The “Mutualization” of Late-Stage Venture Capital Valuations

June 25, 2015

The “Mutualization” of Late-Stage Venture Capital Valuations Photo

In search of a boost to their returns and an inside track to initial public offerings (IPOs), mutual funds (along with hedge and sovereign wealth funds) are increasingly competing with, and in many cases pushing out, venture capital (VC) firms from later-stage financing rounds of private technology companies. This marks a reversal, as these investors have historically invested in technology companies at the time of or following their IPO.

The shift benefits private technology companies, as non-traditional venture investors tend to have a longer-term investment horizon than venture capital funds. This is an important distinction, as companies are staying private longer, resulting in larger pre-IPO operations and the need for more cash to keep running. Additionally, these non-traditional investors tend to have lower return targets than venture capital investors, making it easier for them to justify paying higher valuations. While a 1.5x return over 18 months might satisfy a mutual fund, for example, it would likely miss the return bogey for a venture capital firm. The consequences of this shift can be seen in the recent late-stage financing rounds of Uber, Snapchat, and Lyft, which lacked VC participation.

The dollars that non-traditional investors can bring to the table are significant. On the mutual fund side, the SEC limits investments in illiquid securities to 15%. Fifteen percent of the T. Rowe Price New Horizons Fund, which is an active investor in private financing rounds, is approximately $2.5 billion. That's a lot of dry powder, and T. Rowe Price is not alone. Wellington Management Company, BlackRock and Fidelity Investments, among others, also actively invest mutual fund dollars in private technology companies. BlackRock, for example, led the April 16th Series D funding of Domo, valuing the company at $2.0 billion; T. Rowe Price, led the April 30th Series D financing round of Warby Parker, valuing the company at $1.2 billion; Wellington, the May 12th Series F funding of MarkLogic, valuing the company at $1.2 billion; and Fidelity Investments, co-led the May 13th Series C funding of Zenefits, valuing the company at $4.5 billion.

Hedge funds such as Coatue Management, Tiger Global Management and Maverick Capital are also allocating significantly to private technology companies. According to Pacific Crest Securities, a Portland, Oregon-based technology investment bank, Coatue and Tiger Global took part in at least 37 pre-IPO financing rounds, totaling $5.6 billion between 2012 and 2014.

Key Takeaway: Non-traditional players are driving up late-stage venture capital valuations. These aggressive valuation step-ups are resulting in unrealistic return expectations and creating an inevitable conflict of interest between the entrepreneurs and the investors. Investors are focused on gaining access to high-growth companies; at times overcapitalizing them and in the process creating unrealistic growth expectations which often drive short-term decisions that negatively impact long term success. One may want to consider focusing their venture capital investment efforts on less-affected early-stage managers, while opportunistically allocating to later-stage opportunities where they believe the managers have a clear informational, operational or pricing advantage.

Tags: Chart of the Week | Venture capital | Private equity | IPO | Valuation | Mutual funds | T. Rowe Price | Hedge funds

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