Navigating the Turbulent Times:
LTC Memo by Kannan Paul
25 May 2022
None of us know how long the current bearish market sentiment will last as we have no recent benchmarks for the confluence of the somewhat unusual macro-economic conditions that currently exist. On past record we can only assume that the current downtrend may have more to run (the average bear market lasts 289 days with a peak to trough decline of 37% according to Bank of America research) especially given that the various world orders have shown quite categorically that they are not shy to act to protect the status quo. Some even go so far as to say the “Fed put” no longer exists and it is deliberately suppressing US stock prices to dampen the US consumer via the wealth effect. There are essentially two polarised views on inflation; one that it is transitory and that there are already signs that that demand is weakening due various reasons including a significant drop in the growth in the money supply from 30% a year ago to 5% now and Chinese construction is work down by at least 25%; the other, increasingly the more consensus view, that inflation is more pernicious and entrenched with higher oil prices, food prices and a tight labour market here to stay.
We can all agree however, that technology isn’t going away, and it will, for the foreseeable future, be the main source of significant growth in productivity, innovation, and output. Downturns mean that competition shrinks, talent becomes more liquid and affordable, the pace (albeit temporarily) slows down - all of which allow for significantly better decision making and much more rigour and efficiency in execution within those business.
At LTC, our role is to provide our members and investors insight into the private market tech space and address the issues that we hear from them, hence this memo. Here are two key questions our members have asked recently we thought we would share our POV:
1. Have Private market valuations reflected Public market valuations and how are privates valued in funds?
The key question. On the face of it, this does not seem to be the case. Many VC and PE fund performances YTD seem not to be reflecting the downdraft. We believe that private valuations will come down significantly from here. One of the main concerns we hear from investors is there is no clarity on how funds are valuing the businesses they have invested in or consistency across the funds in how they value. Clearly capital raising valuations has been the most used metric but in a downturn like now with liquidity drying up fast, good well-funded companies don’t raise, certainly at a lower level. That doesn’t mean their valuations aren’t lower though. Public peer group valuations are a key metric for the private markets but the funds have quite a lot of latitude as to the weighting of this versus other variables such as growth rates etc. This lack of consistency and transparency is a feature of private markets and has been to its advantage in the historic bull market; but now it is a concern and we are very cognisant of this elephant in the room and is very prevalent in our analysis and investment approach at LTC which we detail below.
Positioning: Private Markets have historically been the beneficiary of strong hand investors, the ones whose liquidity profile means that they do not succumb to selling at the hint of a market downturn. Also, historically, private markets has been the part of the portfolio which an investor psychologically “writes off” and is not reliant or expectant of a return. More recently, this has been called into question as private markets have been the focus of a much broader range of investors, often who are reliant on the success of their private market portfolio. From the myriad of small investors to the large (historically public market) hedge funds who have dramatically increased their private market allocations recently (Melvin, Tiger Cubs etc) to pick up performance and will now be forced to aggressively devalue their private market holdings so that the mix of the public to private investments is not too skewed. This is worrying investors. However, against the examples of a few high profile, but in reality, insignificant hedge funds (in terms of Global AUM) , large institutions from pension, endowment funds to sovereigns are increasing dramatically their allocation to private. Analysts suggest that 10% of global assets will be allocated to private markets by the end of 2023, versus the 5% now (and in some countries e.g. UK, even lower, @ c. 1%.) These institutions are the definition of strong hands. Why? These investors are sophisticated and are less likely (given the underlying structure of private markets), less prone to make emotionally-driven decisions. Warren Buffett reflected on this point in his 2014 shareholder letter: “owners of stocks too often let the capricious and irrational behaviour of their fellow owners cause them to behave irrationally as well… liquidity is transformed from the unqualified benefit it should be to a curse.” As a result, Private markets have benefitted from the intrinsic liquidity restrictions it places on investors, curtailing emotionally charged decisions and thus providing a valuable diversification/hedging tool to public markets. For example, between 2000 and 2002, NASDAQ fell 78%, whereas annual venture capital IRRs were positive on average. The same is true of 2008 and the market disruption in March 2020 appears to have created the same dynamic.
2. Will Private continue to yield the best tech opportunities?
Private Markets are by definition, long duration assets. The volatility we are currently in the public markets will likely encourage the best tech companies to stay private longer rather than shorter, a trend already very much in place. Amazon went public, 3 years after it was incorporated with a market capitalization of $660million in today’s money; Google 6 years after its started; Facebook 8 years and Uber 10 years. Virtually none of the value that Amazon built was in the private market; 3% of the value created by Alphabet/Google was in the private market; 17% of Facebook and virtually all of Uber’s value. Companies are staying private longer, much longer, resulting in the necessity of investors to have access to value-creation in the private markets. Many reasons are attributed to this shift from public to private including the underfunding of US pension funds and the increased regulatory scrutiny of public companies but what is clear is that the trend of companies raising more money in private markets than public markets in each year since 2009 continues to gain momentum ($3 trillion in private and $1.5 trillion in public in 2017) contributing to half the number of public companies in the US today than in 1996. Long duration assets are the key ones to own in an inflationary environment with liquidity drying up. If you want to invest in the best tech companies, the private market is still the place to be part of their maturation.
Positioning: Separating the wheat from the chaff. A shake out is not such a bad thing because it will allow there to be a great differentiation between the companies and investing styles. “A rising tide floats all boats... only when the tide goes out do you discover who’s been swimming naked”. LTC has unparalleled access to VCs, PEs, companies, banks as well as a diversified, risk-managed investing style. Our historical returns speak to our ability to pick the best “deals” at the time. Compare with March 2020 when markets were significantly down - some of these past deals such as Revolut, Monzo, Airbnb have netted us handsome returns and prove our approach to investing as it has always been - disciplined and measured. We believe in capital preservation and careful risk management. Whilst the precise parameters with which we look at investments might be tweaked, the principles are still the same. We’ve talked about our sweet spot before: we look for solid companies with a fundamental grasp of a sizable market, identifiable exit strategies, scope for significant growth for a few years post our exit timeframes, a proven revenue model, product market fit, plenty of runway and good cash management. We combine these with our very conservative retakes on company forecasts (looking specifically at our exit timeframes), working out realistic multiples both now and in the future (rather than just comparables).
The strength of our Club, network and deep partnerships fuels our comprehensive and hard to access deal flow. Our 8-person investment team comprises of many decades of combined venture experience, 3 PhD holders and successful company builders. Our “deal-focused” investment approach allows us to not be wedded to any particular segment, sector or fund, ensuring we look across all private markets and pick the best deals when they come, purely on the merits of the deal itself and its ability to generate alpha for investors.
If you have any questions, Kannan Paul (LTC Investment Advisory), Konstantin Sidorov (LTC Founder and CEO) and Robin Bagchi (LTC Non-Exec Chairman) are always available for a coffee at 67 Pall Mall to chat further.