While Franklin Templeton and T. Rowe Price might disagree on Canva’s valuation, what they have in common is that they both hold their Canva investments in what are called crossover funds, which can invest in public equity markets and private companies.
As VC valuations soared last year and cashed-up investors scramble for a piece of the action, these crossover funds have helped push valuations to stratospheric levels.
Indeed, the September 2021 funding round that saw Canva double its valuation to $US40 billion in just five months now looks like something of a high watermark for the excess that built up in the VC sector. The round was led by T. Rowe Price’s crossover funds, with Franklin Templeton’s crossover funds investing too.
But as US venture capital heavyweight Sequoia Partners warned its portfolio companies in a presentation that did the rounds of financial markets last week, the capacity of crossover funds to invest in private start-ups is being restricted by the big losses they have sustained on their public market bets.
“Unlike prior periods, sources of cheap capital are not coming to save the day,” Sequoia said.
“Crossover hedge funds, which have been very active in private investing over the last few years and have been one of the lowest cost sources of capital, are tending to wounds in their public portfolios which have been hit hard.
“Many don’t even have the capacity to invest, as the drawdown in their public portfolios has created an imbalance in their hybrid funds where their private investments (which have not been as dramatically marked down) represent more than the maximum private capacity within their funds.”
The global VC sector is hunkering down as funds dry up and valuations fall.
Commonwealth Bank chief executive Matt Comyn said this week his discussions with senior VC industry leaders on a recent trip to the US suggested the fund-raising environment was tougher than during the GFC, and tech firms were slashing staff by between 10 per cent and 30 per cent in an effort to cut costs.
Cutting costs will, of course, weigh on revenue growth – which will weigh further on valuations. And falling valuations will mean that stock options that start-ups used to lure and retain staff, don’t work as they used to, adding to the sector’s problems.
Crossover funds have also emerged as the most obvious channel by which falling tech stock valuations are being transmitted to private markets.
This is forcing the Australian venture capital firms – including those that have enjoyed spectacular gains from Canva’s meteoric rise, including Blackbird Ventures, Square Peg Capital and AirTree Ventures – to give their valuation process serious thought.
Standard practice in the VC industry is to only revisit a valuation when there’s a credible funding round. When the share prices of a start-up’s listed peers soar, the VC firm leaves their valuation unchanged. And it’s the same story when a start-up’s listed peers plunge, as had occurred in the last six months.
But there is movement on this. Venture capital pioneer and Square Peg founder Paul Bassat says his firm aims to be as transparent as possible with its investors, known as limited partners, and is tweaking its valuation processes.
“We undertake our valuations process across our portfolio on a quarterly basis and have recently added an additional procedure to our valuation process which is to obtain external independent valuations on our material assets,” he says.
“We believe this is entirely appropriate given the scale some of our portfolio companies are now reaching.
“More broadly, one of the benefits of private markets is that they exhibit lower volatility than public markets as they are not priced on a daily basis. This means private markets aren’t repriced upwards as regularly in market rallies, nor are they marked down as much in pull-backs. As a result, private markets, at least partially, avoid overshooting on both the upside and downside compared to public markets.
“We think this is one of the core advantages of venture capital compared to other asset classes. What will matter most for our long-term returns is identifying the outlier companies that in success can be enormous, and this is what we will continue to focus on.”
Bassat, who always takes a clear-eyed view of his sector – and Square Peg’s new approach – sounds very sensible.
The VC sector knows its limited partners, which include superannuation funds who have increased their allocation to venture capital and private equity, are thinking hard about this too, particularly in light of the Australian Prudential Regulation Authority’s recent focus on the treatment of unlisted assets held by super funds.
APRA’s review of the way unlisted assets are treated found that funds’ “revaluation frameworks were typically inadequate, with no predefined revaluation triggers and weak or no processes for monitoring and adjusting revaluations”, and “had an over-reliance on external parties, including fund managers and asset consultants”.
Better valuation practices can only make the VC sector stronger in the long run.