Secondhand Flowers

flowersOld O’Malley used to dispense sage advice from his stoop in Brooklyn. The smoke of cheap cigars and the cracking of the Yankee game on the transistor radio hung heavy in the humid night as O’Malley meted out wisdom like Aristotle under an olive tree. And one nugget that stuck with me through the years goes as follows: “never buy a girl secondhand flowers. The last girl may have enjoyed them, but your girl will just think of them as used up.”

So what does this have to do with investing? Recently, I was talking to someone about a company that was about to go public and they were lamenting the large discount to public comps implied by the bankers’ pricing guidance. Of course, IPO investors crave a first day pop, but the discount seemed to be bigger than they had seen lately. We wondered aloud why that might be? Lackluster aftermarket performance of last year’s IPOs? Higher perceived risk in the economy? Idiosyncratic risks of this company? And so on. This person also talked about how the bankers remarked that some private companies were pretty close to being overvalued relative to public companies, creating an inversion that would make any liquidity efforts tough.

But then it hit me: maybe it’s because we’re asking public market investors to buy secondhand flowers? Stick with me here: in the heyday of the IPO market, there was a lot of meat left on the bone for public market investors. Josh Kopelman wrote a great blog post a while back that analyzed the returns available to public market investors in private tech bellwethers of yore, a group that included the likes of Apple, Google, Netflix, Salesforce, and Yahoo. He surmised that 97% of the upside in these companies was eventually captured by public market investors. Now, imagine today’s unicorns and decacorns. How fully priced are these companies in the private markets? How long will it take for their market caps to grow by a factor of 20? How much bloom is left on those roses?

Of course, the late stage private market is today’s equivalent of the emerging growth public market of old and the highfliers in my portfolio look like they’re refugees from the S&P Midcap 400. It makes sense, after all: in the wake of the well-documented changes in public market structure, private companies found it harder to go public and money seeking the returns historically associated with emerging growth public companies flooded into venture capital. It also makes sense from a theoretical standpoint: if you believe in Modern Portfolio Theory, you seek to invest in the fabled World Wealth Portfolio which contains all the world’s assets. As public markets got less hospitable to small, fast growing companies, they became less representative of the economy and money seeking “market completeness” found its way to venture.

But VC can’t be the old Roach Motel (“roaches check in but they don’t check out”). Companies need to get liquid so that LPs get cash back to redeploy into the next cohort of funds that will back the next generation of startups. The past half-decade has been a little funky, as we’ve been of pricing private companies seemingly for perfection (and, of course, the VCs are happy to take big mark-ups — just in time for their next fundraise; quite the coincidence!) Let’s always be cognizant that public market investors heed Buffett’s Equation: Opportunity = Value – Perception. And of course, perception (or hype) is articulated in valuation.

The slowdown that we’re starting to feel should be taken as a good sign: good companies should still be rewarded, but valuations may better reflect experience not hope. And with any luck, the public markets will again think of our flowers as fresh and perhaps we’ll get a laxative for the capital constipation that’s keeping capital locked up in mature companies and money out of our hands.

3 thoughts on “Secondhand Flowers

  1. Bingo. Remember the old days when GPs would hang onto shares forever after the IPO because they didn’t want to crystalize the carry yet? That had its own issues, but we’ve come a looong way. (My 3rd ex-commonlaw wife told me so).

    Liked by 1 person

  2. Hi, Chris, as I read what looked like a hope lament (“With any luck…”), I couldn’t help but recall that “hope is not a strategy”. But then, what is there to replace hope?

    I think it is operational wisdom and expansion of methods of liquidity. Today I was looking again at how the SRC Holdings of Jack Stack gets their operational wisdom and liquidity events approximately right (it can be done better, actually), and again thought that most VC/PE boys are missing much of the growth juice and big new slabs of meat on the “bones” of their portfolio companies. *With any luck* they’ll notice it. 🙂

    Liked by 1 person

  3. This is really interesting: Opportunity = Value – Perception
    So much of VC is momentum – the press, the communal drooling of VCs egging one another on (encouraged by founders) to issue term sheets to hot deals.
    But intrinsically any VC does not have a great opportunity at a given epoch, where there is positive perception. At which point they wouldn’t invest. I don’t really know of any conviction investors that ignore social signals.
    The formula really applies to cash generating assets at a semi-mature state.

    One observation though is- are second hand flowers not beneficial to founders? It seems private market pricing is in fact higher than public market (at least at growth stage). You have seen a few companies get ratcheted at IPO (e.g. Square).


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