How the Current Public Equity Downturn Could Work Its Way Through Private Markets
Lessons From the 2000 Dotcom Debacle and the 2008 Global Financial Crisis
Public markets have done a 180-degree turn since the beginning of the year with plunging stock prices, shrinking multiples, and valuations. The IPO calendar has dwindled to a shortlist, and the SPAC market is on ice. The questions are: what does all this mean for the private market? How will public market performance affect the private market, and how will it affect new funding or the valuation of current holdings? Will private market investors start marking down positions, what process will they follow, and what will be the timing? What lessons can private companies and investors learn from previous downturns in 2000 and 2008 when a similar public market contraction worked its way into the private market?
After 10+ years of a private market boom driven by fiscal and monetary stimulus, and big institutional interest and higher allocations to privates, valuations were priced to perfection. Even the slightest macroeconomic risk could herald a slowdown in the private market resulting in lower valuations, tougher conditions for raising capital, down rounds, pressure on startups to reduce burn rate, and investors pushing portfolio companies to fast-track profitability. This viewpoint discusses how a potential downturn in the private market could play out, what the sequence of events could be, how private company management and investors may act, and what impact it may have on valuations, exits, and investor sentiment.
How a Private Market Downturn Could Play Out
A downturn in the private market is not unprecedented. We experienced two similar dislocations in recent decades that transpired in 2000 and 2008. Rosenblatt has studied what happened in those two periods of time and what the sequence of events was, and the impact on different stakeholders, including how investors altered new funding plans, how they managed current portfolio holdings, how LPs reacted, and what management of private companies did. This is captured in the illustration and we share our major observations below. The objective is not to forecast/foretell what could happen this time but to simply to draw some lessons from 2000/2008, so we can all be better prepared to handle the situation.
· Private Markets Lag Public Market Performance: There is usually a 2-3 quarter lag between the time that public markets contract and when the impact becomes fully evident in the private market. During the 2008 crisis, while the S&P500 declined 30% between Q1-Q3 2008, new capital continued to be invested at a growing pace during this time. On the other hand, as the stock market began recovering over Q1-Q3 2009, private capital being invested remained depressed, and it took another two quarters for new capital investment to start rising again. Valuations in the private market similarly lagged the public market. In the current environment, Wall Street-darlings like Square and Paypal have shed nearly three-quarters of the value from their respective peaks, Nasdaq has dropped 33% YTD, but private market valuations have only started reporting declines in the last few weeks. Klarna raised a round of capital in May at a $30 Billion valuation, down from $46 Billion in June 2021 and there has been a talk of Stripe’s valuation coming down. Fidelity Investments began the process early by marking down its holdings in Stripe in April this year by 9%, as well as in other tech companies like Reddit and Bytedance. (Fidelity’s Growth Company Fund invested in Stripe’s Series H round). But we are not seeing widespread mark downs or write downs in the private market quite yet.
· Investors’ Step-up Oversight of Portfolio Companies to Reduce Burn Rate and Encourage Management to Fast Track Profitability: When economic conditions weaken and the business environment starts to deteriorate, General Partners (GPs) immediately start assessing the damage, stress testing portfolio investments, and conducting triage on holdings, separating them into firms that will do fine, those that need help, and others that cannot be salvaged and must be exited. At the same time, investors that used to manage their holdings with a soft hand, attending Board meetings but leaving company management to its own devices for the most part, now manage them very closely, staying close to management and overseeing business performance monthly. Just as Sequoia wrote in its famous 2008 letter to its portfolio companies, GPs across the industry will get down to asking functional leaders within each of their company holdings: product teams will be asked what features are absolutely essential to building, marketing teams will be pressed how to measure and cut spending, sales and business development staff will be pressured what the real probability of converting prospects is, and the CFO will be quizzed about what payments can be deferred and which departments can be scrapped.
· Impact on Investor Accounting/Reporting of Current Investments: A tremendously important issue is the valuation that GPs ascribe to private positions or the price at which they carry equity on their books. Unlike public market equities that are marked to market every day based on their performance, private investors have greater flexibility and discretion in valuing their equity positions. Usually, there is a 3–6-month lag when we begin seeing lower valuations in the public markets percolate down to private companies. ASC 820 (formerly called Rule 157) and 409A are two SEC/IRS rules that guide investors in valuing private investments but they leave much room for individual investor discretion. What’s changed in this downturn compared to 2000 and 2008 is a more aggressive SEC exerting greater pressure on investors to be more transparent and conservative in estimating the fair value of their equity investments. LPs like pension funds and endowments can also be expected to aggressively push GPs how their investments are doing and what the right valuation is of their holdings. This means the contraction in multiples for public companies like Square and Coinbase should start getting reflected in comparable private companies in their respective sectors sooner than it happened in 2000 and 2008. Lower valuations are already being reflected in marketplaces like EquityZen and Forge that list private securities for sale. Also, large institutional investors like Fidelity Investments and hedge funds like Tiger Global have already started marking down their positions which may pressure other investors to follow suit.
· Limited Partners (LPs) Shift Their Tactics: As in the lead-up to 2000 and 2008, the number and breadth of LPs allocating capital to private companies rose sharply in the last few years. At the same time, institutional investors including endowments, foundations, and public pension plans increased their allocations to private investments. But as private markets slow down, LPs will start getting worried about their private market allocations, and some LPs may be unable to meet capital calls and forced to liquidate positions. This could create a vicious down draft as more investors rush for the exits not wanting to be left holding the bag. During the 2000 and 2008 downturns, this also caused prominent LP/GP relationships to sour, with LPs filing lawsuits claiming they were misled by GPs regarding fees, carried interest, and governance. Several prominent endowments and pension funds sued their GPs for lack of full disclosure about fees and weak portfolio performance after the 2008 crisis. That crisis also swung the pendulum of fund structuring and terms back towards more LP-protective provisions. We can expect that to happen again this time around, with liquidity preferences climbing back up again.
· Private Company Management Alters Business Focus: As business conditions deteriorate, the management of private companies shifts course from growth at any cost to conserving cash and reducing their burn rate. They reduce executive compensation, slow-down hiring, reduce Capex, eliminate non-critical vendors, and renegotiate supplier contracts. We are already seeing Crypto companies like BlockFi cut staff by 18-20%, just like public firms like Coinbase have done as well. The website Trueup estimates that 46,540 people have been laid off from tech companies year-to-date. As the crisis continues, private companies try to secure funding, pivot to new business models, and in the worst-case situation, consider selling out or simply shutting down. But not all private companies share the same fate. There are significant differences across sectors and between companies within the same sector. As an example, FinTechs tend to be high beta stocks, which means a downturn contracts their multiples much more than private companies in other sectors. Even within the FinTech sector, consumer-oriented models like Challenger Banks can suffer more than institutional-focused SaaS businesses, emphasizing the difference in performance even within the same sector.
· Investors Explore Unconventional Exits: If the public markets remain soft and the IPO market shuts down, but for the most compelling companies, investors may become even more willing to explore unconventional exits like merging portfolio companies with similar firms or entertain an exit to alternate buyers (e.g., sell to non-financial strategics such as Google or Amazon, etc.). This has been happening to some extent in normal times as well but the pace and frequency may increase in a contracted downturn. Restructuring operations, funding, and capital structure may also become popular options. Investors have pushed the crypto firm Celsius to hire a restructuring lawyer and consider options to secure its financial position after the contraction in the crypto market severely hurt its business.
· New Fundraising Slows Down, While “Winning” Investments Suffer Collateral Damage: LPs (typically institutional investors like pension funds, insurance companies, endowments, and family offices) may brace for a prolonged slow-down and reduce allocations to privates due to heightened risk, a higher illiquidity premium, and because lower public market valuations push private market allocations above target rates (called the Denominator affect). This could severely hurt the ability of GPs to raise large amounts of capital, which they have been doing in the past few years. The second issue is more subtle. In a downturn, even solid portfolio companies get marked down because public market comparables are significantly underperforming. This could happen in the Crypto sector as Coinbase’s stock performance indiscriminately drags down private firms building infrastructure for institutional adoption of Crypto and digital assets for the long-term. Coinbase’s 5x revenue multiple (down from 15x a few months ago) may drag down multiples of institutional crypto infrastructure companies that were valued at 15-18x revenue at the end of 2021.
· Varying Impact on B2B Versus B2C: Another distinction is the varying impact of a downturn on B2B versus B2C firms. Our analysis reveals that B2C companies would suffer more than their enterprise counterparts due to less sticky retail relationships, the soaring cost of customer acquisition, and more stable business models. In the past few years, B2C firms have enjoyed higher multiples than B2B companies, and that gap in spreads may narrow in a downturn. According to the venture firm Top Tier Capital Partners, the average revenue multiple of a select group of B2C public tech companies in 2019 was 11.2x compared to 8x for B2B firms. We can expect the valuation differential in favor of B2C companies to contract during a downturn as retail business models suffer more than institutional-focused ones.
· Impact on Different Types of Investors: Finally, a downturn will impact different classes of equity holders differently. As downturns lead to greater down rounds at lower valuations, the value of the common stock (held by employees and management) declines more than preferred stock (held by institutional investors). That means founders and employees would absorb a disproportionately higher impact of a downturn as their holdings are devalued more than institutional investors. Employee morale could also decline significantly, which is detrimental to operating the company precisely at a time when the firm needs to hunker down and ride out the storm.
Expect Greater SEC Oversight of Private Markets This Time Around
Compared to 2000/2008, the SEC can be expected to exercise more aggressive oversight of the private market during this downturn due to several reasons. The private market is much larger than it has ever been, with $9.8 Trillion in AUM being managed across buyout funds, venture capital, growth, private debt, and real estate as of 2H 2021 (McKinsey). Secondly, U.S. public pensions (including firms like Calpers and Calstrs) constitute a much larger portion of private equity assets and hedge funds, accounting for 35% of private equity capital (Source: Wall Street Journal). Furthermore, the allocation of U.S. pension funds to private-equity investments has been growing for three years and reached an average of 9% of holdings in 2021, according to Preqin. For all these reasons, SEC Chairman Gensler has taken an aggressive stance towards private investors, asking them to be much more transparent in disclosing fees, being open to independent financial audits, and providing more frequent and more comprehensive performance results. The SEC has already proposed to Congress that private funds must report greater information to the SEC, citing its need to better monitor systemic risks. Another proposed rule is that major hedge funds must report to the SEC significant events such as a 20% loss in assets within one business day. Current Dodd-Frank rules already require hedge funds to file quarterly reports about assets and performance.
Studying previous downturns in 2000 and 2008 reveals several lessons which could be instructive in navigating the current market environment. The most important insight is that a public market dislocation works its way through the private markets with a 4–6-month delay, and it happens in fits and starts. How private companies are performing, how investor sentiment is shifting around new funding, or how investors value current investment are opaque issues very difficult to decipher in the best of times and even tougher in a market downturn. But what we do know is that as valuations and multiples contract in public markets, that sentiment eventually percolates down to the private market as we have already begun to see happening in some sectors.
Meanwhile, investor attention is shifting rapidly from finding suitable investments and deploying capital to conserving capital on hand. This means tougher funding conditions for entrepreneurs, including smaller funding rounds, down rounds, stricter corporate governance, and tougher terms for raising capital. As a result, marginal players may get sidelined accompanied by a flight to quality. Investors may also be less willing to fund early-stage companies that pose a higher risk, preferring to use scarce capital to double down on later stage or more established portfolio positions. Market conditions will drive fewer exits at contracted prices, which means GPs (including VC/PE firms) would require lower valuations to achieve the same return. This would in turn, enable these investors to conduct more flat or even down rounds for portfolio companies that are struggling to get traction and build scale in a downturn.
Investor confidence and sentiment matter even more in private markets than in public equities due to weaker liquidity, less transparency, and concentrated power in the hands of a few investors. Investor confidence in the private market is also very fickle due to a lack of transparency, illiquidity, and tremendous information asymmetry. So the slightest threat of market softness makes investors want to rush for the exits causing enormous selling pressure. It’s the opposite of what we witnessed in the last few years when influential institutional investors like SoftBank and Tiger Global bid up valuations unleashing an investing frenzy. But a downturn may cause the investor sentiment to flip polarity quickly. That’s what happened in 2000 and 2008 when equity markets got hit, and the contagion hit investor confidence in the private market. It took a few months, but once confidence in private investments began souring, valuations and funding dropped quickly. We may not be fully there yet, but there are ominous signs building.