Steady Growth Wins the Race
Much has been written about “unicorns,” and rightly so – companies like Airbnb and Uber are game-changing, disruptive, and many will create extraordinary returns for their early investors. After the term was coined in 2013 by Aileen Lee of Cowboy Ventures, the market’s fascination with companies worth over $1 billion has been unbridled. Google search interest in unicorns more than doubled over the course of the year, while commentators including mainstream and financial journalists alike weighed in to suggest a cornucopia of variants including the “decacorn” (worth over $10 billion) and, perhaps more telling of the current market, the “unicorpse” (once, but no longer valued over $1 billion).
Even so, early-stage venture investors in unicorns are able to do fabulously well in almost any outcome. However, the total capital invested by these early VCs is dwarfed by amounts deployed in the same companies by later-stage funds and “crossover investors,” non-traditional participants in the venture market including mutual funds, hedge funds, and sovereign wealth funds. In 2014, 17% of minority growth equity syndicates included a crossover investor versus just 8% in 2011. The fact that this entirely new class of growth-stage technology investors has sprung up in the past few years is in itself a classic sign of an overheated market. Has this risen to the level of a bubble? We think history will show that it has – but unique to the current market, this contention has been borne out only by a recent, modest slowdown in venture financing but not by a precipitous drop in public markets.
What is atypical by historical standards is that recent overheated valuations are primarily limited to the private markets, with the public markets conspicuously not validating the unicorn phenomenon on a broad basis. If we are in fact in a bubble, this will be the primary difference between today’s market and the “dot-com” era – the big losers will not be individual public investors, but rather institutional investors and their limited partners. Funding has been robust, as have mark-to-market returns (at least until recently), but the returns of actual cash for later-stage unicorn investors have thus far been lackluster – a point articulated nicely in a recent New York Times article. Much of VCs’ gains have been on paper, as can be observed in the returns of recent vintage venture capital benchmarks. While the recent drop in unicorn valuations and the modicum of cash returns may be signs that the bubble is beginning to deflate, the same trend can be seen in smaller high-growth companies overall. Generally speaking, these are companies operating in growing or even disruptive sectors with strong management teams and capable boards of directors – yet, their investors are coming to the realization that they may have overpaid for growth.
We believe a significant shift is occurring that will have long-term implications for valuations of high growth companies: that the market’s focus on growth at any price is fading and that investors are increasingly seeking a clear path to profitability. Regrettably (or perhaps thankfully), the market in which we’ve been living for the last several years – where assumptions were rosy, every horse could grow up to be a unicorn, and deals were “priced to perfection” – is likely gone.
Within the venture ecosystem, we believe that growth equity is the tortoise to the early-stage VC hare. A now-famous Cambridge Associates study found a favorable risk-reward tradeoff in growth equity – a focus we feel has been validated through our time investing in growth businesses. Making growth investments in middle-market companies may not be as exciting as underwriting startups to unicorn status, but there is a far more scalable investable universe, greater consistency in results, and substantially less volatility in outcome. Over the long run, we believe the best returns can be achieved by maintaining valuation discipline throughout the market cycle, focusing on workhorses rather than unicorns in the underserved middle-market, and bearing in mind the tradeoffs between growth and profitability. While investors may enjoy watching the unicorn herd stampede by, ultimately, they should expect steady growth equity to win the race.