Concerns of 'Delusion' – Are Private Company Valuations the Canaries of the Stock Market? And, Hubris Meets Money

By Herb Greenberg

Friday, November 19, 2021
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Nobody knows who, what, when, where, or why this market will crack...

All you can do is keep an eye on the trends, data points, and other events that suggest late-cycle behavior... knowing full well that the meaning "late" is relative and subject to interpretation.

With that in mind, the spiking prices that private equity ("PE") and venture capital ("VC") firms are paying for private companies are sounding alarm bells.

While you might not be hearing VC and PE folks using the word "bubble," they're increasingly voicing concern.

And as the following chart shows, they're doing it as the disconnect between the multiples paid for private companies – and the multiple of the entire stock market – aren't just growing apart, but going in different directions. And that's after years of trading in line with one another...

The big question is what this means for stocks, and what I can say with certainty...

I don't think anybody really knows because prices and values – both public and private – keep testing new limits. But as prices continue to rise, this is one of those data points to toss into the mix of things that should not be ignored.

That's especially true based on the tone and in some cases the urgency of what some VCs and their PE counterparts are saying.

Keep in mind, these are the very people who stand to gain the most if values continue to rise, which makes it that much more interesting.

Their concern isn't just the sheer size of the deals, but the velocity of increasing valuations...

Perhaps nothing tells the story better than this chart from Pitchbook, as of the third quarter, which shows the value of private companies when they're sold or go public...

Among the most ominous comments came from Scott Kleinman, co-president of private equity giant Apollo Global Management. He was quoted by Bloomberg last week as saying...

We are all in a state of collective delusion here. We will look back in 20 years from now and say, "What were we all thinking? How is this really feasible that a buyout can happen at 25 times EBITDA [earnings before, interest, taxes, depreciation, and amortization]?"

He continued with this reminder...

High-growth firms like technology companies are "very dependent" on the prevailing interest rate environment, and valuations fell 20% to 25% in a matter of days when rates rose earlier this year. A rise in rates will have a massive effect on valuations that people are paying for companies.

The story is similar on the VC side, where the amount of money flowing into startup funds is off the charts.

Take a look...

That hasn't been lost on longtime VC Fred Wilson of Union Square Ventures, who worried aloud in his blog this week...

We have been seeing quite a few seed rounds getting done in and around $100 million post-money and that concerns me...

His point was that for funds that invest in early-stage companies that don't yet have a proven business models and have high failure rates... that's a lot of money. Or as he put it (emphasis added)...

I think they are being delusional, comforted by the likelihood that someone will come along and pay a higher price in the next round. But it seems that person may also be delusional. Because when you model things out, the numbers just don't add up.

Lux Capital, another VC firm, took those concerns up a notch in its latest letter to its investors...

While the letter isn't available to the public, co-founder Josh Wolfe summarizes the key points, along with screenshots of each page from the letter, in his Twitter feed. It's a great read. Some of my favorite points (emphasis added)...

Generally: valuations have risen, diligence has fallen and excess is in excess.

And...

In the last 12 weeks, during Q3, startups raised more cash than startups did during the entire 1999-2000 dot-com boom and bust.

And...

It was common for founders to fake it before they made it, with fluffing and bluster. But in the current moment, founders' focus is preempted with pitches to them from investors of why they should take more money, open or extend rounds or do secondary transactions. We like to say that chips on shoulders put chips in pockets.

Character is built through adversity and hardship and steep slopes. Yet today, the hero's journey: climbing cliffs, clinging to crags in adrenaline filled moments, has given way to flattened slopes, navigating with ease and negotiating with entitlement – at least from a financing perspective.

An entire generation has not seen a downturn, has not experienced widespread loss from widespread leverage across sprawling interconnected systems, has not run back to safe haven occupations or embraced tomes of value investing or timeless classics warning of rampant speculation, of devils taking the hindmost or of the madness and delusions of crowds. Jonathan Swift said reason is a very light rider and easily shook off.

As I think back on it, look no further than "unicorns"...

Many of us went from wondering what a unicorn was just a few years ago – if you still don't know, it's a startup with a billion-dollar valuation – to yawning when a new unicorn is seemingly being born every day. Or as the chart below shows, almost every day...

Arguably, rising stock prices have dragged all these private values higher. As I said earlier, it's impossible to know when all this ends, or what the catalyst will be.

In the very least, the relationship between private and public valuations – and the warnings being raised by those who stand to make the most – should serve as a reminder that the higher stocks go without a correction, or even a pause, the greater the risk.

It sounds obvious, but based on the velocity of valuations, it obviously isn't.

Moving on, when hubris meets marketing meets money...

News that naming rights to LA's famed Staples Center went to Crypto.com, a crypto broker based in Singapore, marked one of those moments.

Not only is crypto one of hottest investment crazes of today, but the crypto trading website marries perhaps today's most speculative asset class with dot-com... which currently holds the crown as the symbol of modern-day stock market bubbles.

The minute I saw the news, I retweeted a New York Times story with the announcement, adding:

Thinking what I'm thinking?

If you've been around since stadium naming rights were a thing, you knew exactly what I was thinking: That this is yet another sign of bubble-bubble-toil-and-trouble.

Since they often reflect the egos of those involved, naming rights have a history of picking the tops of some stocks... and even being a precursor of trouble for the company whose name is up in neon.

It's often referred to as 'the stadium curse'...

The most famous was Enron Field in Houston, named after one of Wall Street's hottest stocks... until it was brought down by fraud, forcing the company into bankruptcy.

There are a bunch of others, and everybody has a favorite, including PSINet Stadium in Baltimore (filed for bankruptcy), Trans World Dome in St. Louis (bankruptcy), Adelphia Coliseum in Nashville (corruption, bankruptcy), and CMGI Stadium Boston (dot-com disaster).

Most, of course, are plain vanilla companies, but even then...

Staples struck a $116 million, 20-year deal for the LA stadium in October 1999 when its stock was $13 on its way to $8 in the 2000 crash. By 2006 it had rebounded to $26, but its business model became increasingly challenged, before going private in 2017 for $10.25 a share.

Which gets us back to Crypto.com...

The LA stadium will be the second sports facility to be named after something Crypto. Earlier this year, the crypto exchange FTX unseated American Airlines (AAL) to win naming rights for the Miami Heat arena, paying $135 million for 19 years.

Crypto.com is paying $700 million for 20 years.

Dan Beckerman, CEO of AEG, which owns the stadium, referred to it as "a match made in heaven" for one reason and one reason only: At $700 million, Crypto is paying one of the highest prices for naming rights... ever.

As Dallas Mavericks owner Mark Cuban tweeted in response to the cynical nature of my "thinking what I'm thinking?" tweet:

Source: Twitter.com/mcuban

Exactly, and it happened fast, and it has gone to their heads. The only question now is whether this will be yet another example of hubris becoming very humbling.

As always, feel free to reach out via e-mail by clicking here. And if you're on Twitter, feel free to follow me there at @herbgreenberg. My DMs are open. I look forward to hearing from you.

Regards,

Herb Greenberg
November 19, 2021

Whitney Tilson

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About Berna

Berna Barshay is editor of Empire Financial Daily and a contributing editor to the Empire Stock Investor and Empire Investment Report newsletters.

She graduated cum laude from Princeton University and earned her MBA from Harvard Business School in 1997.

Following her graduation, Barshay spent 20 years on Wall Street. She began her career in equity derivatives at Goldman Sachs and later worked as a buy-side equity analyst at Sanford Bernstein, where she covered global consumer cyclicals and conglomerates.

Later, Barshay spent five years working as a portfolio manager of the Ingleside Select Fund, a long/short fund with a focus on value and event-driven stocks. She later was a portfolio manager at Swiss Re, where she managed the Consumer long/short book on the equity proprietary trading desk.

She has additional experience as a buy-side analyst at several long/short hedge funds – including Sky Zone Capital, Metropolitan Capital, Buckingham Capital, and LaGrange Capital – where she primarily covered consumer and technology, media, and Internet stocks in the U.S. and Europe, with some additional work in financials and energy.

Barshay is a fashion enthusiast, a pop culture addict, obsessive indoor cycler, and prolific social media user. She currently lives in New York with her husband, daughter, and three dogs.