Last week we spoke with the Wall Street Journal about markdowns by VC/PE firms and concerns that they have been slow to take place. According to CB Insights, median tech company valuations declined across most stages in the third quarter of 2022, with the most significant impact in late-stage as series C valuations are down 21% and series D+ valuations are down 31% relative to 2021.
There have been some notable resets, such as the $6.7 billion fund Tiger launched in March 2021 having a 13% net IRR as of the end of June 2022, down from a 69% net IRR at the end of September 2021, but most fund marks aren’t publicly available.
From our perspective, many GPs have begun to mark down valuations in their portfolio, especially those that are in market with a new fund and need to have a defensible valuation when potential investors are conducting due diligence. Bringing new investors into a fund based on historical performance that will be reset over the coming quarters is not an ideal start to a new long-term relationship.
For example, a 2020 fund we evaluated with 40 investments has markdowns in approximately 12% of the portfolio. We expect that we'll see markdowns impact 25-30% of portfolio companies over the coming quarters, but the severity of those markdowns will be drastically different by fund.
Understanding the entry valuation, current valuation relative to historical norms, and accounting for protection provisions, such as liquidation preference multiples and participation rights, allows you to allocate enterprise value between share classes and forecast a more accurate valuation and return profile.
If a fund will mark down 25% of the portfolio, but the “premium” paid at entry compared with historical norms is only 20%, the total markdown will be limited to 5%. Under the same scenario, the “premium” paid was 100%, which will yield a 25% markdown. Many headline-grabbing funds over the last two years were paying many times more than 100% of the historical norm, and the markdowns will be severe.
Investing is complex, and current market dynamics are all the more reason to rely upon professional diligence when evaluating potential investments.
-Logan Henderson, Founder and CEO
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A Final Thought
Hours into the epic meltdown of FTX this week, Sequoia Capital, who invested $214 million in FTX, announced they've marked the company down to $0.
Due to the diversification within a more extensive VC portfolio, overall fund performance remains "in good shape."
This is why we believe in building a solid base of actively managed fund investments before pursuing a strategy of direct company investment.
Investor downside risk to a single business failure is mitigated when part of a more extensive portfolio of high-potential founders.
Let us know what you think - please don’t hesitate to reach out.
-The Team at Gridline