The Pre-IPO Investment Opportunity in a Down Market
Alex Wang | February 18, 2016
Investing in a down market is tricky – not necessarily because it is fundamentally more difficult than investing in an up market, but because, in many ways, making long investments after a correction goes against our human nature. Even novice investors know the mantra, “Buy low, sell high”, but where do you put your money without feeling the fear if the market goes down again the next day, week, or month? In this post, we discuss the opportunity presented by private company investments in a down market.
Stock Markets Are Sagging, With Tech Underperforming
First, some context. 2016 has been a turbulent year for global stock markets. Through February 12, 2016, the S&P 500 Index declined -7.35%, and the NASDAQ composite fell -11.54% (Chart 1). Factors such as geopolitical instability, China uncertainty, and falling oil prices have contributed to global growth concerns following an already volatile year in 2015.
Chart 1. 2016 S&P 500 Index and NASDAQ Composite
(Jan 4, 2016- Feb 12, 2016)
*Adj. closing prices
Source: S&P Dow Jones Indices LLC, Yahoo Finance
Macro factors aside, the general sentiment towards the tech sector has not been optimistic either. Investors are worried about another tech bubble, and whether Unicorns (private companies valued at over a billion dollars) can actually back up their valuations. Following a strong 2015 relative to other sectors, tech has had a rough start to 2016 as even formerly strong companies like Apple and LinkedIn saw major sell-offs in early February triggered by weaker earnings/guidance.
What about newcomers? We took a look at the largest tech companies by current market cap that went public in 2015. The returns are mixed. Within calendar year 2015, companies such as GoDaddy and Square managed to return investors a profit, whereas all these companies are now trading below their opening day (Chart 2).
Chart 2. Performance of Selected 2015 IPO Tech Companies
*Data as of Feb 12, 2016
Source: Company S-1s; Yahoo Finance; Forbes; WSJ
So what now? 2016 has been a reminder that public markets are no safe haven. Stated differently, public market performance is not necessarily a truthful reflection of a company’s cash generating capabilities; this is because:
- Public stock prices are largely affected by analysts’ estimates vs. companies’ actual earnings, whereas analysts do not always have access to sufficient information to make accurate projections
- The stock market is unforgiving when companies miss or lower guidance; whereas for the fast-changing tech sector, shifting guidance could be seen as inevitable to reflect the competitive/innovative nature of the business
- In certain cases, one company’s bad news may drive down the entire sector, which may not be reflective of an industry leader’s value, as analyzed by Covenant Asset Management here (after a good summary of market behavior during and after pullbacks).
The Pre-IPO Opportunity
Introducing pre-IPO alternative investments could be a smart investment decision in a down market. While primary and secondary market valuations in private companies have come down, opportunistic long-term investors are licking their chops. EquityZen has observed that discounts for common stock, relative to the preferred stock price for the same private tech companies, have widened in recent months. However, many of these private companies are still (a) generating considerable revenues, (b) growing at impressive rates, and (c) maintaining sound fundamentals and unit economics. By either picking these leaders or having a diversified exposure to this sector, investors can access these companies at cheaper valuations than previously available.
Here are a few other reasons why you should consider investing in proven, late-stage private companies today:
1. Potentially Generate Superior Returns
Private companies, though typically riskier than their publicly-listed counterparts, can often generate high risk-adjusted rewards due to their high-growth upside and early competitive advantages. The inclusion of private companies as part of a portfolio’s allocation of alternative investments, as shown on an efficient frontier (Chart 3), may also help increase overall return.
Chart 3. Markowitz Efficient Frontier Illustration
Source: Robert W. Baird; for illustration purpose only
2. Bring Diversification to Your Portfolio
Private investments have low correlations with the public market (Chart 4), therefore the inclusion of private investments can lower the overall volatility of a portfolio. This means that when public equity markets are down, alternative investments can dampen the downside impact.
Chart 4. U.S. Venture Market vs. Cash-Matched S&P 500 Total Returns
3. Preserve Value
Private investments are not subject to the constraints of public markets, nor are they affected by the macro volatility of the market in real time. In stressed times, private companies, particularly those at later stages with sound unit economics and sufficient cash flows, can maintain their value through sustained growth.
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