VC Valuations
Why VC valuations look too high to limited partners
January 31, 2023
Jeff Nasser has been spending a lot of time lately explaining to his institutional investment clients why tech stocks crashed by as much as 80% since 2021 highs, while VC portfolio losses are only averaging in the single digits.
The answer is straightforward when addressing the discrepancy over the short-term: Stocks are repriced continuously, but startups are valued only when a new funding round occurs.
But over time, public and private market valuations should start converging.
Under fair-value accounting standards, venture firms, just like other private market asset classes, are required by the American Institute of CPAs to review underlying investments each quarter to ascertain whether the value of portfolio companies has increased or decreased in the current economic environment.
The valuations that VC firms have been providing their LPs show that private market prices are still far from catching up to the steep drops of their public equity counterparts.
"We're a little surprised how long private funds are taking to write [values] down," said Nasser, a deputy CIO at Strategic Investment Group, an outsourced investment firm that manages portfolios on behalf of foundations and other institutions. Even firms with meaningful exposure to the late-stage venture, which should generally be easier to value because they can compare revenue multiples to publicly traded equivalents, had "mostly flat" returns through Q3 of last year, Nasser said.
While LPs expect VC firms to make substantive valuation adjustments in anticipation of a year-end audit review, the resulting declines are still likely to lag prices of publicly traded companies.
According to the PitchBook Global Fund Performance Report released on Tuesday, VC funds returned -8.16% in Q2 and -4.84% in Q3 of last year. While the second quarter marked the first time venture returns turned negative after years of outstanding performance, a significant part of those losses stems from declines by newly public companies still held by private fund managers, according to PitchBook research.
VC firms' approaches to assessing fair value generally fall into two camps, according to Nasser. The first group tries to adjust values in response to what is happening in public markets. But the second camp is holding valuations steady.
"They are throwing their hands into the air and saying, 'There is nothing we can do about it. That's our policy,' " Nasser said.
David Larsen, managing director at Kroll, a firm that helps LPs and GPs value assets, said that while many of his clients have a rigorous approach to valuation, many other VCs are reluctant to write down investments until there is a new round of financing.
Every company in investors' portfolios, regardless of size, must be analyzed under fair-value rules. But many VCs choose not to adjust the values of early-stage startups because the revenues are often too small to be subject to valuation metrics.
"Fair value is the price you will receive if you sold the investment to a willing buyer as a willing seller today," Larsen said. "It is not what you'll ultimately receive when you exit."
While many VC funds still have wide latitude in how they apply fair value guidelines, Larsen said that in recent years, auditors—who review fund investments annually—“have become a little more astute at looking at the current environment and pushing VCs to do a better job with valuation.”
Joanna Rupp, a managing director in charge of the University of Chicago's private equity portfolio, said she expects VC benchmarks to be down an additional 10% to 15% once the auditors review and sign off on VCs’ analysis of valuations through Q4 2022. That means that venture portfolios will be down 20% to 25% from their 2021 peak prices, she added.
While those losses aren’t insignificant, they are much less severe than the 40% to 60% discounts that shares of startups are fetching in the secondary market.
LPs recognize that there will still be a gap between GP marks and reality, said Hilary Wiek, a senior PitchBook strategist. "If I want to sell my position as an LP, secondary buyers might laugh me out of the room if I try to sell it at what GPs are pricing it," she said.
Despite this, Larsen predicts that the write-down process will continue to be slow—even for companies that may be on a path to failing entirely—because many companies have years of cash runway.
After the dot-com bubble burst, it took three to four years for valuations to fully correct, said Nasser, adding, "That's the closest historical precedent to what's happening right now."
This time, he tells clients, a new wave of valuation resets may take just as long.
The answer is straightforward when addressing the discrepancy over the short-term: Stocks are repriced continuously, but startups are valued only when a new funding round occurs.
But over time, public and private market valuations should start converging.
Under fair-value accounting standards, venture firms, just like other private market asset classes, are required by the American Institute of CPAs to review underlying investments each quarter to ascertain whether the value of portfolio companies has increased or decreased in the current economic environment.
The valuations that VC firms have been providing their LPs show that private market prices are still far from catching up to the steep drops of their public equity counterparts.
"We're a little surprised how long private funds are taking to write [values] down," said Nasser, a deputy CIO at Strategic Investment Group, an outsourced investment firm that manages portfolios on behalf of foundations and other institutions. Even firms with meaningful exposure to the late-stage venture, which should generally be easier to value because they can compare revenue multiples to publicly traded equivalents, had "mostly flat" returns through Q3 of last year, Nasser said.
While LPs expect VC firms to make substantive valuation adjustments in anticipation of a year-end audit review, the resulting declines are still likely to lag prices of publicly traded companies.
According to the PitchBook Global Fund Performance Report released on Tuesday, VC funds returned -8.16% in Q2 and -4.84% in Q3 of last year. While the second quarter marked the first time venture returns turned negative after years of outstanding performance, a significant part of those losses stems from declines by newly public companies still held by private fund managers, according to PitchBook research.
VC firms' approaches to assessing fair value generally fall into two camps, according to Nasser. The first group tries to adjust values in response to what is happening in public markets. But the second camp is holding valuations steady.
"They are throwing their hands into the air and saying, 'There is nothing we can do about it. That's our policy,' " Nasser said.
David Larsen, managing director at Kroll, a firm that helps LPs and GPs value assets, said that while many of his clients have a rigorous approach to valuation, many other VCs are reluctant to write down investments until there is a new round of financing.
Every company in investors' portfolios, regardless of size, must be analyzed under fair-value rules. But many VCs choose not to adjust the values of early-stage startups because the revenues are often too small to be subject to valuation metrics.
"Fair value is the price you will receive if you sold the investment to a willing buyer as a willing seller today," Larsen said. "It is not what you'll ultimately receive when you exit."
While many VC funds still have wide latitude in how they apply fair value guidelines, Larsen said that in recent years, auditors—who review fund investments annually—“have become a little more astute at looking at the current environment and pushing VCs to do a better job with valuation.”
Joanna Rupp, a managing director in charge of the University of Chicago's private equity portfolio, said she expects VC benchmarks to be down an additional 10% to 15% once the auditors review and sign off on VCs’ analysis of valuations through Q4 2022. That means that venture portfolios will be down 20% to 25% from their 2021 peak prices, she added.
While those losses aren’t insignificant, they are much less severe than the 40% to 60% discounts that shares of startups are fetching in the secondary market.
LPs recognize that there will still be a gap between GP marks and reality, said Hilary Wiek, a senior PitchBook strategist. "If I want to sell my position as an LP, secondary buyers might laugh me out of the room if I try to sell it at what GPs are pricing it," she said.
Despite this, Larsen predicts that the write-down process will continue to be slow—even for companies that may be on a path to failing entirely—because many companies have years of cash runway.
After the dot-com bubble burst, it took three to four years for valuations to fully correct, said Nasser, adding, "That's the closest historical precedent to what's happening right now."
This time, he tells clients, a new wave of valuation resets may take just as long.
Related read: To mark down or not: That's the question VCs face as market slump persists
Featured image by Drew Sanders/PitchBook News
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