Year of the Rat outlook: Will US private equity reach bubble valuations?

For the Year of the Rat, AsianInvestor offers a set of financial and economic predictions. In our second instalment, we ask whether US private equity is reaching a bubble.
Year of the Rat outlook: Will US private equity reach bubble valuations?

Every Chinese New Year, AsianInvestor makes 10 predictions about developments that will affect global financial markets and the portfolios of Asian investors, especially asset owners. These developments can focus on asset classes, geopolitical events, or structural issues surrounding particular markets. 

in our second Year of the Rat outlook, we consider the likelihood that valuations are reaching bubble territory in the popular asset class of US private equity. 

Will US private equity reach bubble valuations?

AnswerYes (unicorns in particular)

Many have likened the exuberance of the US private equity market to the days before the dotcom bubbles burst. Investors are seeing surging valuations of portfolio companies, particularly technology-linked companies amid a frenzy for the sector. This is leading to increasingly speculative bets in start-ups with questionable business models.

We all know that internet companies that did not survive the crash far outnumbered those that did. But there are some signs of history repeating itself. Just look at US private equity market today.

Many unicorns, or companies with pre-IPO valuations of at least $1 billion, have seen these lofty valuations come tumbling down after listing on stock exchanges. The share price of ride-hailing company Lyft, for example, fell by almost 40% of its IPO price to stand at $47.47 as of January 22.

Meanwhile supposed revolutionary co-working space company WeWork saw its supposed valuation collapse after reporting massive losses, forcing it to pull its planned initial public offering. This despite being backed by the supposedly Midas-touched tech investor and Softbank founder Masayoshi Son. Indeed, in November Softbank reported a $9.2 billion write-down on its $10 billion investment in the company. Ouch.

A total of 558 companies have been crowned as unicorns. While it would be unfair to say all have bubble valuations, many look vulnerable.

According to start-up tech news service Techcrunch, a total of 558 companies have been crowned as unicorns. While it would be unfair to say all have bubble valuations, many look vulnerable. A recent study by the National Bureau of Economic Research (NBER) concluded that roughly 50% of unicorns are overvalued.

“The ever-increasing number of unicorns out there is something I find very hard to rationalise,” a global fund manager told AsianInvestor.

While the NBER's study – conducted by Will Gornall at the University of British Columbia and Ilya Strebulaev of Standford Graduate School of Business – only examined 135 unicorns, it should serve as a warning sign to investors hunting for extra returns in the private equity market.

But if valuations among unicorns in particular are looking peaky, will it cause the US private equity bubble burst in the coming 12 months? Probably not.

There have been plenty of successful private equity investments serving to remind investors that it's most important to ignore excitement about a new company concept and focus on the core driver of growth: the ability to make profits. Companies’ multiples can go up and down, and the use of leverage to boost financial health is ultimately subject to changes in monetary policy.

The ordeal of WeWork has also underlined just how important it is for investors to do their due diligence, drill down into the details, and not be swayed by the “fantasy value” of unicorns.

As for private equity fund managers, they slowed their fundraising slightly in 2019 and paced themselves when acquiring companies to avoid overpaying, according to alternative data specialist Preqin. That said, war chests are still huge; private equity funds still raised over $500 billion last year, the fourth year in a row that they have done so. There is a lot of money looking for deals. 

Given the lessons learned by WeWork and the huge sums of capital available in the market, asset owners – whose primary goal is to uphold their fiduciary duties – would be well advised to remain sceptical about writing big cheques to aspiring unicorns. Hopefully this caution will serve them well.

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