Private Markets Hide All Manner Of Sins

fifty dollar cash notes

Private Markets Hide All Manner Of Sins

A number of notable companies and investors today appear largely unaware of the relationship, and potential disconnect, between growth and financial sustainability.

It is all well and good to own part of a technology firm that is growing revenue and users rapidly and burning cash. It is also fine to systematically bet on small tech co’s based on the odds of finding a unicorn. Still… It is entirely less good if your business (investment manager) is highly dependent on raising new money to pay your fees and operating costs because you invest in non-yielding businesses that cannot be easily sold.

Companies like WeWork, Softbank, and Tesla spring to mind. Funds like Blue Sky (ASX:BLA), and the myriad VC investors and institutions that invest in private businesses (including your superannuation fund). And a few other special creatures here and there…


Imagine that interest rates are low and public equities are expensive and investors are desperate to earn returns. Now imagine that there is a VC investor, who we’ll call Seleukos Percival Ioannou V (SPIV – Percy for short), that offers investors the opportunity to contribute capital to a VC fund with proven private investment expertise. This firm will invest in the most attractive private companies with an IRR target of at least 12% per annum – higher than typical stock market returns to account for the illiquidity and additional risk.

Our mate Percival raises a hundred million.

He invests this money into a selection of smallish tech companies as well as some property development projects in grossly undersupplied property markets. Very cool.

As the unprofitable tech companies grow revenue, their valuation rises. In true VC style they are hopelessly unprofitable – in fact they are burning cash, because they are all trying to exploit the S-curve of user adoption by hiring rapidly and jamming as much customer acquisition $$ into the market as they can afford. Still, they’re growing nicely, user count is up, revenue is up, customer retention is up, and valuations sensibly increase. As the companies mature, the price to sales multiple they are valued at also expands – let’s say from 3x to 5x. Through this mechanism, a company with $1 of revenue, valued at $3 on a 3x sales multiple, growing revenue at 30% p.a., becomes worth $10.985 in 3 years time at a 5x sales multiple. Three bags in three years – not bad, pal!

Property Always Wins

Percival’s property development projects are also going OK – everybody likes property; the asset class that always goes up. He puts down 20% equity investments/deposits and borrows the remaining 80%. The properties are progressively revalued as they approach completion. As the building is half-finished, it’s worth 50% of the estimated fair value of the property once completed. How do you value a building?  Well, just maybe, our dealmaker Percival decides he’s going to forecast 8% per annum property price growth and then value the development based on estimated future property prices. Let’s say it takes 3 years to build a large apartment building from the pre-approval phase; a $100 building growing at 8% per annum will be valued at $126 in 3 years. When half complete, it’s worth $63. The initial $50 investment to half-build it (of which only $20 is equity), is then worth $63 – a 26% return in 18 months. Very credible, and the ROE looks even better!

Let’s say Percy’s put $60m of his initial $100m into tech companies, and the other $40m into property development. After three years at 30% revenue growth and the P/S multiple moving from 3x to 5x, his tech assets are valued at $219.7 million, and the gross value of his property (20% deposit, 80% loan, ignoring all finance costs) is $251.94 million.

Based on these revaluations, Percy records $159.7m profit before tax on his tech co’s, and earned $51.94m on the $40m he put into property (ignoring finance costs for simplicity). That’s $211.64 million profit and assuming a flat 30% tax rate, $148.148 million in profit after tax.

Pretty astonishing performance for an initial $100m investment – except Percy made a boo-boo. He’s put all of his $100m into investments and has nothing remaining to either a) keep the firm operating (listing fees, staff salary, bonuses, audit fees, valuer fees, office rental, etc) or b) pay his management & performance fees for running the business. The timeline of any sale process is also uncertain – it can take many months to structure a major sale, and that’s before you consider that you would be silly to sell a tech co that has (deservedly) grown its valuation 3x within the last 3 years. Fortunately for Percy, the market can see that his asset valuations have risen rapidly, and is very willing to give him money. Percy raises a billion buckaroos, pays his management fees, and puts all of the rest into new investments. Genius that he is, he’s just learned that he can raise new capital when he needs it, so financial prudence is the last thing on his mind.

Or maybe – just maybe – he’s learned that he has a lot of latitude in valuing investments, so he’ll make a ton of money from performance fees either way…

The Funding Game

So after starting with $100m and growing it, Percy raises $1bn in new money. He pays all his fees and such and puts the money into new investments. Unbeknownst to him, however – with the ability to set his own valuation for investments and charge a fixed fee per annum based on those valuations (revenue is growing…we get a third party valuation bi-annually…) – the market is about to enter a downturn. What does that look like?

Percival, emphatically not at all blinded by his past success and ridiculous incentives, continues to assume that property grows at 8% per annum. He puts 40% of his fund into property. He puts the other 60% into tech, except a bunch of VC firms have raised billions and starting investing in private co’s in order to emulate his success, good deals are getting harder to find, and Percy gets a bit excited by the bull market “tech is changing the world” meme. Nevertheless, Percival is a smart man who is pretty sure he knows how to find deals, as his previous success shows.

The tech firms continue to grow – or at least, Percival’s valuations for them – grow at 30% per annum. The property grows at 8%. In this way, $1 of tech revenue (and $3 of valuation) turns into $10.985 in 3 years at a 5x multiple. $100 of property value (20% equity) turns into $125.972. Percival dutifully levies his management and performance fee.

Except this time, some body or some thing shows up to throw a spanner in the works.

  • Glaucus calls you a Ponzi scheme
  • The GFC eliminates the ability to roll over debt or raise new capital (fear increases/ rates go up)
  • You need too much money relative to your (inflated) valuations for a cap raising to be realistic
  • Cumulative losses and/or diminishing returns on incremental spend reduce investor appetite for your vehicle

Ponzi Scheme

A rough definition of a Ponzi scheme is “using money from later investors to pay returns to earlier investors”. If you are invested in illiquid assets with no cash flow, are on the hook for future equity injections, or if you have no exit event but set up some kind of exit facility for a small number of investors – or if you simply need the money to pay your operating costs – you are dependent on new money coming in to keep the show on the road.

You might not technically be a Ponzi scheme, but you are dependent on external funding and there is an obvious, massive, single point of failure if you are dependent on the vagaries of investor and market psychology for getting new money when you need it. This is especially true if you have external obligations to contribute further money at a later date.

The problem is not that you are investing in unprofitable businesses or that the market is in a downturn. The problem is not even that you run out of cash and require additional funding. The problem is that you are caught at a fulcrum where you desperately need money to keep the lights on and so your funding provider has leverage. Your valuations come unstuck because you have to take whatever price is on offer. You can’t easily sell your businesses because sales take time to structure and when you sell a loss-making business above a certain size, what you are really selling is an open-ended liability to your buyer (these are not easy to sell, for obvious reasons).

Short sellers, of which there is a growing number of decently aggressive ones, are in a prime position to exploit this. If you are fragile and need additional money, and a short thesis (well-founded or otherwise) can deprive you of the confidence you need to raise that money, you are f-u-c-k-e-d. Doubly so if your valuations are a little loose or you have high liabilities, because these can serve to “validate” the short thesis.

There were other problems, but fundamentally this appears to be the crux of what wrecked Blue Sky Alternative Investments (ASX:BLA).

Structural Profitability

Second to the acute cash requirements, to my mind the intermediating factor here is the “structural profitability” (or lack of) of the businesses that have been invested in. Many companies that VC/private investors invest in appear to be what I’ll call “structurally unprofitable” (in a loose sense). They might be profitable at scale, but they are not profitable now and could not become profitable next year or the year after by cutting expenses, for example. If the investors are tapped out, and if the company itself cannot sell a product profitably, the customer acquisition costs cannot be sustained, and thus the growth cannot continue, and the whole thing grinds to a halt – including the valuation, which typically relies (to some degree or another) on strong revenue growth. Because of this fragility, I feel there is a certain naiveté in some of the “private markets are better than public markets” stories going around, and I would be very surprised if there were not already a few of these types of ticking time bombs dotted about the place.

I could go on – this phenomenon also applies to many individual companies, far more so than asset managers – but I think the point is clear.

It is my view that a meaningful number of market participants are in for a wake-up call. The bill is already in the post. It’s not entirely clear when it will arrive, but as an investor, you emphatically do not want to be there when it does.

I have no position in, and no financial relationship with, any company or firm mentioned in this article. It is not my intention to paint private market investors as incompetent or short sellers as aggressive; this is simply a caricature of a hypothetical situation that I think will become more common in the future. This is a disclosure and not a recommendation.

Comments: 4

  1. Avatar Richard Colebatch says:

    Very good commentary 10 Foot. I do invest in a number of IT stocks and am always concerned when the EBITDA or EBIT grows at a lower percentage than the Revenue. The 4C reports are very useful for working out if I am on a “live horse”, so to speak. If there is two or three quarters of “cash burn” in the bank and the percentage increase/decreases are the right way round and I think I understand the business, I will invest. I also like to meet the team at their AGMs and weigh up if I can be bothered sharing their vision for the company. JMT

    • Thanks Richard. I definitely think there is a good case to be made that global SaaS businesses are a new, very attractive business model that should be valued higher than old line businesses like brands. Like you I struggle when companies are seeing their cash burn accelerate even as their revenue grows (ie if revenue grows up but EBITDA doesn’t improve). That’s why I don’t invest in a lot of small tech companies despite the potentially high returns on offer if you get one right.

      However one metric i’ve started using just to test myself is revenue added vs cash spent. If a company is getting a good return on its cash spent (e.g. spend $10m, add $15m revenue) then I can sort of roughly see if they’re adding value.

  2. Avatar Andy says:

    What do you think of the soon-to-be listed Pengana’s Private Equity Trust?

    • No view at all (have not looked) beyond a general scepticism for any business where a manager gets to charge fees based on valuations they set (no idea if this is the case at Pengana). I would look into how the fees are charged – e.g. are performance fees paid at the time of valuation, or only once an investment is completed and sold?

      Private equity *usually* acquires an existing ~profitable business like ASX:ING or ASX:DSH (before IPO) and strips cash out of the business (selling assets) + fires a bunch of people to improve margins. As a result PE usually generates a lot of cash and shouldn’t run into the difficulties described in the post above.

      This is a good look at a fairly spectacular private equity transaction from a few years back:

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