Fidelity Investments last week again marked down the valuations of some of the highest-flying unicorns in its portfolio. Not surprisingly, the front-page news stoked the current narrative that the market for late-stage venture-backed companies is falling apart.
A look at two different sets of numbers tells an entirely different story.
More companies rising than falling
First, based on Stock-Watch data from The Wall Street Journal on Fair Market Value reports of public funds like Fidelity, the internal rate of return (IRR) for these investments in companies on this list – primarily unicorns – is a very respectable 17.5%.
How do we arrive at the 17.5%?
The Journal’s data shows that 30% of these companies have a fair market value below the initial investment cost of the respective investors. The average write-down from the initial investment in this group is 25%. At the same time, 70% of companies on the Journal’s list are above the initial investment cost. The average increase in this group is 81%.
So as of March 31, 2016, the total performance of these investments is 1.4x the initial cost, and they yield a 17.5% annualized rate of return based on the reported initial investment date.
What investor wouldn’t be interested in that kind of performance?
For perspective, it’s important to note that a 30% write-down rate (based on the number of companies) is actually within the historic average. A 25% markdown (based on cost) is actually less than expected. In reality, both of these numbers confirm the current market is moving along its historic average; we see a regression to the mean, not a disintegration of the market.
Capital is not drying up
The second misperception is that capital has stopped flowing to late-stage venture capital companies. With no IPOs in the first quarter, the conventional wisdom is that unicorns may stumble without much-needed funding during a critical point in their development.
The numbers don’t bear that out either.
In fact, capital inflows in “mega rounds” – those financings of $100 million or more – were at an all-time high in the first quarter of 2016. Early data shows that in Q1 2016, about $8.8 billion was invested in these mega rounds across 23 companies. That’s up from $6 billion in 21 companies in Q4 2015.
This increase represents an annualized investment rate of $35 billion for 2016, up from $26 billion in 2015 and $16.7 billion in 2014. Clearly, there is not only a quarter-by-quarter improvement but also a continuation of a longer-term upward trend in capital deployed in late-stage, VC-backed companies.
Taken together, all of these data points tell the big picture about the health of the market for late-stage, venture-backed companies. It’s a solid market, with all of the ups and downs you’d expect in active capital markets.
So why is the market so unnerved?
One reason is that until recently, mutual fund companies like Fidelity didn’t report valuation markdowns. They didn’t have enough exposure in the asset class to trigger regulatory filings. Even when there was a markdown, very few were looking for those reports. Today, the information is readily available and easily reported.
Another reason for the apprehension is that our expectations are out of whack. Over the past six or seven years, this asset class has experienced phenomenal growth. In 2009, there was only one unicorn, and it was called Facebook.
Today, depending on how you count, there are about 150 unicorns, and many more former unicorns have graduated to the public markets. Some have even become deca-unicorns, meaning that they are worth tens of billions of dollars.
The spectacular appreciation in valuations has conditioned the market to believe shares in this asset class only move up and to the right at a very sharp angle.
A normal market
As the froth comes out of the market, it’s natural to ask how big of an adjustment there might be. The dot.com crash still haunts everyone. The lingering fear is that the same thing will happen to unicorns.
In reality, this asset-class is here to stay. A breather in the market is good for everyone in the innovation economy.
In psychology, there’s a well-known phenomenon known as “confirmation bias.” It’s the tendency for people to actively seek out and assign more importance to evidence that confirms their hypothesis and ignore or underweight evidence to the contrary. That bias often leads to statistical errors and errors of judgment.
As someone who has studied physics and makes a living analyzing facts, I don’t think the most important numbers about this market lie. Instead, I suspect a little confirmation bias may be hard at work.
Sven Weber is a Managing Director of SharesPost’s SEC-registered investment advisor, SharesPost Investments Management, LLC. He is responsible for the management of the SharesPost investment vehicles. Sven is also the President and a Trustee of the SharesPost 100 Fund.
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