Valuation Volatility
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In this short article we sum up how Volatility can help Venture Capital investment
How volatility affects later-stage VC.
The main reason we focus on later-stage VC, is that we like the risk profile of this specific market segment, versus its potential returns. Together with illiquidity, the only other major risk of investing in later-stage U.S. private tech companies is the volatility of their valuation from 1-2 rounds before IPO up until the end of the lock-up period.
Venture capital performance is usually driven by some outsized successes in the investment portfolio, where few deals return all the gains. But on top of the venture capital return model, valuation volatility can be used to increase return on investment in portfolio companies, through the use of secondary markets.
2. VOLATILITY IS AN EXAGGERATION OF VALUATION DYNAMICS.
In a 1981 paper on market volatility, Prof Robert J. Shiller, an American economist (Nobel Laureate in 2013), academic, and best-selling author, currently teaching Economics at Yale University, challenged the efficient-market hypothesis, which was the dominant view in the economics profession at the time.
In a nutshell, if the stock price is the estimate of the value of the company, then market prices are way too volatile, in relation to tangible manifestation of the value. He used dividends to prove its intuition, showing that prices moved far more than their proxies.
Shiller demonstrated that share prices would overshoot the good news or drop too low at other times, say considering expectations of an interest rate hike.
We agree with conclusions of the paper: rational expectations do not work, valuations do not represent long term value of companies and they are overreacting on both directions.
Courtesy of @VueApe. Deploying capital in steps during the “interest rate hike cycle” has benefited PRE IPO CLUB average cost.
3. How to benefit from valuation volatility.
At PRE IPO CLUB as an example, after we select a target company, we deploy capital during time: we benchmark the optimal position size against the rest of the portfolio, and then, we invest in smaller lots, say ¼ of total position at the time, instead of full capital allocation to the optimal position.
We do so because we believe that in today’s world, shocks are more frequent, and private markets are becoming more volatile (in tune with listed equities), which allows our strategy to load up and fill positions at lower average cost over time.
To quote Warren Buffet: “We have usually made our best purchases when apprehension about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist”.
4. Conclusion.
Good investors should welcome volatility, the correct sizing of investments should allow them to benefit from periods of weakness as well as strength. If you are interested in learning more about our deal flow at the current discounted valuations, get in touch with us here.
@ipo_club
