Feb 16, 2023 - Economy

Private tech company valuations are just marks on paper

Illustration: Sarah Grillo/Axios

If you put money into a privately held tech company in 2021, did you lose money as tech valuations imploded in 2022? And if so, how much money did you lose? These somewhat metaphysical questions are bedeviling investors, all of whom have slightly conflicting incentives.

Why it matters: At stake is a messy admixture of fear, hubris, and attempted price arbitrage — not to mention ontological confusion over what a valuation even is.

The big picture: When investors put money into private companies, the only number that really matters is their ultimate return on investment, once the position is exited. But various stakeholders — including journalists — love to follow the fortunes of investors, entrepreneurs, and stakeholders along the way.

Driving the news: Tiger Global, one of the biggest investors in hot tech stocks, recently said in an investor letter that it had marked down its private portfolio every month last year, per the FT.

  • Between the lines: The letter reads as a defense of its new valuations against worries among its investor base that they might not have as much money, on a mark-to-market basis, as Tiger says they have.

How it works: Private company valuations aren't set every day on a public market. Rather, such companies can go years between funding rounds that value the stock.

  • All the same, investors in those companies like to have a feeling for what they're worth. VCs and hedge funds, in particular, need to assign some kind of valuation they can report back to their own investors every year or quarter.

Between the lines: Corporate PR operations generally work on the basis of higher equals better, when it comes to valuations. For other shareholders, however, the calculus is more complicated. Here are some examples.

Hedge funds and venture capital funds have reason to be conflicted. If they're raising a new fund, the operators of the old fund will often want it to show stellar returns, with the idea that potential investors in the new fund will be impressed by them.

  • On the other hand, if those funds keep their valuations high while publicly traded valuations are plunging, the result will be that their investors — foundations, endowments, and the like — will end up overweight private companies and underweight public companies. That in turn makes it less likely they'll be able to invest in a new round.

Big public funds that are bought and sold on a regular basis similarly like to boast of a good performance history. These are funds managed by the likes of BlackRock, T Rowe Price and Fidelity, which often put illiquid assets into managed funds that retail investors can buy and sell at net asset value.

  • But they also have a significant incentive to use lower valuations. If investors in those funds think the value of illiquid holdings is being overstated, it's rational for them to take profits (or sell) the fund — as happened recently with Blackstone's BREIT, a private real estate-focused fund.

The ultimate owners of the shares — the investors in the funds — generally prefer feeling rich to feeling poor, especially if they themselves need to report their results to various boards, or if they're running a fund-of-funds that they want to show high returns. So they tend to prefer higher valuations.

  • On the other hand, when valuations start feeling utterly divorced from reality, investors want the people managing their money to be honest about what their assets are worth.

By the numbers: Bloomberg charted the valuations that hedge funds and mutual funds assigned to 46 private companies. Some companies are marked consistently lower by funds across the board — like payment processor Stripe, down over 50%.

  • Others were all over the place: Instacart, the grocery delivery service, is either down only mildly — or down 61%.

Context: When hedge funds or VCs charge 2-and-20 on their assets — a 2% management fee and 20% of the profits — it doesn't matter what valuation they give to those assets along the way.

  • The 2% management fee is charged on the purchase price, not on any subsequent marks. And the 20% of profits is only payable once the profits have been realized.

The bottom line: No one really knows how much a private company is worth unless and until it's sold, goes public, or does a new funding round. At that point, valuations get back in line with each other.

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