There’s Unicorn Blood in the Streets

(Bloomberg Businessweek) -- You could call them the unicorn vigilantes. And they have a message for the big startups looking to make the move from private investment havens to public markets: Stay away from Wall Street until you get your act together.

Much like the so-called bond vigilantes of the 1980s and ’90s—they started selling when they saw signs of inflation, pushing up interest rates even before the Federal Reserve could act—analysts, fund managers, and other investors are showing signs of increased vigilance about all the new equity being pushed onto the stock market. They’re casting suspicious looks at the unicorns (the nickname used for startups with private valuations of $1 billion or more) that are losing large amounts of money. And at those with convoluted corporate ownership schemes and plans for multiclass share structures that water down the voting power of ordinary investors. And at those that present themselves as tech companies, deserving of Silicon Valley valuations, when in fact their businesses are more mundane. Sometimes the companies’ founders don’t even survive the transition from private to public; Uber’s Travis Kalanick and WeWork’s Adam Neumann were bounced from the top job at their startups amid heightened scrutiny of their management skills.

The result is unicorn blood in the streets. Office-sharing behemoth WeWork’s parent, We Co., canceled its planned initial public offering. So did talent agency and entertainment conglomerate Endeavor Group Holdings Inc. Airbnb Inc. may try a different route, allowing its investors to cash in by directly listing shares on the market rather than attempting to raise fresh capital through a conventional IPO, Bloomberg News reports.

We Co. has turned into the poster child for wounded unicorns that come to Wall Street offering promises of disruption, with visions of stock market capital in their heads. “WeWork’s planned IPO turned into a highly publicized debacle that suggested public investors may finally be done overpaying for blazing-fast growth,” IPO specialist Renaissance Capital wrote in a note summing up the third quarter.

It’s far from the only disappointment. Companies such as Uber Technologies, Lyft, and Peloton Interactive were able to get their IPOs off the ground, but the shares are trading well below their initial offering prices. The FTSE Renaissance US IPO Index of companies that went public in the past two years started off 2019 with a bang, outperforming the broader stock market, but it’s lost 15% from its high in July.

Among the biggest unicorn vigilantes are the people who control the membership of benchmark stock indexes. Because of a change in rules in recent years, companies with multiple share classes can’t be added to indexes maintained by S&P Dow Jones Indices LLC and face restrictions at FTSE Russell. Among the companies affected are 7 of the 10 biggest IPOs in 2019, including Chewy, Lyft, and Pinterest, according to Goldman Sachs. Not being in an important index means those stocks will be ignored by most passive investors, who represent more than half the money in U.S. mutual funds and exchange-traded funds. “Multi-class voting to insulate management from its own shareholders comes at a significant long-term cost,” write Goldman’s equities strategists, led by David Kostin.

Recent market and economic trends are also having an impact. President Trump’s trade war and impeachment inquiry, upside-down portions of the Treasury yield curve, and reports showing that global manufacturing industries are shrinking have led to increasingly nervous speculation about a recession. That’s not the ideal environment in which to ask investors to take on a lot of risk by buying into an IPO, especially from an unprofitable company. The best-performing sectors in the S&P 500 in the third quarter were utilities, real estate, and consumer-staples companies—famous for their high dividend yields and/or relatively safe, steady businesses, rather than blockbuster growth and disruption.

Some investors also point to a disconnect between private markets, where unicorns feasted on a seemingly endless supply of cash and valuations were starting to look bubblelike, and public markets, where scrutiny of business models is more robust.

Where did all this private market cash come from? One theory can be found in a recent paper by Michael Ewens of the California Institute of Technology and Joan Farre-Mensa of the University of Illinois at Chicago. They point to deregulation efforts in the investing industry in the 1990s, particularly the National Securities Markets Improvement Act of 1996. That law made it easier for startups to raise funds by reducing some disclosure requirements. It also increased the number of investors allowed in a fund before it was required to register under the Investment Company Act. The result, according to the authors, is that the spigots of private equity and venture capital were opened wide, allowing companies to stay private much longer and grow much larger without needing to raise money via an IPO.

Of course, the stock market is often the ultimate destination for venture capital and private equity investors looking to cash in. Why so many of them rode unicorns in that direction this year is open for debate. Perhaps it was partly coincidence, though more cynical folks will argue that it was because the business cycle was growing old, and the window to cash in on a buoyant stock market looked like it was closing.

Regardless, what we have now is a herd of unicorns with inflated valuations trying to sell themselves in a stock market where investors are in the mood to play defense. They’d rather not place risky bets on companies that are long on ambition but, in many cases, short on profit. “We’ve had a delayed feedback loop between public investors and private investors, because there was so much private capital chasing these venture-stage companies,” says Jennifer Foster, co-chief investment officer of equities at Chilton Trust. While there’s also a lot of money chasing investments in public markets, she says, there are a lot more decision-makers analyzing securities. “The scrutiny on the business models—it’s a healthy dynamic for a vibrant equity market to have those kinds of dialogues and questions.”

Some are looking at We Co. as more than just a quirky company with a quirky founder and an IPO prospectus full of red flags. Morgan Stanley strategist Michael Wilson views its failure to launch onto public markets as a major turning point—the way the failed leverage buyout of United Airlines in 1989 marked the end of the junk-bond-fueled LBO craze of that decade; the way the AOL-Time Warner merger signaled the end of the dot-com bubble; and how JPMorgan Chase & Co.’s takeover of a collapsed Bear Stearns in 2008 marked the end of the financial excesses that followed the turn of the century. “So if this is the event, what are we ending?” Wilson asks. “In our view, the days of generous capital for unprofitable businesses is over.” —With Vildana Hajric and Sarah Ponczek

To contact the editor responsible for this story: Eric Gelman at egelman3@bloomberg.net

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