China’s dot-com businesses are hot property in the private equity & venture capital (PEVC) world. Thanks to the success of high-profile unicorns like online payments business Ant Financial – valued at a whopping $150bn – PEVC groups are eager to find the next big thing. Internet businesses with novel business models are especially popular PEVC investment targets, and many have enjoyed high valuations before going public.
But some venture-backed companies have suffered a sharp drop in share price post-IPO. Consider consumer electronics giant Xiaomi. Before Xiaomi’s 2018 listing in Hong Kong, the company was positioned as an internet services company even though it derives most of its revenue from sales of mobile phones. Today Xiaomi is valued at $35bn, which is about two-thirds of its market cap when it listed.
High Valuations Are Unreliable Indicators of Actual Worth
The PEVC industry’s financial firepower is accelerating, and some firms take the view that their growing influence should be enough to convince public markets to accept their valuations – even if these are high. We’ve seen this phenomenon become increasingly prominent in both the US and China over the past few years. But the reality is that high valuations in private markets don’t always reflect the true worth of a tech business.
For a start, the method used to measure value may be unsuitable. Due to the lack of comparable domestic companies, a common practice is to take a valuation multiple from large, well-established comparable companies based overseas. This multiple is then applied to a local start-up with a short operating history, which has yet to prove the viability of its business model. The result is an artificially high valuation.
Most start-ups claim they provide internet services and should be positioned as internet companies, and therefore use daily active user (DAU) and gross merchandise value (GMV) as valuation matrices. However, there are very few true internet companies. Most start-ups are in the traditional industries operating businesses through online and internet tools; they are not internet companies and they have to be valued against their peers in the same industries. This explains Xiaomi’s current market cap.
PEVC’s focus on revenue growth potential also overshadows the importance of profitability. Given the size of China’s market, this is understandable. However, many so-called internet companies’ unit economics don’t work and therefore they often have to rely heavily on high capital expenditure and user subsidization for revenue growth. So even if a company increases in size and revenues soar, it may never turn a profit.
Public Markets Are Vital in Verifying True Valuations
When identifying the most promising investment targets, unit economics and sustainable profitability are vital. But such businesses don’t always attract the highest valuations. Take GSX Techedu, China’s largest online large-class tutoring service by gross billings. GSX Techedu is a strong earner with a 64% gross profit margin and a highly scalable business. To price its IPO on the New York Stock Exchange back in June 2019, GSX Techedu was valued as an education company on a price-to-earnings basis. As a result, the company’s market cap at its IPO was lower than that of many privately held peers – even those whose online one-on-one or online small-class business models have yet to prove profitable, and even companies with large scalability.
The example of GSX Techedu highlights the vital role that public markets play in verifying the valuations seen in private markets. In public markets, profitability is king. WeWork’s recent cancellation of its IPO is a reminder of the power of public markets.
At Prospect Avenue Capital, we believe the IPO is the only exit route PEVC funds should consider. To generate the returns that LPs expect, PEVC firms must focus on investment targets that can be successfully listed. This means they must be correctly positioned and valued based on the industry they operate in. They must be able to show sustained profitability. They must have a scalable business model that capital markets recognize. Only such companies are robust enough to withstand the fluctuations of the post-IPO secondary market.
China has an extensive and complex regulatory framework. In the report Preqin Markets in Focus: Private Equity & Venture Capital in Greater China's Innovation Economy, Ming Liao explains how start-ups and small businesses operating in China’s fast-growing internet sector can navigate this system.
Prospect Avenue Capital
Prospect Avenue Capital is a $500mn growth capital fund focusing on China's technology, media & telecoms (TMT) sector. Established in February 2018, PAC has deployed nearly $200mn, including five mid- to late-stage investments. Except one US IPO in 2019, PAC expects two more IPO listings in 2020.
PAC's founding partner Ming Liao is a Princeton graduate and Morgan Stanley-trained former investment banker. He earned his BA in Economics in China and his Master in Public Affairs in Economics at the Woodrow Wilson School of Public and International Affairs at Princeton University. Apart from Morgan Stanley, he held senior executive roles at The Carlyle Group and UBS AG.