Risky IPOs, overvalued tech unicorns, and a world without recessions are all in vogue these days as investors make the classic bull assumption that tomorrow will always mirror yesterday.
With the Fed sending more steroids into the longest (and most hated) business cycle on record, one can’t blame investors for forgetting about bears and dreaming about unicorns.
But more informed investors may want to have a look under the hood of the mutual funds they hold, for there might be a number of unsavory unicorns wreaking havoc on their money.
WeWork Didn’t Work
Last week, we took a deep dive behind the sordid scenes of the disaster IPO that never was, otherwise known as WeWork, here.
This brainchild of the seemingly brainless Adam Neumann was valued at $47 billion one day, and then zero the next.
Hedge fund legend Bill Ackman thinks the company is worth zilch and is predicting nothing but write-downs ahead.
Meanwhile, Fidelity Inc. has revised (downgraded) WeWork’s valuation by 40% since September, putting WeWork at $18 billion.
In short, none of the “best and brightest” can actually agree with themselves (or each other) on just how to value anything.
Unfortunately, WeWork is not alone. Unicorns, like horses, are pack animals.
So, let’s saddle up and take a ride with a few more unicorns and see just how these mythical creatures are conceived…
Uber: A Ride-Share Revolution or Just Uber-Hyped?
In June of 2015, BlackRock Inc. and other “valuation stewards” (i.e. stock pushers) like Fidelity Investments had valued their investment in Uber Technologies Inc. within a range of $33-$40 a share.
Midweek, the stock was trading at $26 per share, so depending upon which day investors saddled up with Uber, losses are hitting the screens, exacerbated by sellers this week exiting as the “lockup” for early investors has expired, and disappointed investors want out.
Unfortunately, those losses could get far worse.
Many, including Hamish Douglas of Magellan Financial Group, think the company will be bankrupt within a decade…
Lyft: In Deep Need of a Lift
Let us not forget Lyft. Within 20 days of its heralded IPO, it was down 20%, based largely on the now confirmed fact that it’s not ever going to make a profit.
Last quarter, Lyft saw a net loss of $662 billion. Ouch.
Like Uber, Lyft faces a range of legal obstacles, including the fact that its drivers, once considered “independent contractors,” received no corporate benefits.
But the laws, beginning in California, are changing, and thus the overhead is rising at Lyft and Uber.
JUUL: Has This Jewel Lost Its Shine?
Then there’s JUUL Labs Inc., a popular e-cigarette provider originally launched to help tobacco smokers wean off nicotine via vapor rather than burned leaves.
Unfortunately, and based upon a shamelessly obvious youth-centric marketing campaign, JUUL did little more for smoking than get more underage folks hooked on nicotine.
JUUL is now facing the burnt end of a government crackdown (likely induced by the tobacco lobby, go figure?).
Vaping may seem safer than smoking, but the stock most at risk of getting burned today for bad press and bad marketing is JUUL.
As of September, Fidelity has cut its valuation on the e-cigarette company by 48%.
The Best and Brightest Missed This?
So how is it that Wall Street’s sell-side analysts could get it so wrong?
How can valuations in start-ups swing by 40%-60% in a matter of months?
Well, I’ve seen this movie before.
It all began during the IPO-rich dot.com craze of the late 1990s when any MBA with a Harvard business model and a contact in Silicon Valley could spit out a tech startup IPO for a quick buck.
And we all know how that ended.
But today the ol’ greed and stupid is back in full swing, as private bankers and tech whiz kids seek to cash out before the whole world turns upside down.
You see, when markets rise to the moon on Fed steroids, this means that passive Index ETFs (far cheaper than hedge funds and actively managed mutual funds) rip up and to the right, dramatically outperforming many private fund managers, although the jig may be up there, too, as ETF investors begin to bail, by some $1.6 billion in October, the most for any month on record, according to Bloomberg.
Faced with this distorted reality, the fancy lads on the private side need to come up with a way to outperform doped markets churning perpetually upwards on the tailwind of a drunken Fed.
In short, the greedy get creative – which means they get less ethical and less mathematical.
The big venture capital firms with zip codes in California and front row bar tabs at Shutters by the Sea need to protect themselves from the S&P competition with more easy money schemes.
How do they do this?
Simple: They create unicorns.
How Unicorns Are Made: IPO Fantasy Land
These clever tech backers have a pretty good template for easy money.
First, they buy into absurdly overvalued startups like Uber, Lyft, WeWork, or JUUL. Then, they set (invent) their own initial valuations based entirely upon creative writing rather than fifth-grade math.
You see, as long as the pre-IPO unicorns stay private for a long enough period of time, their venture capital “backers” (breeders?) can essentially value these companies on fictional projections and best-case scenario hoopla rather than anything resembling caution, cash flow, or arithmetic.
In other words, profits don’t matter. Valuations are invented, not earned.
It’s crazy, but that’s how this absurd game is actually played. I mean, I once lived in California, too…
The ABCs of Crazy
In early-stage startups, valuation is fun. I remember it well.
All stocks are common stock and the venture backers as well as “whiz kid” founders get a proportionate share of what the West Coast fancy lads call “post-money” valuation – i.e. nosebleed projections fabricated by the seed capital speculators.
This “seed capital” makes “founders” rich on paper – and allows boneheads like Adam Neumann to surf in the Maldives on “valuations” rather than earnings or profits.
Once these seeds (dollars) are planted, the later-stage investors – the big private equity funds and banks – come in for their share of the myth-making and money pumping.
These big boys, however, are less fun, and rather than get common stock, they start turning the party into something more debt-driven, though the gravity-defying valuations just keep going up, because, after all – the big boys are now in the mix.
They obviously care about honest valuation, right?
Wrong. The big boys care about pumping up the valuation before a safe exit.
That’s because they know that the fun can quickly turn sour, as any who lived through the dot.com “revolution” can recall.
That is, at some point, these overvalued private companies need to find a new way to make even more cash – that is, by going public – so they head for an IPO.
This means these once private companies, having sucked the financial blood of the seed capital and then later the private equity funds, can now suck the blood of the everyday “public” investor – meaning YOU.
Enter the IPO Game…
By going public, tons of new money initially flow in because by this stage, the public market investors have been reading all the propaganda and drinking all the pre-IPO Kool-Aid.
More investors want in on the fun – overvaluation be damned!
Furthermore, most IPOs launch with a ton of fanfare (i.e. sell-side and media overhype). Hence the stock prices (already based on totally distorted valuations – think WeWork…) often skyrocket – which is why everyone wants in on the IPOs.
And you betcha, those IPOs are fun in the first innings. I made a small fortune on a late 90s IPO that never turned a dime of profit. Just saying…
But here’s the rub: Once the initial sugar high of the IPO wears off, those unicorn companies actually have to make a profit, which many of them (as we discussed above) just can’t seem to pull off.
Imagine that, actual profits? Earnings? (Shout out to Elon Musk…)
Days, months, and sometimes even years later, the stock prices so “loved” after the IPO hype start to revert back to the mean of reality.
Many former stars begin to tank in price like a unicorn without a horn or an Uber without a profit.
That’s when investors like YOU get uber-screwed.
But not the fancy lads in pre-IPO land. These venture capitalists are more like sharks than unicorns and they protect themselves with something called a “liquidation preference.”
This means the greedy guys in the early part of the game (unlike you) can get their money out first if the IPO fails once it hits the market.
And when the world turns increasingly toward a recession, those once sky-high IPO valuations begin falling to the earth, which means YOU get clobbered while the punks who pumped up the pricing during the pre-IPO party get to duck out of the frat house before the police show up.
How to Ride a Unicorn
That’s the dark side of the venture capital/IPO scam in a nutshell. Once the highs come off, the folks who typically lose the most are everyday investors like YOU.
Now don’t get me wrong. The hype-spinners can get burned, too. Think of Masayoshi Son who just lost $5 billion between Uber and his failed attempt to take WeWork public.
But given that “ballers” like Mr. Son are just part of the same Kool-Aid machine that overvalued these lemons in the first place, do any of us really feel sorry for IPO hucksters like Son?
What all of this boils down to is this: Don’t be fooled into believing that every tech startup that makes it across the IPO finish line and into a sudden market peak is a miracle in the making or a safe bet in the long-term.
For you sophisticated day traders who can ride such fantasies up and down, sure, there’s plenty of money to be made, long and short, in the IPO paddocks.
But for those of you recently buying into the latest IPO-heavy ETF or mutual fund de jour, you may want to rethink their holdings.
The bells have already tolled for WeWork, and are tolling now for Uber, Lyft, and JUUL.
Just use your common sense and watch these positions carefully, and check under the hood of any mutual funds that are pushing these lemons on you today.
4 responses to “What No One Is Telling You: How IPO Unicorns Are Made”
November 08 2019