Yves here. Please welcome back Sebastien Canderle, a former private equity insider who has written here from time to time on private equity. Today he turns to a con innovation which true to financial services industry form, is old wine in new bottles. Promoters have come up with a new implementation of an old scam dating back railroad share manipulation: that of watering stock.
Mind you, methods as crude as the ones used nearly 150 years ago don’t fly in the US stock market. But private markets are a new Wild West. And leverage plus persuading investors to use questionable profit measures like “Adjusted EBITDA” as the basis for valuation creates new opportunities for chicanery.
By Sebastien Canderle, a financial consultant, a lecturer at Imperial College London, and the author of The Good, the Bad and the Ugly of Private Equity
In the late 19thcentury, New York financier Jay Gould earned a reputation as a swindler. One of the notorious robber barons alongside industrialist Andrew Carnegie and oil magnate John D. Rockefeller, Gould became a pariah on Wall Street for his attempt to corner the gold market in 1869.
His most daring move had come a year earlier in his fight over the Erie Railroad with the main shareholder, and the richest man in America: Cornelius Vanderbilt.
To wrench control from Vanderbilt, Gould and fellow directors of the Erie Railway Company, James Fisk and Daniel Drew, came up with a scheme to issue new shares at an inflated price. Vanderbilt kept buying shares on the open market but sustained heavy losses, eventually conceding ownership of the railroad.[1]
New shares offered at a premium to the value of the underlying assets came to be known as ‘watered stock’, a term coined by Drew himself.[2] As a cattle drover prior to his career as a railroad developer, he knew of the practice adopted by ranchers to make cattle drink large amounts of water before being sent to market. The weight of the consumed water would make the cattle deceptively heavier, enabling the ranchers to fetch higher prices for them.[3]
Adapted to financial markets, this technique involved the counterfeiting of stock certificates and unauthorized stock release, resulting in an automatic dilution of ownership. Speculators would sell shares to unsuspecting buyers and then pocket the proceeds, leaving their victims with grossly overvalued stock.
Stock exchanges are now better regulated, even if a decade of furious money printing by the Fed shows that market manipulation can take many forms.
Untrammelled stock issuance is no longer an issue in public markets, but loosely-supervised private capital markets can be subjected to abuse.
In the credit-dependent segment of corporate buyouts, significant capital overhang explains why valuation multiples average 14 times EBITDA in the U.S.,[4] comfortably above the 2008 peak of 12 times. There is little evidence that the targets’ underpinnings have improved meaningfully. Rather, thanks to the inventive use of adjustments called ‘addbacks’, earnings can warrant higher leverage and bolster enterprise values.[5]
In anticipation of their introductions to stock exchanges, buyouts are loaded with debt the way cattle were once gorged with water. Private equity firms then market overpriced shares to public investors while bagging dividends from IPO proceeds.
As VC-backed start-ups, PE-owned buyouts and hedge fund-sponsored SPACs keep on pricing IPO shares at huge premia to the fundamentals, are we witnessing the return of stock watering?
Unlike the version of Jay Gould’s days, the problem arises well before the IPO stage. Start-ups are raising mega rounds, issuing ever more shares at multibillion-dollar valuations to fund ambitious multi-year growth plans. Even prior to the pandemic, venture capitalists encouraged portfolio companies to hoard cash to cover several years’ worth of operating costs rather than adopt the usual 9-to-12-month runway.[6]
Inflation in valuations is undeniable, notwithstanding the sometimes unfathomable hypergrowth plans. That explains why the number of unicorns – start-ups worth at least $1 billion – has ballooned from less than 450 in March last year to more than 800 today. Their combined value has doubled to $2.6 trillion over the same period.[7]
These paper values, however, are phantasmagorical. Four years ago, two Sauder and Stanford business school professors convincingly demystified the valuation methodology behind the unicorn phenomenon. Based on a sample of 135 unicorns, the study concluded that almost half of them lost their unicorn status when adjusting for various contractual terms such as automatic conversion exemption, liquidation preference, and IPO ratchets. The authors reckoned that the methods applied by VCs “overstate company values in all cases, with the degree of overvaluation ranging from 5% to a staggering 188%.”[8]
The inclusion of unissued stock options when calculating post-money valuations, another trick identified by these two professors to magically inflate start-up values, is a brazen example of modern stock watering techniques. As they put it:
plans for future dilutive share issuances do not increase the current fair value of a company. Clearly, a company cannot arbitrarily increase its value by authorizing (and not issuing) a large number of shares.
Fair value has become all too relative. And key performance indicators no longer provide a reliable gauge either. Facebook’s last pre-IPO $1.5 billion funding round in early 2011 had occurred at a 25-time revenue multiple.[9]British fintech firm Revolut’s recent pre-float $800 million fundraise valued it 90 times ‘adjusted’ revenue, which included non-recurring items.[10]
Yet Facebook’s metrics were much more compelling. Its 2010 revenue had risen 154% on the prior year to c. $2 billion while operating margin was +52%.[11]By contrast, Revolut’s 2020 top line only grew 60% year on year to £261 million (including exceptional items) and its operating margin was negative.[12]
As further evidence of the disconnect between stock value and asset value in private markets, Facebook’s $50 billion 2011 valuation stood at 10 times its net assets whereas Revolut’s recent £24 billion ($33 billion) sticker equates 60 times its net worth.
For young cash-hungry enterprises, external funding is the conventional means to fund growth. Nevertheless, today’s investors are getting far less bang for their buck. Since its inception in 2015, Revolut has raised over $1.7 billion in capital,[13] but it only generated £222 million ($305 million) in recurring revenue last year, its sixth year of operation. By 2009, its sixth anniversary, Facebook had amassed half Revolut’s war chest ($835.7 million) in outside funding,[14]yet it was recording $777 million in annual revenue.
Due to unchecked money creation, particularly in the last 18 months, privately-backed businesses at all stages of development are now grotesquely overcapitalised. Many will struggle to grow into such spuriously bloated capital structures to justify their price tags.
But it would be simplistic to place all the blame on central banks. Later-stage investors – those typically participating in pre-IPO funding rounds – are responsible for throwing money at unproven, loss-making business models. SoftBank’s Vision Fund, which co-led Revolut’s latest round, is known for using capital as a weapon in order to build ‘money moats’.[15]
At a time when public corporations are using excess liquidity to buy back shares, frequently to compensate for the dilutive effect of lavish issuance of employee stock options,[16]private markets are stockpiling. Combined dry powder across alternative asset classes is hovering at an unprecedented $2 trillion.[17] With so much oversupply, investment returns are plummeting; in fact, for many unicorns yields might already be in negative territory.
Even when rigorous, securities analysis leaves plenty of room for investors to pay over the odds. As more and more start-ups are foie-gras’d with quasi-unlimited funding and leveraged buyouts get stuffed with cheap debt, the current breed of private businesses brings to mind dishes of goose liver at Christmas or turkeys on Thanksgiving Day. And many might well end up in the same state of decrepitude, pre- or post-IPO.
Vanderbilt had lost a rumoured $7 million during the Erie War. Under the threat of litigation, Gould had agreed to indemnify him.[18 ]Sadly, public investors tempted by the new version of watered stocks are unlikely to be made good when the current phase of market excess comes to an end. But private capital firms will be there to deploy dry powder and pick up shares at bargain prices.
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[1]https://archive.org/details/bookofdanieldrew00whit
[2]https://www.investopedia.com/terms/w/wateredstock.asp
[3]https://www.investopedia.com/terms/w/wateredstock.asp
[4]PitchBook US PE Breakdown, 2020 report
[5]https://www.reuters.com/article/investors-addbacks-idUKL2N22L1MK
[6]http://investorsnewsblog.com/2019/02/03/investors-urge-tech-start-ups-to-hoard-cash/
[7]https://www.cbinsights.com/research-unicorn-companies
[8]https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2955455
[9]$50 bn EV on $1.97 bn revenue in 2010 (Sources: https://www.bbc.co.uk/news/business-12257786, Facebook, Inc. Form S-1, Update to Preliminary Prospectus, Issued May 3, 2012)
[10]£24 bn EV on £261m adjusted revenue in 2020 – https://www.theguardian.com/business/nils-pratley-on-finance/2021/jul/15/revolut-valuation-makes-little-sense-compared-lloyds
[11]Facebook’s 2009 revenue was $777m and operating profit in 2020 was $1.03bn (source: Facebook, Inc. Form S-1, Update to Preliminary Prospectus, Issued May 3, 2012)
[12]Revolut’s revenue was £166m in 2019 and operating loss in 2020 was £122m (source: Companies House, Revolut Ltd, Annual Report & Financial Statements, For the year ended 31 December 2020)
[13]https://craft.co/revolut/funding-rounds
[14]https://www.startupranking.com/startup/facebook/funding-rounds
[15]https://news.crunchbase.com/news/softbank-vision-fund-strategy-turnaround-under-the-hood/
[16]https://www.fool.com/investing/2020/12/30/alibaba-stock-buyback-wont-solve-biggest-problem/
[17]PitchBook, Private Funds Strategies, Q2 2021
[18]Renehan Jr., Edward J. (2007). Commodore: The Life of Cornelius Vanderbilt. New York: Basic Books. pp. 264–5
8 comments
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doubtful they any business will grow (at least not in the US…) with extremely few examples. get past those, and you will find they have no plans to grow any time soon (been that way for a decades now). most of them have been in survival mode, using any gains they to buy back stock as opposed to growing their business.
Regards to Jay Gould, I did an interesting read a few years back called the Tycoons. Pretty compelling to read, as it covers the nascent industries that took advantage of continental rail once that became an actuality.
Regarding today, who really knows how a Robin Hood should be valued, for example. I cast a wary eye towards the SPAC issuance of the prior years. Which I know is a slightly different topic from the above.
Are the ratios being discussed any sort of red flag to whether or not a startup is dangerous in the day-to-day? Having a pot of money, impunity and disruption ideology is a recipe for hurting people. But it’s two different lenses on an entity, and I’m wondering if there is any kind of demonstrable correlation between whether or not your ratio is more like Revolut than Facebook – say egregious unicornness – and how likely it is that a given startup will do tomorrow’s equivalent of killing a five-year-old pedestrian in a crosswalk or putting out fraudulent syphillis tests on the Walgreens shelves.
Thank you for your comment, Kevin. I admit that I hesitated before adding an anecdotal comparison between Facebook and one of today’s unicorns. Everyone knows that today’s valuations are mental, so it is not much of an insight to show how, even a company like FB, considered richly valued at the time of its IPO, now looks sane vs. modern unicorns. Anecdotal evidence is plentiful but it won’t allow us to reach a definitive conclusion unless academics (which I am not) do comprehensive research. I compared Facebook, Twitter and LinkedIn (the old generation of unicorns) to many of today’s unicorns, and no matter how you cut it, benchmarking along criteria like revenue growth, EV/revenue, EV/net assets, gross margin, EBITDA, growth in membership or user base, shows that fair value no longer exists. Accounting schenanigans and manipulation of all kinds are also spreading. So, there is an element of fraud in this matter, but mostly from the financial reporting aspect. Regarding your last point, I wouldn’t want to state that these unicorns are offering fraudulent products or services. I think that would be pushing it. Many offer valid solutions. It’s just that their owners and founders are caught in a dangerous spiral of excess.
I think the evidence is here that it’s no longer pushing it. And this matters because that’s one way in which overvaluation may matter to everyone, not just shareholders. I just pulled up that Theranos was “once valued at $10 billion,” My STD test example is real and Arizona customers received refunds. Holmes is currently on trial.
On a question about methods, I think your use of filings on Companies House is fascinating and useful. Is it correct that I would not even have been able to do the analysis of valuation relative to revenues for a US startup who is nowhere near an S-1? I would only know a valuation if they publish it in the tiny boilerplate news stories that they run on Reuters, FinSMEs and everywhere, saying “so-and-so raised series X from X Partners on a valuation of X.”
But I can’t compare that with their revenue in the USA in any systematic way, just one by one if something leaks or they decide it would be advantageous to reveal it. (Or publish a lie – how would I know?) Unless I have onerously expensive subscriptions to Preqin or Pitchbook through an institution. Is this still the case? If so, there’s a serious asymmetry where a unicorn or a unicorn-to-be can hurt you (through their partnerships with retailers, or by putting precarious, exhausted drivers on the road) but you can’t learn about them.
Every bubble has its share of fraudulent behavior. The US has Theranos, Germany has Wirecard, the UK recently saw the Greensill fiasco. But again, for now these are in the minority, which is why I was referring to shenanigans rather than outright criminality. The next crash might unfold a few more, as happened in the early 2000s and post-2008. We’ll have to wait and see.
The UK’s Companies House is indeed a great depository for financial record-keeping of any private company incorporated in the country. I am not aware of any similar government-backed registering organization in the US. That’s why I use websites like Crunchbase and Craft. But that leaves out any private company that has not raised money from VC firms or those not willing to disclose their financials.
As a final note, bear in mind that Companies House filings have to be audited (for companies above a certain size) so the financials are reliable. The same cannot be said about financials released through a commercial database. Even the data I get from Preqin and PitchBook I find questionable at times. These publishers rely entirely on the honesty of the data source.
Thank you!!
I bang my head on the opacity and potential for questionable quality if they feel like it. I wonder if we could start in the UK and deduce anything about the US mothership, for organizations that start in the US and expand to London etc.
Someone much smarter than myself once observed, “when the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”