- Private assets could see a derating similar to that experienced by public markets late in 2018, creating selective opportunity in the public small cap market.
- The value of current venture capital deals is large and growing, while the number of venture capital-backed exits is decreasing.
- Many assets backed by venture capital may very well need to go public at meaningful discounts to private market valuations in 2019.
Venture Capital Deal Value Rises, Deal Exits Slow
While the beginning of 2019 has seen small cap stocks recoup some of their losses from late 2018, the fourth-quarter correction washed away quite a bit of the excess, making the asset class look more attractive than it has in several years. After soaring to a post-crisis high in 2017, the estimated 12 month price-to-earnings ratio for the Russell 2000 Index has come down to earth. At the same time, there remains a tremendous amount invested in venture-capital and private-equity funds, as well as private leveraged-loan financing. These private assets could see a similar derating, creating opportunity in the public small cap market.
We have recently noted that an increasing percentage of stocks in the small cap market are unprofitable, and that continues to be the case. About 38% of the index had negative trailing 12-month earnings, as of the end of 2018. This number has been rising, as the number of initial public offerings (IPOs) of companies with negative earnings has been rising. According to Kailash Capital, the percentage of IPOs completed in 2018 for companies losing money hit 83%, an all-time high — even more than during the Internet Bubble of 1999.
The big market reset in the fourth quarter raises questions about how agreeable the environment for money-losing companies will be in 2019. For the last 10 years, the market has been forgiving to money-losing companies, because economic growth was strong and valuations were reasonable. Now, however, the economic outlook is much foggier, and given the timing of many private equity deals, we speculate that private valuations may be higher than public. If this is so, the public market won’t look like such a friendly outlet for venture capital and private equity investments. And there are a lot of pigs in that python.
Aggregate venture capital deal value has soared since 2013. The large value of current venture capital deals, combined with the decreasing number of venture capital-backed exits, suggests there is an ample supply of private companies that will need to come to the market at some point. According to Prequin, the aggregate deal value in venture capital last year was up sharply to nearly $400 billion, while the value of exits has lagged far behind (Exhibits 1 and 2). The companies buoyed by these deals may very well need to go public at meaningful discounts to private market valuations.
Exhibit 1: Annual Global Venture Capital Deals 2009–2018
Exhibit 2: Annual Global Venture Capital-Backed Exits 2009–2018
Given the valuation changes in the public markets, we’ll be watching to see how friendly 2019 is to IPO activity, especially for money-losing companies. Perhaps the market will rebound and become a friendly environment for speculative investments once again. Or perhaps market skepticism will increase, driving down valuations for all those private equity exits, so that the fixed-income markets become concerned about the large amount of debt those companies hold. That could have a meaningful impact, not only on the private capital funds, but also on banks and other non-traditional leveraged-loan providers, leading to a credit squeeze and recession, in which case small cap investors will want to keep an eye on their exposures. Developments in the private market are worth watching closely for that reason.