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Beware of the Unicorn
Peter T. Treadway

A unicorn used to be a legendary beast from antiquity with a large, pointed, spiraling horn projecting from its forehead. But things have changed.  A modern  unicorn is defined as a private company with a net worth over a billion dollars.  By one source, there were 144 modern unicorns in existence at the end of 2015. Virtually all of these companies are tech startups, broadly defined. Pick up any business magazine or watch the various business shows on TV and usually you will find they have all gone ga ga over modern unicorns.

Yes many of them are great companies.  But where do all these unicorns leave the average retail investor? Answer: out in the cold and possibly facing eventual IPOs with large, pointed, spiraling horns aimed at their wallets. The problem is that, unlike in the good old days of antiquity—say when Microsoft  or Amazon  came public — today’s unicorns are delaying doing an IPO as long as possible. Seemingly endless gobs of liquidity are flowing in from the pockets of institutions and the ultra-rich and pushing up unicorn valuations.  When the unicorns do their IPOs, the hoi polloi in the public market will be offered fully priced equities of relatively mature companies that will come with a tsunami of private investor and insider selling.

Let’s take Uber, which is the largest unicorn and sort of the poster child of the whole phenomenon. Who really knows outside the company but sources in the financial press have speculated that Uber’s value is in the $65 billion area. Uber is a great company providing a great service. Surge pricing, flexible supply, free market economics and state of the art algorithms. As an economist and as someone who has spent hours waiting for taxis in places like Hong Kong and Boston, I love Uber. In theory I want to own its stock. But Travis Kalanick, Uber’s CEO, said with a smile on his face recently on CNBC that Uber would go public “as late as possible.” So much for Uber.

This delay in going public essentially leaves the bulk of the profits to the private rather than public investors. But why the change in behavior? The public market is made up of public and private investors and therefore is a broader market. In theory, the public market should offer greater valuations and liquidity and an incentive to go public.

I offer four possible explanations for this tendency of unicorns to delay their IPOs. The first is the low to negative interest rates prevailing globally which are driving money into risk assets. The unicorns get all the money they want.  Second, if we can believe the popular view that the ultra- rich are getting richer, then they have even more money to invest. The ultra-rich and the institutions are the only entities that qualify and have the connections to get into the private deals. Third, no doubt the instability of the markets in 2015 may have delayed some IPOs. Finally, there is Sarbanes Oxley. Passed in 2002 to “protect” the innocents who lost money in the 2000 tech bubble, Sarbanes Oxley imposes onerous reporting requirements and possible criminal penalties on managements of public companies. With the money pouring in from the pre-IPO market, Travis Kalanick and his fellow unicorn CEOs may look at Sarbanes Oxley and say to themselves “Who needs it!” Unfortunately, neither Donald nor Hilary and certainly not Bernie seem to have reforming Sarbanes Oxley high on their list of priorities. I think of my four reasons, Sarbanes Oxley is the most important.

Putting my economist hat on again, this prolongation of the pre- IPO gestation period is a move to less transparency and efficiency and is strongly biased against the average investor. And by average investor I would include the typical impecunious guy or gal with a paltry portfolio of just a few million bucks. There has been a lot of talk lately that the unicorn market is in a bubble. Well who knows? There are no publicly traded securities and no quotes. There are no 10Qs and public conference calls to aid in valuation. Just the occasional venture capitalist who is willing to talk to the media and give his expert opinion.

But the economic forces driving greater market efficiency and democratization are powerful. For example Travis Kalanick may not care but no doubt there is a whole army of unicorn workers with equity in their companies who may need the money now. And the incentives to get the average investor into what has been a privileged sector for the ultra-rich are strong. A whole “cottage industry” is growing up to fulfill these needs. For example a firm called EquityZen is matching buyers and sellers of stock in unicorns. Various funds are popping up which aggregate investors and offer a way to buy into some of the unicorn deals. Then there is crowd funding. Recent SEC rules (a mere 685 pages worth) now permit this as another way to democratize startup funding.

Speaking of Poster Children There Was Alibaba

In September 2014, China’s Alibaba raised $25 billion which made it the largest IPO in history. The IPO price was $68 per share, the stock opened at $92.70 and finished the day with a gain of 38% from the IPO price. As I recall, CNBC provided tick by tick electronic graphics. I sat up all night in Hong Kong watching what was truly a great global phenomenon and example of international cooperation. The free market economist in me was truly impressed.

But then the dismal doubts crept in. Buy at $68 and sell at $92.70? You don’t need an MBA for that trade. But who got to buy at $68? According to media reports, the major institutions and the FOJs (Friends of CEO Jack Ma). OK, that’s the American way of underwriting and it’s an old story. But maybe I dozed off and missed something. The business stations could have pointed out that their typical viewer got zero to just a handful of $68 shares and basically got screwed.

The irony of all this is that had Alibaba done its IPO in Hong Kong which is what Jack Ma reportedly wanted, up to 50% of the deal might have gone to retail. Unlike the US, Hong Kong has a clawback system for its IPOs which requires up to 50% of stock in hot deals to go to retail. But Hong Kong regulators, in what has to be one of the greatest acts of financial stupidity that even Bernie Sanders could probably not match, rejected the Alibaba IPO. Another irony– the largest IPO in history, a Chinese company no less, got done in the United States. Ordinary Chinese investors, who I believe under their country’s exchange rules were prohibited from buying Alibaba, really got screwed.

So What Is The Typical Tech Investor to Do

In my last Dismal Optimist I argued that you want to invest in evolution which is accelerating. Artificial intelligence, deep learning, algorithms, neural networks, the cloud, virtual reality, autonomous cars, drones, changing the human genome, synthetic biology–the list goes on and it’s all one big technology. And broadly defined it’s mostly software.  If you’ve got the net worth and the connections and/or you are a major institution, go for it. The venture capitalists on Sand Hill Road will take your money and, if the past is any guide, you will get even richer.

But what about everybody else? To update some Simon and Garfunkel lyrics, is the public market really dead? Do the unicorns, whose coffers are overflowing with cash and whose stock is inaccessible to most investors, have a lower cost of capital and all the new technologies locked up?

I’m not that pessimistic. I don’t recommend individual stocks per se and valuations and market timing need to be considered. But at least intellectually, one approach is to construct a “big guy” software portfolio. There’s a short list of public software companies with great current businesses, tons of cash and who “get it” as far as the new AI technologies go. They have the financial heft to compete with the unicorns and the private market for talent and capital. They can buy the unicorns and the startups when they see opportunities. Like Facebook did with What’s App and Oculus Rift.

My hypothetical portfolio would look something like this. The reader may wish to add others.  I have a question mark next to Apple because I’m not smart enough to know if Apple is a toy company dependent on its next gadget or a full time AI contender.

  1. Facebook (FB)
  2. Alphabet (GOOG, GOOGL)
  3. Amazon (AMZN)
  4. Microsoft (MSFT)
  5. IBM (IBM)
  6. Baidu (BIDU)
  7. Apple(?) (AAPL)

We’re lucky to have these companies in the public market. If they were started today, they might be unicorns. But they are already widely owned.  Are they great buys now or are their stocks fully priced? I’ll leave that to the reader. And perhaps I should have other portfolios of chip companies and biotech companies. The software, the algorithms, the deep learning, the cost of genome sequencing, depend on ever improving computer hardware.

I will just conclude by saying the zero interest rate alternative and the continued acceleration of technology at an accelerating rate are a powerful incentives to own stocks, especially tech stocks.