“Objects in the rear-view mirror may appear closer than they are”.
Right now, the opposite is true.
It feels like a lifetime ago – but it has only been 11 weeks since we were trying to find a way forward in the midst of absolute carnage.
As I was writing this post, the S&P 500 had just collapsed to 2,386. Trillions upon trillions of economic value disappeared in mere days.
Less than three months later, the index has crossed 3,100. An astounding performance, adding up to a 30% absolute return and dumbfounding pretty much everyone in the process. In a way, an equivalent of having Mike Tyson punch you right in the solar plexus – and shrugging it off in a nanosecond.
A Private Affair?
In a way, it’s the private markets that may be to blame here.
The private equity / venture capital industry entered this crisis in rude health – and sitting on record volumes of dry powder, estimated at c.$2.5 trillion worldwide.
Sensing the opportunity to acquire assets and knockdown prices, the masters of the universe pounced.
AirBnB was the first landmark deal. As the lockdown was literally sucking the oxygen out of the travel industry, the company locked in two $1bn fundraising deals in rapid-fire succession.
Stripe, arguably the world’s most valuable start-up, landed a $600m equity injection in mid-April.
Marquee investors like Andreessen Horowitz, GA and Sequoia practically fell over each other to provide more capital to the business.
Meet the new titans of industry
And just a few weeks (and multiple system outages) later, Robinhood claimed second place on the most valuable start-up list.
No shortage of investors willing to cut a $280m cheque – and assign an eye-popping valuation of $8.3bn to a company that generated just $20m of revenue in February (although they did triple it to $60m in March).
Public markets clearly took notice and there was a flurry of equity issuance by listed companies in May.
Shopify landed the top spot with a record $1.5bn overnight equity offering. Many others followed, striking while the iron was hot.
Let The Good Times Roll
It’s hard to blame management teams for taking advantage of market conditions.
Who knew this would happen?
Assuming things go well from here onwards, no one is going to beat you up for buttressing your balance sheet. If nothing else, you’ve built yourself a nice war chest to take advantage of M&A opportunities.
And if everything goes south, not raising money when you had the chance will certainly make you look like an idiot.
From a CEO’s perspective, the answer is clear. Don’t look like an idiot.
From the perspective of investors actually ponying up the cash – much less so. Why spend the money now if you can potentially get a much better deal down the road?
A couple of reasons.
First, there’s the pronounced acceleration of long-term, secular growth trends.
It took ten years for e-commerce penetration in the US to go from 5% to 16%.
It then took less than ten weeks for that number to go up another 11%, rising all the way to 27%.
Essentially, any direct or indirect play on e-commerce has seen it’s addressable market double in size in less than a quarter. This is one of the key reasons everyone is lining up to buy Shopify and Amazon.
In a way, it’s surprising the valuations haven’t gone up more.
For the likes of Robinhood, another factor is at play. For a decade, investors (mostly millennials) have grown sick and tired of hearing how the GFC was a fantastic way to get into the stock market and how they missed the boat.
No wonder they felt that the Covid pandemic may be an opportune time to finally put some money to work.
Robinhood tripled its revenue to $60m in March. Assuming the performance holds, you are looking at a revenue multiple of c.11.5x. Not pedestrian, but not unheard of for a category leader in the fintech space.
Finally, there’s the FOMO aspect. No one wants to be left outside when there’s a great party going on indoors.
But is one set of investors walking away with a better deal than others?
Public vs Private: Unfair Advantage?
Fundamentally, both public and private investors are buying into the same companies.
You can argue that Shopify is very similar to Stripe. Industry leaders occupying privileged positions in high-growth markets. Everyone makes money and lives happily ever after.
Unfortunately, with some minor exceptions, us public market investors only get to hold common equity.
In private markets, things are different. Investors have the ability to negotiate specific terms and conditions. Funky structures are common – and private equity is sure taking full advantage.
Let’s have another look at the deals above.
That AirBnB deal? Well, it was structured as a $2bn debt injection, with some equity warrants sprinkled on top.
If valuation holds up, equity warrants are in the money, providing further upside to investors.
If it doesn’t (remember WeWork?) – well, Silverlake and Sixth Street still get to collect their coupon. The yield on the debt instruments is estimated to be in the 9-12% range.
Not bad, considering half of the debt is structured as first-lien, meaning the loss of principal is highly unlikely.
How about those nice people stepping up to inject money into Robinhood?
Turns out that the value of their investment will be protected if the next funding round (or an IPO) values the company below the current $8.3bn valuation. No taking from the rich in this case.
And while details of the Stripe round aren’t public (another advantage of operating in the private markets), it would be surprising if investors didn’t look to give themselves a form of downside protection there as well.
What Happens Next?
So what does happen going forward? Is the whole thing a house of cards, about to collapse?
The simple answer is – nobody knows. But if you look at revealed preferences, two things become evident:
First, despite all the hand-wringing and pessimism about “Wall Street vs Main Street”, investors are piling into the markets, unwilling to miss out on the next leg of transformative growth.
Secondly, those who can (i.e. those who operate in the private markets) are looking over their shoulders – and trying to protect the downside in case of a second wave of infections or a delayed meltdown in the economy.
Unfortunately, retail investors like ourselves don’t have the second option.
Our only form of protection is ensuring that our investment strategy is in line with our risk appetite, addresses our long-term objectives, and leaves a sufficient buffer of cash to ride out any near-term fluctuations.
For an investor, today’s market environment can be incredibly frustrating. It simply doesn’t compute – and I can’t blame you for the desire to sit out the nonsense and wait for a more conducive backdrop to put money to work.
However, what I have written 11 weeks ago holds as well today as it did back then:
It may also be tempting to cash out and sit out the volatility. I can’t blame you. But rest assured – when we declare victory against the coronavirus, it will be far too late to “get back into” the stock market. That ship will have sailed.
Choose your strategy carefully.