For the last half decade, the acceleration of venture capital funds into startups has been, to say the least, tremendous. Aggressive valuations in pre-IPO continue to remind investor of the tech bubble in 2000. 2015 saw over $60B go into venture capital investment, doubling 2013.
However, the latter portion of 2015 and thus far in 2016, saw VC firms begin to pare back on valuations and look further into company burn rates as they focus on keeping costs in line while promoting growth; this concept was pushed to the back burner is the hunt for all out growth. This was brought about by companies which saw valuations cut dramatically post IPO as the public markets brought valuations back to reality; many mutual funds held the short end of the stick. BlackRock, T.Rowe Price, and other mutual funds have said 13 of the unicorns they own are worth, on average, 25% less than what they paid for them.
The two charts below indicate stagnation, if not an all out decline in funding for two reasons:
- As volatility in the equities market continues, investors are paring back in the short term in hopes of better entry points
- Economic indicators continue to give mixed signals on growth in the US & abroad
The above factors have led to a search for truly valuable companies which are not calculated full value based on projected revenue ramps.
CRE & Tech
Another eye raising statistic was the impact the office market has had as valuations decreased and entrepreneurs have to reign in spending and overhead. The San Francisco office market saw its first material increase in vacancy since 2009: Class A vacancy rose by 0.8% to 8.5%
Of course, I have to add the statistic that of asking rents spiked by 14% Y/O/Y to $64/sq.ft while demand has dropped by 30% Y/O/Y as of April 2016.
Fitch Rating Agency came out with a cautiously optimistic report on the certain office markets; “Lower tech-tenant demand in markets such as San Francisco, Silicon Valley, Seattle, New York, and Los Angeles based on cooling tech employment and capital availability.”
My fear lies in a combination of shadow inventory and capital availability.
Some companies, especially startups, across the US make plans during uptrends in the business cycle to hire lots of people and shoot for continued growth at a cost of absurd burn rates. Additionally, they lease spaces with the thought that they’ll need them in 12-18 months. However, if they don’t execute, such as Twitter, which is attempting to sublease over 100,000 sq.ft, it creates shadow inventory. When shadow inventory hits the market, most don’t developers, investors, and brokers do not expect to account for this additional inventory, thus a glut is created and net rents are pushed down across the board. On new construction spec,Class A competes with Class A- and Class B+ competes with Class B-.
This decrease in net rents hits developer pro-formas and the market begins to see smaller developers tumble while cash-rich ones weather the storm (remember, real estate is relatively highly leveraged and most investors are buying office complexes at sub 6% cap rates in prime markets so their debt coverage ratios are not able to handle much stress).
Concerns Abroad
Concerns regarding valuations in the startup community as a whole is not just in the US. About one year ago, the Chinese government was seemingly open to startups going public, however, as the Chinese markets have faced tremendous volatility, entrepreneurs and investors fear fumbling at the goal line as they go public. Some hopeful IPO companies main concern lies in trading at significantly lower valuations leading to further selling in the public markets as the public markets scrutinize valuations with fine combs. Additionally, the public markets have to determine the risk associated with sky high valuations and room for further growth; this is especially concerning since tech stocks in China trade for 77X earnings vs. 37X for the rest of the markets.
In my opinion, the valuations for many companies are proper, however, a handful of large scale unicorns have created unfulfillable demand by institutional as well as retail investors. As investors continue to pay more for future earnings, mutual funds, and eventually retail investors, are the ones who ultimately suffer. Lastly, a fear is created in the market and panic selling can ensue which can cause a period of unnecessary selling and cutbacks by companies within various industries.
This probably is not similar to the dot com bubble, however, a volatility in valuations has arrived and may not go away until the marketplace reprices risk.