Some unicorns not as pretty as once promised

Some of the unicorns prancing through investors' portfolios are worth less as public companies than when the investments were made, meaning paper profits could turn into real losses, industry insiders say.

Unicorns are startups that are valued at $1 billion or more, most often focused on the technology sector. These private companies are found not only in venture capital portfolios, but also in private equity and hedge funds. Family offices, sovereign wealth funds and outsourced CIO firms also are buying unicorn securities as an equity investment.

These seemingly magical companies with their rapid growth also are found in defined contribution plans because mutual funds also invest in their securities.

But unicorns are starting to lose a little of their power to enchant.

“The dirty little secret about unicorns is that they are not worth $1 billion,” said John Backus, managing partner of early-stage venture capital firm New Atlantic Ventures, Reston, Va.

“Even though at a high level these companies may look like billion-dollar companies, they are not really worth that,” he said. “We are seeing that now in the public markets as these companies adjust their valuations” as they go public, said Mr. Backus, who is also on the board and on the executive committee of the National Venture Capital Association, a Washington trade group.

For example, in Square Inc.'s October SEC filing in preparation for its initial public offering, Square's valuation is lower than its last private funding round and is roughly the same as the company had been valued two or three years ago, he said.

Square is seeking $13 per share in the IPO, whereas a 2014 funding round of convertible preferred stock went for about $15.46 per share, according to SEC filings. Investors in Square — which offers a mobile app for small merchants to accept credit cards — include JPMC Strategic Investments, a private equity and venture capital arm of investment bank J.P. Morgan Chase & Co., and venture capital firms Rizvi Traverse, Khosla Ventures and Sequoia Capital.

“It's tough to know the right valuations for some of these rapidly growing unicorns such as Uber and Airbnb,” noted Michael A. Rosen, principal and chief investment officer of consultant Angeles Investment Advisors, Santa Monica, Calif.

“It's a reflection of the liquidity available ... and so companies don't have to have to go public,” Mr. Rosen said. “The private markets have ample amounts of capital.”

The good news is that unicorns represent a relatively large pool of growing companies with disruptive technologies, which is “encouraging,” he said. Whether their valuations are accurate is another matter.

“Investors going into late-stage private equity really have to ask whether the returns will be as attractive as they had in the past and there are a lot of funds focused on late-stage venture capital,” he said.

“Given the high valuations, I think you have to ask what the upside is from these valuations and as the Square IPO seems to have shown, there is no free lunch here. Valuations in the private market don't always go up,” Mr. Rosen said.

Unicorns are showing up not only in the U.S., but also in other countries including India and China, noted T. Bondurant French, executive chairman of Chicago-based private equity firm Adams Street Partners LLC.

Companies are staying private longer and unicorns underscore this change, Mr. French said.

A decade or two ago, new companies went public quicker at lower valuations and then grew the most as public companies, benefiting equity investors, he said. Today, because there is so much private capital available, companies don't need to go public and instead grow as private companies.

“Sovereign wealth funds, family offices, OCIO businesses, mutual funds, hedge funds are all interested in later-stage private company investments, and not just in funds,” Mr. French said.

They are investing directly in the companies' securities, partially to reduce costs, he said.

That benefits early-stage investors who now are able to get out of the investment earlier by selling their shares to late-stage investors, Mr. French said. (Adams Street makes early-stage investments.)

Still, investors need to be cautious around unicorns — if they don't want to get gored.

“Not all the unicorns will perform according to expectations,” Mr. French said. “They are still very new companies. They are still risky, and the hopes and dreams of their founders and investors don't always work out.”

Some investors are receiving preferred securities in exchange for their investment in the companies, which can come with guarantees that the holders will get their money back before the holders of common securities get a penny, noted New Atlantic Ventures' Mr. Backus.

The holders of common securities are generally founders, company employees and investors that buy these securities on the private secondary markets, Mr. Backus said.

“There's a lot of common stock sitting in venture capital funds that were bought from founders and employees,” he said

For limited partners, unicorns that remain private are boosting portfolio values, but the increases are on paper only, industry insiders note.

The net asset value of limited partners' unicorn holdings is increasing, but there is not a lot of liquidity as there have been few exits, said Michael Kelly, managing director at money manager and consultant Hamilton Lane Advisors LLC, Bala Cynwyd, Pa.

“It's hard to say where it will all end up,” Mr. Kelly said. “My best guess is that they will be viable companies. I don't think a lot will go out of business. Most are reasonably viable businesses.”

With venture capital, mutual funds and hedge funds all providing late-round capital, there might be a point when there is too much capital being thrown at startup companies, some observers said.

So far, the capital invested by venture capital firms and others is “not too ridiculous,” Mr. Kelly said.

“What would worry me more would be LPs committing more dollars to venture capital firms, creating more venture capital firms to compete for these unicorns and then returning to the bubble years,” Mr. Kelly said. n