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Vulture Capitalism (Q1-22)

13 Dec Vulture Capitalism (Q1-22)

Posted at 14:13h in 2022, All CEO Insights by

Investor excitement for innovation companies is justified by recent technological advances and the widespread adoption of trends in ecommerce, cloud computing, web 3.0, and AI. ARK Investment Management (ARK), which claims to focus solely on offering investment solutions to capture disruptive innovation in public equity markets, believes that innovation companies could represent US$210 trillion in equity market capitalization by 2030 (up from approximately US$14 trillion in 2020). As we have flagged in previous letters, both public and private valuations in technology are priced to perfection and disruptive innovators can themselves be disrupted (think Netscape, Myspace, Nokia, Palm, RIM/BlackBerry). Considering that growth is slowing, inflation is surging, monetary policy is tightening, market volatility is increasing, and geopolitical tensions are intensifying, the upside for innovation companies should be capped in the near term. The ARK Innovation Fund was the worse performing fund in Q1-22 according to financial analytics firm Morningstar, falling 30%. Yet, investors continue to pile into venture capital (VC) in record numbers and VC firms seem oblivious to the tech valuation corrections happening in public markets.

Although the start of 2022 has witnessed a healthy recalibration of public technology company valuations, median U.S. VC pre-money valuations continued to climb in Q1-22. Early-stage valuations surged to US$67 Million from US$45 Million in Q4-21 as non-traditional venture capital investors, including hedge funds, increased their focus on earlier deals. The rapid pace of dealmaking has created an environment where the due diligence process has significantly shortened, according to the VC coverage group at J.P. Morgan. Heated competition for deals sometimes leaves only a weekend for VC partners to get to know founders and their businesses before having to commit capital, which has driven early-stage valuations to sky-high levels. Pitchbook estimates that the venture market had amassed more than US$230 Billion in dry powder at the end of 2021, a record high.

Momentum in VC deals might be robust but exit counts and values have collapsed. Q1-22 posted only US$33.6 Billion in total capital exits for venture capital-backed companies in the U.S., a precipitous drop from the previous three quarters of over US$190 Billion each. Traditional IPOs have neared a complete halt so far in 2022, representing the weakest start to the year since 2016. Some companies are forced to revisit SPACs and are exploring other dual track M&A options. As mentioned above, technology continues to be the most targeted sector for M&A. With corporate balance sheets flush with cash, approximately US$2 trillion in the S&P 500 alone, and financial sponsors holding another US$2 trillion of dry powder, corporate buyers will be keen to plug their innovation deficits.

The lofty valuations of VC backed companies depend on longer duration cash flows and terminal values, which get quickly revised downward when discount rates increase. VC market adjustments will trickle down from the public markets and affect later stage companies first. The ten largest VC backed listings in 2021, which including Rivian, Coinbase, and Roblox, now combine for a US$121 Billion market capitalization, less than half their total post-money exit valuations. Exit valuations for VC backed companies are also resetting lower. J.P. Morgan recently observed that investors are requiring more structural and downside protection in deals, such as payment-in-kind dividends and liquidation preferences. Many of these companies will be confronted with the immensity of investor expectations that will not be met and be forced to either “down round”, restructure, or divest. The opportunity for distressed lenders experienced in the technology sector will be significant. After all, it is the technologies of failed companies that become the scaffolding upon which future innovations are built.

Article excerpted from the Q1-22 investor letter



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