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.
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. 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.
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., 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.
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.
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.
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%.”
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.British fintech firm Revolut’s recent pre-float $800 million fundraise valued it 90 times ‘adjusted’ revenue, which included non-recurring items.
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%.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.
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, 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,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’.
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,private markets are stockpiling. Combined dry powder across alternative asset classes is hovering at an unprecedented $2 trillion. 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.