Investment Strategies for Coronavirus
After a decadelong bull-run, coronavirus has ushered in a new economic reality. The National Bureau of Economic Research (NBER) recently announced that the U.S. economy entered a recession. NBER recorded a peak in economic activity in February 2020 and a sharp contraction in March that led to significant increases in unemployment. The U.S. Bureau of Labor Statistics disclosed that the unemployment rate reached 14.7% in April 2020 and dropped slightly to 13.3% in May 2020. These economic indicators elucidate the severe effects coronavirus is having on the U.S. Companies are trying to adapt to novel market conditions, where consumers stay home to stop the spread of the virus and pare back spending.
In a previous post, we outlined how these circumstances may affect companies’ business fundamentals and valuations. These effects include reduced total addressable market sizes and decreased operating margins, resulting in lower valuations.
This article will discuss investment strategies investors can use in the pre-IPO marketplace during this economic downturn.
Private Company Investments
Investments in private companies are fundamentally different from public company investments. First, public equities are readily tradeable on stock exchanges. Second, public companies disclose quarterly and yearly reports on financial performance, among other things, to keep investors informed before they buy or sell the corporation’s shares.
Liquidity and financial disclosure requirements are largely absent in private company investments. As a result, investors must understand that pre-IPO investments are longer term and riskier in nature. Additionally, coronavirus has added a new layer of uncertainty to all investments, and it is likely to continue to cause bad news in the near term. These dynamics will increase volatility for pre-IPO investments, as startup valuations may widely fluctuate as they navigate this environment.
Despite the bleak economic conditions, investors may be able to generate positive returns using various investment strategies, such as “discount shopping,” “option pricing,” and “resilience trading.” These strategies are not exclusive to the private markets or the current economic environment, and they are only intended to distill information to formulate an investment thesis.
Investors on the EquityZen platform should expect to hold pre-IPO investments for two to five years. Additionally, not all transactions will have a successful exit. Business fundamentals and understanding how they are changing due to coronavirus are paramount in this environment. Depending on your risk tolerance, the following strategies may help you invest in pre-IPO companies.
As the public markets have shown, coronavirus is exerting downward pressure on valuations. In the private markets, price discovery is not immediate, because startups peg their valuations during fundraises. While their official valuation may not have changed, the price at which investors are willing to purchase equity has likely decreased due to coronavirus.
Thus, investors may be able to generate positive returns by investing at a discount to a startup’s last round. By lowering the investment’s entry basis, investors can reduce the hurdle to generate positive returns and potentially reduce the risk of the investment. Discount shopping, though, requires confidence that the company is only trading at a discount given current market conditions but is fundamentally sound to survive coronavirus. In other words, the market is incorrectly discounting the company’s valuation for broader economic reasons and not considering the company’s ability to weather the downturn.
Examples of such sectors that may fit discount shopping include healthcare and technology.
An option is the opportunity to buy or sell an underlying asset at an agreed upon price (often called the strike price) in the future. Option buyers believe the price of the underlying asset will exceed the strike price in the future, realizing the difference between the future price and the strike price. Option buyers usually purchase options out-of-the-money, meaning the current price of the underlying asset is below the option strike price. The risk to the buyer is that the future price does not exceed the strike price, resulting in the loss of the cost of the option. Additionally, fluctuations in price have no impact on options because the option buyer is only concerned with clearing the strike price and generating profit above the option cost.
While options in the pre-IPO market do not exist, the option strategy can be employed. Investors can elect to view their pre-IPO investments as options. Investors would be purchasing shares in pre-IPO companies with an understanding that their investment is currently out-of-the-money. The cost of the option would be an investor’s investment amount. The strike price would be the cost of all the investor’s “option” investments. The future price is exit price of the investments.
Thus, investors are hoping that one or few of their pre-IPO investments will have an exit price that covers and exceed the cost of all their “option” investments. This strategy, though, increases risk. Investors must accept that most, if not all, of their investments will generate negative returns or go to zero.
Examples of such sectors that may fit option pricing include travel & hospitality, retail, and transportation-as-a-service.
Downturns affect companies differently. Some startups may have all the right ingredients to excel during and after coronavirus. As a result, investors seeking a less risky investment strategy than the two above may want to employ resilience trading. In this investment strategy, investors choose startups they view will not just survive coronavirus but excel in the post-coronavirus economy. These startups are likely high in demand as many people flock to safer investments during uncertain times. Thus, investors will need to accept that prices may be higher – likely reducing returns –, but the risk of the investment will also decrease.
Resilience trading differs from discount shopping, because discount shopping assumes the market perceives a startup to be struggling in this economic environment. Therefore, the market sees the startup as a riskier investment, likely depressing the price of the investment.
Examples of such sectors that may fit resilience trading include gaming, infrastructure-as-a-service, security, and delivery service.
The U.S. economy is experiencing a structural shift as consumers and businesses assess how to fight coronavirus. Some companies are struggling in this new environment, while others are excelling. The above strategies, coupled with an understanding of companies’ fundamentals, will help investors understand the risk and returns of pre-IPO investments.