record amount of cash sitting on the sidelines searching for yield anywhere they can get it creates a huge amount of money chasing after a shrinking amount of investments which drives up asset prices. According to Bain & Co., last year private deals traded at higher multiples with higher leverage than at their peak in 2007. These weak balance sheets and high valuation multiples might be the new norm in private markets, but we are skeptical that it will work out when these companies are taken public and forced to compete with established companies that are profitable. It’s not hard to imagine how levering up to purchase newly formed, financially weak, and unprofitable companies at high valuations can turn out very poorly if not properly executed.
If the best private equity can do after a decade of declining interest rates, rising valuation multiples, and record capital flows is to generate performance in line with public markets, imagine what will happen to that industry when those conditions are no longer in their favor.
A term we like to use when describing companies that we favor is “proven enterprises”. These are companies that have flourished through several business cycles while earning positive cash flow for shareholders, maintaining modest leverage, and paying consistent dividends. Many IPOs may be flashing in the headlines right now but for each high flying IPO that goes on to become a thriving long term business, there are multiples more that go out of business and are never heard of again or become case studies in finance classes for poor corporate practices.
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