Working with top VC managers key to unicorn investing: report
These have an excellent track record of identifying, investing in and developing seed companies, says UBS
Singapore
INVESTING in unicorns - the holy grail for investors - is both challenging and risky. But this may be overcome by a systematic, diversified approach of investing with top-quartile venture capital managers, according to an exclusive report by UBS.
Kasper Wichmann, UBS' head of private equity for the Asia-Pacific, says in the report that even as unicorns - private companies with US$1 billion + valuation - are becoming more common, the challenges and risks associated with identifying and investing in them are "considerable", making it a "nigh-on impossible task for the individual investor".
For one thing, unicorn status is far and few between for startups, says Mr Wichmann. Citing research by data firm CB Insights, he says that only 1 per cent of 1,098 US startups kicked off between 2008 and 2010 went on to become unicorns, among them Uber, Airbnb and Slack.
It is also difficult to identify unicorns, Mr Wichmann says. Firstly, it is hard to look seven to eight years ahead and predict if a venture will work out. It is also challenging to turn a great idea into a viable business, even if there is a mass market for it over time. Thirdly, businesses suffer not through a lack of capital but a lack of know-how and execution.
To quantify this, the report looks at eight business-critical events for a startup: sufficient capital, capable management, product development, supply chain, competitive environment, customer interest, product pricing, and enforceable patents.
Applying a high probability of a successful outcome of 80 per cent on each event leads to a combined probability of success of only 17 per cent, the report finds. Moreover, if just one variable drops to a 50 per cent probability, the combined probability of success falls to 10 per cent, illustrating how critical these factors can be for success, the report says.
It becomes even harder to invest in startups that are close to achieving unicorn status, Mr Wichmann says. Firstly, prior investors have pro-rata follow-on rights, which give them an option for the next round and create a hurdle for new investors. Secondly, new investors need to be approved and bring to the table other sources of value, such as industry know-how and networks, on top of just capital.
"When you reach later rounds, money is a commodity. Just bringing money is very unlikely to get you a seat at the table," says Mr Wichmann.
When investors do manage to invest in a startup with unicorn potential, it comes with a lot of risk, he adds. In the early rounds - when the upside of investing is said to be the greatest - there is often business model and tech risk, and failure rates for startups can reach 65 per cent.
In the later rounds, as the startup starts to generate revenue and has overcome business model and tech risks, it still faces risks like market competition, consumer demand and management execution. Mr Wichmann says: "At this point, there is by no means a guaranteed positive outcome, let alone the certainty, that the company will become a unicorn."
Even during the late stages or pre-initial public listing (IPO) rounds, where "friends and family with big cheque books are welcomed as purely financial investors to support continued rapid growth", there is, contrary to common belief, still quite some risk, argues Mr Wichmann.
Investors in a pre-IPO round will often have the "least remaining upside" and be the "most exposed to any form of market correction", he says.
For instance, Snapdeal, an e-commerce startup and one of India's first unicorns, was heading towards an IPO with a peak valuation of US$6.5 billion in 2016 when continued high cash burn and increased competition from Amazon and Flipkart forced it into a down round and a valuation of US$2.5 billion in early 2017, a figure that has since continued to devalue.
Mr Wichmann says: "While the early-stage investors certainly took a hit, they will all still make money on Snapdeal. It is however very unlikely that the later-stage predominantly financial investors punting on a pre-IPO round will recover more than fractions of their original investments."
Nonetheless, there is a way to simplify the process of selecting and investing in unicorns, he says. That is to invest in one or more experienced managers, or "unicorn catchers", that have demonstrated an excellent track record of identifying, investing in and developing seed companies into unicorns. These include SV Angels, Sequoia Capital and DST Global.
"They can do that because they have the expertise to not only invest in long-term growth opportunities, but bring with them the expertise and contacts that fledgling companies need to fulfil their potential," he says.
Mr Wichmann's advice to investors is to leverage long-standing relationships with top-quartile managers, invest in a diversified way across a selection of these managers, and gain access to high-potential startups. "A fund-of-funds strategy may be able to effectively overcome the challenges of unicorn investing and deliver a high-potential portfolio, while mitigating risk."
UBS Asset Management, which has since 2000 adopted a systematic, diversified approach for its venture investment programme, has exposure to 30 per cent of the world's over 240 unicorn companies today, and invested in "a good number" of the top-performing venture capital managers, going by the report.
