Our New York Magazine Article: “Fake ‘Unicorns’ Are Running Roughshod Over the Venture Capital Industry”

Our new article is a revisitation of an important study on so-called venture capital unicorns that we posted on last year. Our immediate reason was that the article didn’t appear to have the impact that it warranted, so we wanted to do our little bit to help. But as you’ll see, the study had bigger implication that I managed to miss on the initial write-up.

If you are so disposed, please comment at New York Magazine as well as here. Thanks!

You might think that a study demonstrating that venture capital-funded “unicorns” are overvalued, and by a stunning 48 percent on average, would shake up the industry. Yet “Squaring Venture Capital Valuations With Reality,” a paper announcing just that finding by Will Gornall and Ilya A. Strebulaev (professors at the Sauder School of Business at the University of British Columbia and the Stanford Graduate School of Business, respectively), received only a perfunctory round of coverage from some important investment and tech publications when it was published.

It’s no surprise that a study casting doubt on the worth of darlings like Lyft and Cloudflare didn’t move investors or change the venture capital industry. Trade press reporters don’t have much of a future if they take to biting the hands that feed them, and the investors with overpriced wares don’t want to admit they’ve been had, or, worse, that they’re part of the problem. But write-ups of this important paper, with its sensational finding, missed that the authors’ analysis is deadly for the venture capital industry as a whole.

The median venture capital fund loses money. Only the top 5 percent of funds earn enough to justify the risks of investing in venture capital. The nature of venture capital is that the performance of those few successful funds in turn rests on the spectacular results of a small fraction of the investments in a particular fund. Gornall and Strebulaev’s finding that the performance of the winners — and even the also-rans — is overstated further undermines the already strained case for investing in venture capital. If you are Joe Retail and think this isn’t your problem, think twice. If you invested in high-growth mutual funds, your holdings probably include shares in large venture-capital-backed private companies.

How does this pervasive overvaluation come about in the first place? Once you understand it, it’s breathtakingly simple.

Story continues here. Thanks again!

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    1. Lambert Strether

      Fixed. For some of us who are less youthful, the New Yorker still occupies the mental space of New York’s premier glossy magazine (and therefore would be the natural venue in which to publish).

      This has of course changed, since New York Magazine now easily eclipses the sadly diminished New Yorker.

      Hence the mistake.

        1. Yves Smith Post author

          I was surprised to have several very literate and politically savvy readers say New York Magazine is one of their top 3 reads, and none of them are in New York. Many readers decry the fall of the New Yorker, which is running on brand fumes. It does have the occasional excellent article, but those have become the exception.

        2. Lambert Strether

          > “Easily eclipses” the New Yorker…That’s kind of a stretch.

          The New Yorker I grew up with and read well into adulthood wasn’t a cheerleader for a political faction. Now it is. The cheerleading runs through almost everything they write. Now I have to give every article the smell test. That didn’t used to be the case. I mean, they used to publish Seymour Hersh. Now they don’t.

  1. rd

    Interesting article. For a long time, I have held that “financial engineering” as a term used in the media is the polar opposite of actual engineering.

    Real world engineering views complexity as requiring work to understand, analyze, and design for. So much of real world engineering uses fairly simple models with factors of safety (often referred to as “factors of ignorance” although the theory behind factors of safety is actually much more complex than that). This is done so that we can quickly and cost-effectively design for numerous potential failure modes that are known to be commonly present while focusing our attention on the areas where we need to apply energy analyzing the complexity to get a cost-effective solution. The closest analogy of that I have seen in finance is Benjamin Graham’s “The Intelligent Investor” which is a simplified version of Graham & Dodd “Security Analysis”.

    So we see “financial engineering” blow up frequently (dot.com, subprime mortgage securities, and probably PE/VC) because upward trending lines are extrapolated without a real model and hard work analysis of the complex underpinnings of the system. “We are making money so we are right” becomes the model as shown nicely in “The Big Short” movie. If only investors could have Margot Robbie in a bubble bath explaining the complexities of finance more frequently, we might reduce the likelihood of blow-ups.

    1. KYrocky

      While I was in engineering school there was a terrible collapse of walkways in a Hyatt hotel in Kansas City. A structural engineering professor taped the newspaper story to this office door with a note that asked us students: “So you want partial credit?”

      The only thing actual engineering and financial engineering have in common is math. Mistakes in either can ruin lives, but there appear to be few penalties in finance, zero concern with learning from the mistakes, and little to no outward effort by the regulators or the profession to keep the mistakes from repeating.

        1. djrichard

          But for a Federal Reserve intent on creating inflation, anything helps. Including fraud. In fact, that might all that’s left.

      1. marku52

        Those walkways fell because the builder deviated in a “slight, but significant” way from the original plans. Not actually an engineering failure.

        1. Steve

          but engineers approved the proposed change from the builder, thereby making it THEIR failure!

          Two Professional Engineers lost their licenses over that.

          Most PE’s now consider this an “engineering failure” and study it as such

    2. knowbuddhau

      Yes, an excellent point. Makes it seem so naturally science-ish, tho, without having to bother with actual empirical evidence. Much classier than “cooking the books,” don’t you think?

  2. Amfortas the hippie

    so…they’ve either discovered that their magic dice are loaded…and can’t say anything, due to pride and the fact that the entire bidness model is built on “trust” and/or gullibility;
    or they’ve known this all along and add possible risk of legal and extralegal remedies to the list, above.
    given that “VC”…even the rainbow unicorn kind.. is why so many cool things got out of the proverbial garage, i think it’s sad that it’s been parasitised this way.
    But it isn’t surprising, since it seems like Vegas is the real model for all this.

  3. shinola

    If you’ve gotten this far without reading the entire article, I would recommend going back and doing so. It’s not long and definitely worthwhile.

    “Financial engineering” – I think that if Mark Twain were alive today, he might fit that into his comment about “Lies, damn lies and statistics”

  4. diptherio

    Interesting comment from someone going by “heel” on the original article:

    They have a pretty good racket going, I wouldn’t want to upset anyone by talking about it.

    Which sounds exactly like a line out of Goodfellas or The Godfather

    Historian Thomas Repetto says that a lot of mob guys moved to Wall Street after getting booted from Vegas. Just sayin’.

  5. Craig H.

    > One factor is that it’s a lot of work to value every class of stock.

    You might think that people would read at least enough Investing 101 to get the lesson that you should never invest in something which you don’t completely understand. Apparently there is a misconception these operators take advantage of that rich people have complicated investment portfolios and that’s their secret.

    Thomas Stanley is more useful than the glitzy schlock in Money magazine and that ilk.

    The Millionaire Mind by Thomas J. Stanley

    1. rd

      I keep telling my kids that they cannot compare themselves to other people. You have no idea what is actually going on in that other person’s life with respect to finances or personal life. Just because it looks good on the outside does not mean it is going well on the inside.

      Instead, you have to just analyze your own life according to your own needs, wants, assets, and opportunities.

      It is useful though to read biographies once researchers have been able to delve down deep into their subject’s background to understand the complexity and entirety of a person’s life.

  6. a different chris

    >the ones who are wealthy and sophisticated enough to be allowed to invest in venture capital funds in the first place, are adults capable of taking care of themselves.

    Well they truly are. If things aren’t proceeding as expected, just buy a Congressman or two. Doesn’t matter which party, although if you are buying in bulk you should make sure to split it pretty evenly.

  7. Susan the other

    New York Magazine looks like it carries good topics. One of these days I’ll read a bit more. But for now, thanks for giving us the link. I was a little puzzled why the SEC was giving PE such a slide. The info in the last para tying in the Kentucky pension fund law suit was nice. VC/PE really is just one big shell game of obscure language. That the SEC refuses to go after anything but blatant ponzi schemes seems like dereliction of duty tho’ because this is as ponzi as it gets – it’s just customized ponzi twice removed from disclosure. The whole idea of mutuality, as in “mutual fund” is being corrupted by allowing this 15% loophole for the benefit of VC/PE.

  8. Yoni Rechtman

    1. Mutual funds regularly haircut the valuations of their investments (see the recent reporting from Bloomberg at Palantir). 2. You don’t calculate markups (paper gains) based on new post-money valuations. You calculate them as last round post/new round pre (the fair market value). So it all gets priced in anyway, even if it makes for dumb/bad/inaccurate headlines

    1. Yves Smith Post author

      That is false, see the paper and the comments by the author in the article. 90% of mutual funds use the post money valuation method, which is accurate only if what they own is from the last round of fundraising.

      And your either don’t get the basic point or are obfuscating. The post money value is NOT the fair value of the older classes. The newest issue inevitably sucks value out of each and every issue before that. Your misuse of “fair market value” shows a lack of comprehension of the issues the authors clearly set for in their paper. I suggest you read it.

      The authors have even seen mutual funds with the multiple classes of stock carry them at the same incorrect price (post money value).

      And as we stated, and again you misrepresent, when the values are marked down, they are still marked down from the same incorrect (save for the very last round of investors) inflated post money valuation.

  9. Synoia

    Engineering deals with certainties.

    All systems crash
    All structures fail
    All machines break

    Engineering tries to identify where, how and when to defer the failures, state the “unknowns,” quantify the terms “stated assumptions,” “within design limits” and “expected life.”

    What’s discussed here could be described as the distinction between marketing and engineering.

  10. Bobby Gladd

    Fabulous. Love your NY Mag piece. Downloaded the 54-pg paper as well and am slogging through it. apropos of Uber, it seems clear that they want to cash out handsomely at an absurd IPO overvaluation and dump their crap in my IRA accounts. Right? Lotsa swell transaction fees to be had by all of the Exit players and the Street.


    This VC quant stuff is above my pay grade, but I did do a 5-yr stint in subprime risk mgmt, where the joke was “the best things in life are FEE!” We made successive record profits every year I was there. I quit in 2005 to go back to health care analytics, it was just too seamy.

    I forwarded your article on to my niece and her husband, founders of a now early-stage VC funded startup based here in the Bay Area (NeuroTrainer.com). I always worry about them getting chewed up in the VC machine. They’re already had to push back on the persistent “scale up FAST!” exhortations.

    Tweeted your stuff and posted it to Facebook.

    I recall reading recently somewhere that VC funded IPO exit grads do not outperform the markets overall. That true?

  11. The Rev Kev

    Congrats on your latest article published and look forward to many more. A bit above my pay-grade here but is the heart of this problem the excess liquidity that has been sloshing around the world’s financial markets since it was let loose after the financial crisis? All this money for all these investments (like in the shale fields) has got to be coming from somewhere. It’s like too much money chasing too few opportunities leading to stupid investments.
    It’s like they are all hoping to snag “the-next-best-thing”. Read about a guy named Masayoshi Son who invested $20 million back in 2000 in a new company named Alibaba. That investment is now worth $50 to $60 billion and I wonder if the legend of this guy is what is inspiring all these unicorn investors to push the envelope of all the lending practices. They all want to be the next Masayoshi Son.

  12. UserFriendly

    you got a comment on the site that I don’t know the answer to.

    10 hours ago
    1. Mutual funds regularly haircut the valuations of their investments (see the recent reporting from Bloomberg at Palantir). 2. You don’t calculate markups (paper gains) based on new post-money valuations. You calculate them as last round post/new round pre (the fair market value). So it all gets priced in anyway, even if it makes for dumb/bad/inaccurate headlines

  13. Scott1

    David Cay Johnston is a Civil type Financial Engineer. Most Financial Engineering from Wall Street Finance is dominated by Meyer Lansky type financial engineering.
    Warren Mosler is both an Economist and a Financial Engineer.
    It was Henry Petroski who allowed Financial Engineers into the discipline of Engineering, and he does know Engineers and Engineering. “The Essential Engineer”.

  14. Darius

    Great article. I didn’t realize venture capital was such a scam, with all the mythologizing about it. I would appreciate a similar treatment for leveraged buyouts, which have devastated metropolitan daily newspapers, To mention just one sector. Why is this happening and what can a union, for one, do to fight it? Thanks.

    1. John Wright

      In my opinion, leveraged buyouts receive support because the management of the bought out firms, the fee seeking Wall Street firms and banks all usually do well.

      The damage to the employees or community does not matter.

      The story I heard years ago is that young undergraduate Michael Milken heard his instructor at Penn state that “a lot of companies could take on a lot more debt” but that no one can borrow enough money to take them over.

      Milken set about to prove him wrong.

      Years ago it was suggested that companies and management are more efficient when they don’t have an equity cushion and must service a high debt load.

      This was promoted as an advantage to the economy of leveraged buyouts (AKA private equity)

      But I have not read anyone pushing the same narrative for student loan debt, which has the same financially leveraged math applied to graduating students.

      For more than two decades I worked for the electronics firm Hewlett-Packard.

      When I was there, the two founders were very influential as they controlled about 40% of the stock.

      The employees knew that “Bill and Dave” didn’t have the company borrow money because “they didn’t want financial risk on top of business risk”.

      H-P did remarkably well as it was self funded from earnings and funds raised from employees buying via the company stock program.

      But “Bill and Dave” were electrical engineers who did not appreciate the glory of financial engineering.

  15. Steve Ruis

    So, only the top 5% of VC funds make enough return to justify the risk. When you combine this fact with the recent study indicating that a similar percent of stocks make the bulk of the gains in the US stock market, with the rest losing money, are we allowing the fairy tales of lotteries make the foundation of our economy?

    1. sawdust

      There is a distinction to be made between the ‘economy’ and capital, no?

      I’m kinda fine with the VC process. Investors are mislead (bad) and it can leak down to people who aren’t wealthy and hurt needed savings (really bad). Follow the $ and you can see capital from wealthy individuals end up at startups that hire a lot of regular people, college grads, etc. I know a lot of people who got their start in roles like marketing analysts at well-funded startups. They were almost always underpaid but it’s one of the few places you actually get trained and developed.

  16. sawdust

    Really solid article. You nailed and communicated a lot of the details without losing big picture. A few random technical thoughts from my experience valuing PE/VC shares:

    1) Post-money valuations are used as marketing by company for customers, to attract employees, etc. in addition mislead investors. And it kinda has to be higher than the last one if you want the ‘top talent’
    2) A new round of funding is a good Fair Value data point (Level 1 on FV hierarchy) but there’s often viewed the same as an active market which ignores the winner’s curse.
    3a) Even in valuations that consider all rights & preferences (let’s say a basic OPM approach), there is plenty of ‘judgement’ room (e.g. volatility, comparable companies, handpicking historical time periods, etc.)
    3b) Related to above, there just aren’t that many comparable public companies to late stage internet VC. So you’re almost always under-representing risk. Many VC companies operate in winner-take all markets.
    4) A valuation done for IRS tax purposes (typically a 409a on a basis of Fair Market Value) is often used for everything else (like Fair Value under ASC 820/ IFRS 13) because management doesn’t want to pay for another valuation. These often (but not always) overvalue because it’s conservative, there are prescribed/established approaches to use, and whatever random viewpoint the VC/management has (like we want to issue options to new employees at a higher strike prices)

    So there are some structural reasons other than greed/abuse that we’ve ended up in this mess. And (theoretically) places where actors are motivated to produce lower values that could be pushed.

    1. Bobby Gladd

      Thanks. I come here to learn. I am never disappointed.

      BTW, I just finished Tim Wu’s “The Curse of Bigness.” I found it excellent, if swimming against the neoliberal tide.

  17. Phichibe

    Re: “Financial Engineering”. In one of the 80s books on the LBO shenanigans (I believe it was “Den of Thieves” but I could be wrong) the term was attributed to Joe Perella (sp?), the dumber half of Wasserstein Perella, a boutique IB of the time. (Rahm Emanuel went from the Clinton White House to a Wasserstein bank, where he later got a $15 million payday for a few years of clock watching when the firm was bought by a big WS bank). The funny thing is that the authors made fun of Perella’s pretentions when they gave him the attribution for coming up w/t term.

    Not long after it became the hottest topic in finance, w/ countless academic journals devoted to the subject and many abstruse mathematics books coming out (Ito integrals, anyone?) And of course it all failed in 2008-9, (and back in 1987 when I was a Ph.D candidate at Stanford suffering through a graduate level class on microeconomics taught by a luminary of the field, I recall him coming into class during the 87 crash and chortling that all the fancy portfolio insurance that Markowitz et al had pedaled was coming crashing down, so it seems we never learn). I’m waiting for the next one – see for example the WP oped on CDS’s written on intracompany debts as per the slow motion train wreck at Sears/Kmart. My guess is we’re going to see 2018 the way we now look back on late 2006, Sigh.


    1. sawdust

      Sounds like it could have been from the book ‘Barbarians at the Gate,’ given the players involved.

    2. sawdust

      As an analyst I used to have to value Sears each year as part of assessing their goodwill for the external audit team (2008-2013) while I worked in the Big 4. Analysis would always showed huge impairment (even if you’re just looking at share price and ignoring the even worse looking internal data) but it would get kicked up to the head Midwest audit partner. No impairment and no final memo. I doubt anything ever even made it to the workpapers.

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