Old 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.