Unicorn failures are cautionary tales for average investors

The path from unicorn to unicorpse is hasty — and rather steep.

As the stock market continues to flail, some unicorns — private tech startups that were allegedly worth $1 billion or more just a year or two ago — will likely die a quick death. As long as the Dow Jones industrial average heads downward, some of these once-hot companies will run out of cash because they won’t be able to raise money by going public.

Square lowered its initial public offering price to $9 from its original range of $11 to $13 per share in November. Foursquare recently raised $45 million, which reduced its original valuation by half. Gilt Groupe, which valued itself at $1 billion three years ago, was sold last week to Hudson’s Bay Co. for $250 million.

So who cares? The unicorns are not publicly traded, so why would they concern the average investor? Here’s the catch: Like it or not, anyone with even a modest stock portfolio is probably an investor in one or more of these high-risk companies.

One reason unicorns enjoy such high valuations: Major mutual funds like Fidelity, T. Rowe Price and Putnam have been channeling cash into them. Fidelity’s Contrafund alone has poured roughly $2 billion into pre-IPO tech firms like Pinterest, Blue Apron and Twilio. In 2014, T. Rowe Price invested $2.5 million in 16 private tech firms, according to research firm CB Insights.

Pension funds, university endowments, private wealth management firms and even some retail investors have also invested money in unicorns, either directly or through new private stock exchanges like SharesPost in San Francisco. And unlike the public markets, where the performance of a particular stock is trackable, the unicorns are private and therefore do not have to disclose any financial data. The risk to average investors is a bit of a black box.

“It’s hard to speculate” about the total exposure investors face in private tech firms, said David Erickson, a senior fellow at the University of Pennsylvania’s Wharton School and a former investment banking executive. “While you can quantify the positions of those investors like mutual funds that have reporting requirements, the challenge is the other non-traditional venture investors that don’t have similar transparency.”

Chasing higher-risk assets

Institutional investors like mutual funds and pension funds have traditionally been conservative, generating consistent, if unspectacular, returns for retirees. But in this era of low interest rates, these investors have become more aggressive, chasing highergrowth but higher-risk assets.

Facebook’s $16 billion IPO in 2012 gave birth to the idea that investors can grab a piece of a hot tech firm before it goes public. In the years prior to Facebook’s Wall Street debut, speculation about its IPO — expected to be the biggest ever — was reaching fever pitch, though the world’s largest

social media network didn’t seem to be in any particular hurry to go public. But that didn’t stop people, including employees and investors, from selling Facebook stock to eager buyers.

Institutional investors then wanted access to more fastgrowing tech firms before they went public, so they either bought stock directly from companies or through nascent secondary markets like SharesPost.

“We have seen an influx of institutional capital in this space,” said SharesPost founder and CEO Greg Brogger. “They are moving into the private market because they can’t get growth in the public markets.”

So far, mutual funds are devoting a small portion of their portfolios to unicorns. For example, the 2 billion dollars that Fidelity Contrafund puts into private tech firms represents only about 2 percent of its total assets. High-risk startups require a good deal of research and oversight, said Laura Lutton, director of manager research for equity strategies at Morningstar, and mutual funds have only so many resources.

But private companies are attracting a growing amount of cash from big and small investors alike. CB Insights is tracking 510 tech companies

that could soon go public; collectively these startups have raised $89 billion. The SharesPost 100 Fund, which targets individual investors, boasted $67 million in assets under management last year, an increase of 252 percent from $19 million compared with 2014.

But like the dot-com stocks of the late 1990s and early 2000s, along with the real estate frenzy preceding the Great Recession in 2008, the amount of cash in the private market is far exceeding the supply of quality tech firms. Over the past two years, investors have flooded startups with cash, resulting in 62 unicorn companies with valuations north of $1 billion, versus just 16 such companies between 2011 and 2013, according to CB Insights.

‘It was ego at work’

Companies seem to want $1 billion valuations for the sake of bragging about it, said Anand Sanwal, CEO and cofounder of CB Insights.

“A unicorn became a public relations thing,” Sanwal said. “It was ego at work.”

(Not long ago, a tech firm sent a news release to reporters breathlessly announcing it had become “half a unicorn” — meaning, presumably, that investors valued it at $500 million.)

Investors have been happy to make big bets on unicorns because they assumed the stock market would continue to go up and reward them with profits from a lucrative IPO, Sanwal said. If that sounds familiar, it should. During the housing bubble, people continued to take out mortgages because they incorrectly thought home values would rise and they could simply refinance.

We’re already seeing evidence of a slowdown, if not an outright correction. Last year, 18 companies sold themselves for less money than what they raised, compared with nine in 2010, according to CB Insights.

Sanwal notes that the vast majority of the 150 or so unicorns are real businesses with real revenue and growth prospects. Still, he estimates about a quarter of those companies are on shaky ground, especially if the stock market continues to fall.

Should the tech bubble burst, it probably won’t be obvious right away, Sanwal said. In public markets, you can see the prices of stocks crash as they happen. A correction in the private market will likely be slow and gradual, he said.

“We really don’t know,” Sanwal said.