In his 2015 black comedy The Big Short, Adam McKay brilliantly depicts how some cluey hedge fund managers made serious profits betting on a catastrophic implosion of the global banking system.
While few predicted such a precipitous financial collapse, the ability to short relatively liquid CDO markets enabled some market participants to make banks when the market inevitably corrected.
A similar trade saw Wall Street hedge fund manager Bill Ackman make headlines when sharemarkets capitulated during the onset of COVID-19.
Today, global VC markets have an air of froth about them. With a lot of money being thrown at the asset class in a rush, valuations for many early-stage businesses are ascending beyond financial sanity.
Moreover, in a post-quantitative easing environment, with interest rates near zero, the temptation to swing for the fences on a VC bet in the hope of making 10 times your investment is significant.
Some signs of euphoria in the market include the record percentages of loss-making companies IPOing, the surge in demand for speculative cryptocurrencies, and the enormous mark-to-market value of the VC market relative to actual capital deployed.
There’s a circularity about it, too – superior mark-to-market returns spur interest and further speculation in the sector, in turn driving valuations higher again. Nobody likes seeing their neighbor get rich.
In any rational capitalist market, short-selling acts as a form of financial gravity. It’s a good thing for the market and generally protects the less informed from overpaying.
Yes, occasional blips lead to the collapse of certain hedge funds and the surge in companies such as GameStop, but it generally works.
However, with most venture growth capital funded through private markets, there is no such counterbalance. Investors cannot short the equity of a start-up, which means rumour, speculation, FOMO, and bilateral term sheets are increasingly introducing valuation risk into the system.
Given where we find ourselves in the cycle, it is worth pondering on investments one could make to profit from or at least protect yourself from a market repricing of VC equity.
What would Michael Burry do? Here are four examples.
1. Own the debt
There is an increasing appetite for equity holders to introduce venture debt into their structures. These instruments are nicknamed “vulture funding” for a reason.
While equity holders do protect their dilution, if funding markets dry up, the ownership of the business can quickly transfer to the debt holders. In principle, a venture debt holder could acquire a cash-starved unicorn for $1.
Owning the debt of insolvent venture businesses could have merit for companies with a No. 1 or No. 2 market position.
The prospects of salvageable IP in a leading player are probably good, mainly if picked up at a bargain via a vulture debt structure.
However, beyond the one or two industry leaders, the tail end of the sector is likely to be worthless in a sharp market downturn – even to a debt holder.
2. Short the listed managers
The very public demise of the former listed fund manager Blue Sky Alternative Investments was a textbook case of mark-to-market VC valuations not reflecting intrinsic value or even market value.
While the number of pure listed VC managers in Australia is limited, a significant global opportunity set is available.
Although ownership of the fund manager is entirely different to ownership of the fund or individual portfolio company, any structural capitulation would cause a steep decline in management and performance fees, significantly reducing the value of the management company equity.
3. Selectively short new IPOs.
There is no shortage of profitless IPOs valued on hope, and these newly listed companies can be shorted.
A word of caution, these businesses often represent the best of VC. Those that survived the “valley of death” may have the best long-term prospects.
So, despite being a potential widow-making short, they face the same inconvenient truth. Loss-making businesses need to continue to return to capital markets for funding. If this dries up, it’s game over.
Moreover, pricing pressure on the IPO market should flow back down the chain and result in more digestible valuations at earlier funding rounds.
4. Be under leveraged in your investments
A major trap for VC investors is going too fast, too soon, and not having enough dry powder to participate in follow-on rounds, or even down rounds where pricing is lower than the prior raise.
In a venture, the first cheque is seldom the last cheque given the capital-hungry nature of start-ups. Therefore, sizing up the total investment over the journey is essential.
Those with undeployed cash are likely to be serious winners out of any market correction, particularly the bargains emerging out of down rounds.
The strategy here would be to have modest but not full investment exposures to access shareholder rights in the event of recapitalization.
Over the decade, being long in VC is almost certainly a money-making trade – even factoring in today’s valuations. However, selectively conserving capital in bull markets, owning different parts of the capital stack, including debt, or being short a few momentum IPOs, are a few ways of adding portfolio protection while remaining long.
With opportunities to invest in the energy transition, personalized genomics, and quantum computing, the best is yet to come.
Neil Vinson is Portfolio Manager at Tanarra Capital.