‘The Cheap Money Era’: 2019’s IPOs Have Delivered Some Harsh Lessons to Venture Capital

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From $47 billion to $10 billion—potentially one of the largest valuation drops in 2019. As much-criticized WeWork struggles to IPO at a heavy discount, many companies coming to market this year have been having similar problems. Namely, there’s been a huge disparity between private and public valuations for many companies, and some in the private market are growing skeptical.

To be sure, there have been many notable successes (à la Zoom Video Communications, Datadog, Pinterest, to name a few) to debut this year. But 2019’s IPOs also brought us big flops like Lyft, Uber, and Slack—all three of which are down at least 20% from their debut prices. SmileDirectClub, one of the latest massive unicorns to debut, also disappointed investors in the public markets, trading down some 28% on only its first day. And with the prospective debut of The We Company sometime before year’s end (although even this is hotly debated), investors and analysts are expressing similar anxiety: the private markets and the public markets are largely at odds this year, and private investors are due to lose cash.

“I think that it will impact the valuations in the private markets also—the euphoria that has been there will [be] cut back,” says Reena Aggarwal, professor of finance and director of the Georgetown Center for Financial Markets and Policy at Georgetown University.

The abundance of capital floating in the private markets this year has been feeding many companies that those like Kathleen Smith, principal at Renaissance Capital, a provider of institutional research and IPO ETFs, deem bloated. She claims this private funding has “been able to incubate companies” without too much pushback on important things like cash burn or plans for profitability. But this might be changing.

“This growth at all costs only works in the cheap money era,” Smith tells Fortune, referring to the excess capital in the private markets. “The worry is, does it dry up capital for other companies?”

Funds like SoftBank’s Vision Fund (which notably invested in Uber and WeWork) are in the hot seat. To Smith, case studies like WeWork (what she calls a “cautionary tale”) show a broader problem that investors will have to come to terms with.

“WeWork is a liquidity scare for the private markets—how is it possible a company funded with $12 billion of funding and a possible valuation of $47 billion could not get done in the public markets? It has to be a worry for any of these [private] portfolios,” Smith says. “It’s a wakeup call if you’re in the private market—they must be studying every name they have now.”

But what might 2019’s failures teach the private markets?

The perils of lax due diligence

One thing some on the Street suggest was missing from 2019 IPOs was scrutiny—scrutiny of private companies with massive losses, lofty aspirations (think Peloton’s S-1 line “Peloton sells happiness” or We’s goal to “elevate the world’s consciousness”), and vague plans for profitability.

“WeWork is following a path that was blazed by Lyft—what happens when you have huge losses and crappy disclosure and real arrogance,” says Rett Wallace, CEO and founder of Triton, a firm that focuses on evaluating new listings. Wallace suggests that this trio—”big losses, crappy disclosure, and meaningful arrogance”—is a “lethal combination” that bad IPOs had in common this year.

Indeed, those like Aggarwal believe many of these unicorns were “given a little bit of a free hand.” She maintains investors are going to be keeping a closer eye on private companies’ business plans and losses—and Santosh Rao, head of research at Manhattan Venture Partners, suggests that, especially after Uber’s and Lyft’s “hype and then bust,” investors have become very cautious. “Now they’re reading the fine print, they’re not just looking at the revenues,” he says.

In light of those like SoftBank (who poured billions into WeWork as recently as January while the company was sustaining huge losses), experts suggest many private investors will pause before funding more of these growth-at-all-costs companies.

“The market is distinguishing the good from the bad, but I think the issue is that there’s too many of these companies that have been in venture portfolios that have been permitted to operate without a bottom line orientation,” Smith says.

The danger of late stage investing

As companies grow in the private market, some experts believe the excess capital floating around has made companies’ late-stage private rounds swell to unreasonable levels—or, for Smith, to “incubate.”

In 2019 terms, WeWork’s last private round, funded by SoftBank to the tune of around $5 billion, marked the coworking giant up to roughly a $47 billion valuation. But as has been clear, examining the company’s cash burn ($1.9 billion burned on $1.8 billion revenue last year), as well as other problems, is making public investors increasingly anxious—and unwilling—to validate the private markets’ valuation; which, to Smith, is “the long-awaited reconciliation.”

So what does this mean for private investors? Experts suggest many in the private markets may be reticent to get in on companies’ later funding rounds.

“I think [private investors are] going to realize that there’s not going to be that big bump that you get at the IPO, there’s no guarantee,” Rao says. “Because some people come in late, either they should have a very long time horizon, or they think they’re going to get a big pop at the IPO, … but I think now you’ll see that the incremental investor in the later rounds will be more cautious, will know that the exits may not be rewarding, or the upside may be limited when they go out, so they’ll have to either wait or make sure that the company has a solid business model [and] that it can withstand the scrutiny of the public market that is going to be very intense.”

One way Jill Shaw, managing director at global investment firm Cambridge Associates, suggests investors avoid this drop is to be disciplined and get in early.

“Late-stage venture capital is incredibly expensive,” Shaw tells Fortune. “I think it’s actually the phenomenon of all this money pouring in to late-stage is actually a benefit to the early-stage investors because it’s another exit opportunity [because] companies are staying private longer—so what we see is, a lot of these early-stage investors are either selling out completely or taking money off the table when you have some of these pre-IPO, late-stage investors coming in. They’re not waiting for the IPO, and they’re not necessarily hurt if the IPO doesn’t price at a higher valuation than the prior round.”

Shaw recommends private investors partner with savvy managers with proven ability to identify good early-stage investments to avoid losing cash in pre-IPO companies (like SoftBank inevitably will if We ever goes public, although some fine print in We’s S-1 could provide SoftBank with $400 million worth of additional shares if the IPO debuts poorly).

(Certain) capital may dry up

According to a recent Preqin survey, 74% of surveyed investors believe we are at the peak of the equity market cycle. In fact, according to consulting company McKinsey & Company’s private markets annual review for 2018, some $778 billion of new capital flowed in to the private markets last year. According to the report, so-called “supersize” funding rounds (those over $1 billion) in venture capital funding reached 25 in 2018—or over 25% of all venture capital deal volume. Investment from venture capital firms also hit their highest levels since 2000, injecting roughly $131 billion into deals last year, according to data published by PitchBook and the National Venture Capital Association in January.

And to Renaissance Capital’s Smith, private market capital may be overdue for a return to lower levels.

“Everything is always about markets going in cycles,” Smith says. “Capital contracts [and] goes to the areas where the returns are. There’s been a lot of capital in the private market—the capital will recede from the private market, and when it does, it will cause a lot more challenges. This is one of the longer cycles ever in the public market, and the biggest cycle in private spending I’ve ever seen.”

With some of 2019’s biggest IPOs off at least 20% from their initial prices, private investors may be turning elsewhere to get better returns.

According to data from Cambridge Associates from the 1st quarter of 2019, U.S. venture capital value-add returns over the past 10 years have actually trailed returns for the S&P 500. Cambridge Associate’s Shaw suggests this return discrepancy has more to do with the dramatic swings in the public market (and more dramatic recovery) than private equity, but concedes that “we’re probably going to be seeing narrowing across the board” as larger funds’ investments have struggled to even beat the public markets at all.

“For the private equity firms and others in the private market … especially the mutual funds, the Fidelities of the world, they have a bigger fiduciary responsibility. Broadly, this will impact valuation going forward for both private markets and public markets,” Aggarwal told Fortune.

Growth-at-all-costs companies are a bust

While many private investors will likely be re-examining their strategy moving forward, many firms are maintaining more disciplined, long-term strategies and ensuring they only invest in mature companies.

Mega private equity firm Blackstone’s CEO Stephen Schwarzman told CNBC last week that “some of [2019 IPOs] are immature companies.”  

And for Rao, companies moving forward are going to have to meet some criteria before coming to market with huge private price tags and immature business models.

“The least you can do is be a profitable company,” Rao says. “If they’ve been private for so long and you come with such high valuation, the least you can do is have a very good up and running, fully-baked business model. I think that’s the big realization that people have now; you really can’t come here and demand the same [valuation] that you had.”

Growth-at-all-costs companies like WeWork, Uber, and Lyft seem to be starting to shatter the illusion that big, high-valuation companies can’t lose in the public markets.

“It used to be that public offerings were done at a premium to the private rounds, because public liquidity is worth something—but the concern I’ve got is that this will feed itself into the private market and cause a chill in the private market,” Renaissance’s Smith says. And based on how some of these private investors’ internal rate of returns (IRR) have been hurt by public markdowns, some investors may be reconsidering where (and when) they’re allocating capital.

“The net effect of everything is going to be a good rationalization of the market, the valuations are going to get more reasonable, and now the public market is actually teaching the private market that you really can’t just put anything on us,” Rao suggests. “You have to prove yourself.”

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