In Search of Unicorns: Private Ipos and the Changing Markets for Private Equity Investments and Corporate Control by Keith C

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In Search of Unicorns: Private IPOs and the Changing Markets for Private Equity Investments and Corporate Control by Keith C. Brown and Kenneth W. Wiles, University of Texas at Austin*

n August 23, 2013, a remarkable event occurred: sometimes displacing altogether) IPO events by allowing A new unicorn was born. Unlike the mythical firms to raise hundreds of millions of dollars—billions in O beast that has captured man’s imagination since some cases—while remaining private. antiquity, however, this unicorn was the trans- These PIPO funding rounds began to appear in finan- portation network company, Uber Technologies, Inc. The cial markets in force during 2012 and have grown to the event that happened was the completion of a $258 million point that, in some industries, they now exceed public IPOs private market funding round with venture capital investors in both frequency and dollar volume. For instance, as can that included the likes of Google Ventures, TPG Growth, be seen in Figure 1, although the number of IPO and PIPO and Benchmark. In fact, this was Uber’s third venture capi- transactions for U.S.-based technology companies were tal fundraising event. (The previous two series raised $37 roughly the same from the beginning of 2012 through the million and $11 million, and they followed earlier angel middle of 2013, since that time there has been a clear prefer- ($1.3 million) and seed capital ($0.2 million) rounds that ence among start-up technology companies to continue to dated back to October 2010.) What made this funding raise capital in private markets.2 In fact, CB Insights, a event in August 2013 particularly noteworthy is that, with private equity investor database, recently estimated that by this capital infusion, Uber’s estimated market valuation the end of the first quarter in 2015, there were nine times exceeded $1 billion for the first time, which allowed it to more technology-related PIPOs than IPOs.3 join the growing ranks of companies that achieved that Further, this movement toward financing a company lofty status while remaining privately held. And in so doing, outside of the public markets can continue well beyond the Uber became—in the parlance of today’s capital markets— point at which it reaches the unicorn valuation level. Uber is a “unicorn.”1 a good example of that, having completed several additional Besides introducing another colorful term to the PIPO rounds since its August 23, 2013 capital funding. lexicon, this transaction highlights an important trend Indeed, of the five equity financing series that occurred after that has been developing in the financial markets over the that date through July 31, 2015, four of them raised $1 billion past few years. Specifically, there has been a dramatic shift or more, with the largest, on June 6, 2014, raising $1.2 billion. in the way that private technology firms are now raising With the completion of its $1 billion financing round on July growth capital. Rapidly growing companies have histori- 31, 2015, the private company achieved a market valuation of cally funded several small rounds of private capital from nearly $51 billion and increased the total amount of owner- various sources and investors (including seed, angel, venture ship capital it has raised to more than $6.0 billion.4 And Uber, capital, and private equity) before having to turn to the while certainly a dramatic example of this new funding trend, public market with an initial public offering (IPO) to raise is by no means an isolated case. As of this writing (August the large-scale funding necessary to finance their long- 2015), we have been able to identify 142 unicorn compa- term expansion needs. That process has changed as private nies headquartered in regions throughout the world with a firms are now able to raise growth capital in the private combined valuation of almost $625 billion. markets at a scale that was previously accessible only from Given the size and rapid development of this financing public markets. These non-public capital fundraisings are, vehicle, it is quite likely that PIPOs—and the unicorns they in essence, private IPOs (or PIPOs) that are deferring (and create—will have widespread and significant impacts on the

* We are grateful for the comments and contributions of Sam Hutchinson (CB In- 2. Morgan Bender, Benedict Evans, and Scott Kupor, 2015, “US Tech Funding,” An- sights), Eric Lang, Neil Randall, and Brad Thawley (Teacher Retirement System of Tex- dreessen Horowitz Working Paper. In their presentation, the authors make the point that as), Dan Nash (Wells Fargo), Robert Parrino (University of Texas and Hicks, Muse, Tate PIPOs represent a rebalancing away from the traditional IPO format and that technology & Furst Center for Private Equity Finance) and Henri Servaes (London Business School). IPOs have essentially become a dormant funding tool. The authors remain solely responsible for any errors or omissions in the analysis. 3. CB Insights, 2015, “Data: There are Now Over 9x More Private IPOs Than Actual 1. The use of the term “unicorn” to describe private firms that have market valuations Tech IPOs,” CB Insights Blog, (www.cbinsights.com: April 19). of at least $1 billion is widely attributed to Aileen Lee, managing partner of the seed 4. Douglas MacMillan and Telis Demos, 2015, “Uber Valued at More Than $50 Bil- capital-stage investment firm Cowboy Ventures; see Katie Benner, 2015, “The ‘Unicorn’ lion,” The Wall Street Journal, July 31. Club, Now Admitting New Members,” The Wall Street Journal, August 23.

34 Journal of Applied Corporate Finance • Volume 27 Number 3 Summer 2015 Figure 1 IPO and PIPO Transactions for U.S. Technology Firms: 2013:Q1 - 2015:Q2

30 IPO PIPO 25

10 Number of Transactions

2012: Q1 2012: Q2 2012: Q32012: Q4 2013: Q1 2013: Q22013: Q3 2013: Q4 2014: Q1 2014: Q22014: Q3 2014: Q42015: Q1 2015: Q2

Data Source: CB Insights corporate finance, private equity, and investment markets.5 and we then offer our speculations as to how PIPO transac- Most importantly, by helping companies to remain private tions fit into that story. Next we describe the details of a large for a longer period of time than in the past, PIPO fundings data sample of unicorn firms we have gathered, including may allow these firms to avoid many of the organizational the industry affiliations and geographical dispersion of the and governance problems that often plague publicly traded companies involved in addition to the range of market valua- corporations, such as misaligned incentives between manage- tions and funding rounds raised. Following that analysis, ment and ownership, and a sometimes oppressive regulatory we consider the specific supply and demand conditions that environment. As a consequence of the extended time that are driving the present market for PIPOs and address some PIPO financing permits a company to stay private before prospective research implications about companies that are turning to public sources of capital, private investors are likely able to grow with the use of private capital rather than having to capture a much greater proportion of the increase in value to resort to financing themselves in public markets. from emerging growth companies. Conversely, when IPOs do occur, the post-offering share price increases may be substan- Private Equity, Corporate Governance, and the tially smaller than investors have come to expect from past Market for Corporate Control experience since those public launches may now follow one To provide some context for understanding why PIPOs are or more PIPO funding rounds. In fact, an increase in the emerging as a viable funding source for companies that are tendency for firms to fund themselves privately may lead to evolving from the “new venture” phase of their development, a decline in the number of small firms available to go public it is useful to consider what the scientific evidence tells us in the first place, which could in turn lead to a reduction in about the multi-faceted role that private equity (PE) invest- the number of equity funds specializing in holding portfolios ments have played in the capital markets, particularly with of small capitalization stocks. respect to helping align incentives between the owners and Our goal in this study is to examine the development the management of a firm. Traditionally, PE investors have and economic consequences of the recent capital market concentrated their investments at the opposite ends of the movement toward the growing use of PIPO financing. We corporate life cycle/growth spectrum: that is, venture capi- begin our investigation by analyzing the research literature on tal (VC) firms have concentrated on early-stage companies, private equity transactions to assess the likely effects of private while leveraged buyout (LBO) firms have focused on under- market investments on corporate operations and governance, performing private and public companies, or divisions of

5. First Round Capital’s Josh Kopelman wrote, for example: “I don’t think we’ll fully 6. Mike Wright, Kevin Amess, Charlie Weir, and Sourafel Girma, 2009, “Private Eq- understand or appreciate the impact of the “private IPO” phenomenon for another de- uity and Corporate Governance: Retrospect and Prospect,” Corporate Governance: An cade, or at least until a full cycle plays out…By relying on private financing events as International Review 17, no. 3: 353-375. “comps,” we risk pricing new financings (and creating new unicorns) based on stale valuations.” See CB Insights (2015), op cit.

Journal of Applied Corporate Finance • Volume 27 Number 3 Summer 2015 35 those companies.6 VC funds, therefore, invest in early-stage and board members often have minimal equity ownership companies with the goal that, after several capital-rais- and provide limited oversight.10 ing rounds, the company will have gained significant scale, The emergence of LBOs in the 1980s revolutionized customer adoption, and, hopefully, cash flow generation to the market for corporate control and began to affect the allow it to be acquired or gain access to larger pools of growth governance structures of not only those companies that capital available through an IPO. LBO funds engage in stra- were currently the targets of buyout funds, but also those tegic acquisitions of underperforming companies and, after that might become targets in the future.11 The emergence of a restructuring period that usually lasts from three to five significant pools of capital from both LBO funds and the debt years, these funds plan to exit the investment through either financing that accompanied those LBO deals provided the the sale of the firm to another private buyer or by taking the resources for superior management teams to target underper- company public (i.e., a reverse LBO).7 forming management teams at even the largest corporations. Managers that had previously been relatively insulated from PE Investing as a Source of Corporate Discipline the disciplining forces of effective corporate governance either Over the past twenty-five years, there has developed a substan- became targets of LBO funds or understood that they could tial research literature that provides consistent evidence that be in the future. PE firms, particularly those that invest in larger companies, In response, public companies began to adopt some of the impose a superior governance structure that reduces agency governance practices of PE-controlled companies, including costs and the free cash flow problems that often arise in public tying management compensation more closely to share perfor- companies. In public corporations, diffuse owners (i.e., large mance and establishing more active boards.12 The impact of numbers of shareholders with relatively small percentage PE involvement on the governance of public companies is holdings) bear the residual risk of the firm, while managers particularly impressive, given that PE transactions in the U.S. make resource allocation decisions within the firm but do not have typically accounted for only about 2-3% of total global supply capital and typically bear very little of the residual risk capitalization.13 Figure 2, which comes from recent analysis of the firm. This separation of management and risk-bear- by Karen Wruck, provides a visual indication of how and ing can sometimes lead managers to make decisions that are where PE investments fit into the process of improving the suboptimal from the perspective of shareholders, particularly governance and operating policies of a public company.14 when the governance structure in place at the firm is weak or ineffective.8 Furthermore, there is a free-rider problem that How PE Investments Change a Firm’s Operations arises when individual owners do not have sufficient personal and Governance incentives to monitor management on behalf of all sharehold- Given that the goal of a private buyout is to instill more ers. The benefits of a shareholder’s monitoring activity will be discipline in the operations of the target company, it is not spread across all of the firm’s owners while the costs are borne surprising that considerable research has been conducted on solely by that shareholder.9 the governance structure employed by successful PE firms.15 Agency costs are said to result in a “residual” loss in firm The findings of these studies have shown that the best gover- value that comes from the separation of decision-making and nance structures consist of several key elements, such as (1) residual risk bearing. Shareholders attempt to minimize this small boards of directors (i.e., 5-7 members), (2) concentrated loss in value through a variety of means, including “contract- ownership and board control, and (3) board members and ing” (compensation agreements), reporting (audit and other management with significant equity-based incentives, either periodic reports), and board oversight of management. through direct share ownership or an incentive plan. The PE Ultimately, contracting cannot eliminate agency conflicts, governance structure provides a better alignment between

7. Tim Jenkinson, and Miguel Sousa, 2015, “What Determines the Exit Decision for boards or outside investors; see Michael C. Jensen, 1991, “Corporate Control and the Leveraged Buyouts?,” University of Oxford Working Paper. Politics of Finance,” Journal of Applied Corporate Finance 4, no. 2: 13-33. 8. See, for instance, Michael C. Jensen and William H. Meckling, 1976, “The Theory 11. The market for corporate control is “the market in which alternative management of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure,” Journal of teams compete for the right to manage corporate resources.” See Michael C. Jensen and Financial Economics 3, no. 4: 305-360; and Eugene F. Fama and Michael C. Jensen, Richard S. Ruback, 1983, “The Market for Corporate Control: The Scientific Evidence,” 1983, “Agency Problems and Residual Claims,” Journal of Law and Economics 26, no. Journal of Financial Economics 11: 1: 5-50. 2: 327-349. 12. Steven Kaplan, as interviewed by Donald Chew, 2009, “The Future of Private 9. Fama and Jensen (1983), ibid. It is also worth noting that there is some evidence Equity,” Journal of Applied Corporate Finance 21, no. 3: 8-20. that individual shareholders can coordinate their monitoring activities in order to posi- 13. Steven N. Kaplan and Per Stromberg, 2009, “Leveraged Buyouts and Private tively impact firm value; see Deon Strickland, Kenneth W. Wiles, and Marc Zenner, Equity,” Journal of Economic Perspectives 23, no. 1: 121-146; and Ronald Doeswijk, 1996, “A Requiem for the USA: Is Small Shareholder Monitoring Effective?” Journal of Trevin Lam, and Laurens Swinkels, 2014, “The Global Multi-Asset Market Portfolio: Financial Economics 40, no. 2: 319-338. 1959-2012,” Financial Analysts Journal 70, no.2: 26-41. 10. See Karen H. Wruck, 2008, “Private Equity, Corporate Governance, and the Re- 14. See Wruck (2008), op cit. invention of the Market for Corporate Control,” Journal of Applied Corporate Finance 20, 15. See Michael C. Jensen, 1989, “Eclipse of the Public Corporation,” Harvard Busi- no. 3: 8-21; and Jesse Edgerton, 2012, “Agency Problems in Public Firms: Evidence ness Review 67: no. 5: 61-74; George P. Baker and Karen H. Wruck, 1989, “Organiza- from Corporate Jets in Leveraged Buyouts,” Journal of Finance 67, no. 6: 2187-2213. tional Changes and Value Creation in Leveraged Buyouts: The Case of O. M. Scott & Sons It has also been argued that in the early 1980s, U.S. companies could lose as much as Company,” Journal of Financial Economics 25, no. 2: 163-190; and Wruck (2008), op 30% of their market value before “facing a serious threat of displacement” by either their cit.

36 Journal of Applied Corporate Finance • Volume 27 Number 3 Summer 2015 Figure 2 Reorganizing the Firm for Value

Weak Corporate Governance Focus on size and growth rather than value, weak internal capital markets

Underperformance

Pressure from the Market for Corporate Control Hostile Takeover Offer, LBO as an alternative

Asset Sales, if Necessary Private Equity-Style Governance High leverage facilitates concentrated equity ownership Changes in organizational “Rules of the Game” 1) Decision Rights decentralized 2) New Performance Measures focus on cash-flow rather than EPS and on firm value rather than size or growth 3) Rewards that align Incentives with bonuses based on new performance measures and management-equity ownership

Improved Strategy and Decision-Making Utilizing valuable specific knowledge through effective decentralization allocating capital more efficiently

Improved Performance and Value Creation

Source: Wruck (2008). shareholder and management objectives than that typically after the company becomes privately held. LBO sponsors found in public firms because it provides effective oversight take about 30% of the seats and insiders as a group hold from board members with significant ownership interest, a between 56% and 78% of board seats.18 Management may management team with significant equity incentives that have a majority of the seats on the boards, but the LBO funds better match its interests with major shareholders, and an effi- still have effective control because they tend to own between cient organizational structure with minimal overhead costs.16 90% and 100% of the equity. To further enhance the align- Both the size and composition of a company’s board ment of interests between shareholders and managers, PE tend to change after it undergoes a buyout. When compa- firms usually require managers to make meaningful equity nies are taken private, the number of board members investments in their companies, and studies have shown that usually declines by one or two seats, which is a reduction of management ownership increases by roughly four-fold, on approximately 15% to 30%. Smaller boards are correlated average, when public companies are taken private.19 with better company performance and are thus consistent Corporate governance improvements help drive the with the movement toward better governance structures.17 enhanced efficiency and value increases that have been In addition, the number of insiders on the board increases reported for PE-invested firms, but financial leverage and

16. Jensen (1989), op cit; Wright, Amess, Weir, and Girma (2009), op cit; and 18. Ibid. Note that the percentage of insiders on a board does not change after an Francesca Cornelli and Oguzhan Karakas, 2015, “CEO Turnover in LBOs: The Role of LBO, but that percentage does increase dramatically for management-led buyouts Boards,” London Business School Working Paper. (MBOs), from 62% to 78%. 17. Cornelli and Karakas (2015), ibid. Even organizing something as seemingly sim- 19. Steven N. Kaplan, 1989, “Management Buyouts: Evidence on Taxes as a Source ple as a board conference call becomes more complex as the number of board members of Value,” Journal of Finance 44, no. 3: 611-632. Management’s equity investments are increases. also illiquid which further reduces the incentive to manipulate short-term performance.

Journal of Applied Corporate Finance • Volume 27 Number 3 Summer 2015 37 operating improvements also contribute. Increased lever- The Investment Performance of PE Funds age from buyouts reduces free cash flows and allows firms It is often difficult to assess PE fund performance because to concentrate ownership in the hands of management and (1) there are limited data reported on fund activities, (2) PE funds, both of which help reduce agency costs.20 In what data are available are not consistently available for all addition, debt also provides the well-documented increase funds, (3) funds do not often disclose cash flow data, and in corporate tax shields and enhanced returns from leveraged (4) data that are available may not be available consistently equity. PE-invested firms are also able to implement operat- over time.24 Despite those challenges, there is compelling ing changes that may take some time to implement without evidence that PE funds provide superior returns compared the pressure to report quarterly financial performance to the to publicly traded companies. One recent study found that public markets. U.S. buyout fund returns have exceeded those of public The evidence indicates that both financial leverage and markets, as measured by a range of market indices, for operating changes are consistent factors in driving PE valua- most fund vintages since 1984. Buyout fund investments tions, but that the relative contribution of each seems to outperformed the S&P 500 index averages by between 20% vary over time. In particular, while operating improvements and 27% over the life of the fund, which is a performance and tax shields remain critical drivers of PE-invested firm increment of more than 3% per year.25 On the other hand, performance, the operating improvements associated with although VC funds outperformed public equities during the LBOs after 1990 made considerably less of a contribution to 1990s, they underperformed during the vintage years from increased value than those that occurred during the 1980s. 1999 through 2008.26 Additionally, it appears that firms do not reduce the amount There is also evidence that the best PE firms outperform they had previously borrowed after returning to the public the market and their peers over time, indicating that there markets, suggesting that leverage drives LBO performance is persistence in performance. For instance, recent research and that the sustained change in capital structure is an objec- headed by Professor Steven Kaplan has established a clear tive of the LBO structure.21 tendency for the best PE funds to consistently outperform In fact, the relative importance of financial leverage and the market, on a net-of-fee basis.27 Using a new data set operating enhancements may be changing. One recent study that comprises detailed cash flow information from PE fund argues that the decline in debt costs since 2007 and the diffi- limited partners, he and his colleagues find that there is culty in obtaining leverage have limited the ability of PE firms significant persistence in returns to PE investors in funds to create value through financial engineering.22 This, in turn, raised prior to 2000. After 2000, however, they find that suggests that PE funds will depend increasingly on their ability performance persistence for LBO funds has mostly disap- to enhance operating performance to drive returns, which, in peared, except for those in the bottom quartile of funds. In turn, depends upon the PE firms’ ability to attract and retain the case of VC funds, by contrast, although average perfor- experienced personnel and industry experts to manage the mance has been disappointing for almost 15 years, the best companies in which they invest. Finally, it is worth noting VC funds continue to outperform the S&P 500, and thus that while financial and governance engineering continue to be evidence of persistence continues.28 important in creating value in PE investments, the best buyout But the bottom line on PE funds is that LBO fund returns firms have focused on “operational engineering” by establishing across all quartiles have exceeded those of public markets as a network of operating partners to ensure that their portfolio measured by the S&P 500 benchmark. For VC funds, only companies retain the best managers and advisors.23 Finding those that provide performance greater than the median of all and retaining operational talent is a constraint on the ability of funds tend to remain above the median and exceed returns private equity firms to achieve superior financial performance. from public markets.

20. Wruck (2008), op cit. 26. Shouren Gou, Edith S. Hotchkiss, and Weihong Song, 2011, “Do Buyouts (Still) 21. Gou, Hotchkiss, and Song (2011), op cit; and Jonathan B. Cohn, Lillian F. Mills, Create Value?” Journal of Finance 66, no. 2: 479-517. These authors also provide evi- and Erin M. Towery, 2014, “The Evolution of Capital Structure and Operating Perfor- dence that median risk-adjusted returns to pre- (post-) buyout capital invested are mance After Leveraged Buyouts: Evidence From U.S. Corporate Tax Returns,” Journal of 72.5% (40.9%). Earlier studies based on share price and accounting data indicate that Financial Economics 111, no. 2: 469-494. buyouts enhance financial performance; see, respectively, Kenneth Lehn and Annette 22. Some buyout firms, such as Silver Lake, have recently begun to shift their acqui- Poulsen, 1989, “Free Cash Flow and Stockholder Gains in Going Private Transactions,” sition focus toward firms in high-growth industries, where the use of leverage is less Journal of Finance 44: no. 3: 771-788; and Scott B. Smart and Joel Waldfogel, 1994, appropriate. See also Gary Mathews, Mark Bye, and James Howland, 2009, “Opera- “Measuring the Effect of Restructuring on Corporate Performance: The Case of Manage- tional Improvement: The Key to Value Creation in Private Equity,” Journal of Applied ment Buyouts,” Review of Economics and Statistics 76, no. 3: 503-511. Corporate Finance 21, no. 3: 21-27. 27. Kaplan, as interviewed by Chew (2009), op cit. 23. Kaplan, as interviewed by Chew (2009), op cit. 28. Robert S. Harris, Tim Jenkinson, Steven N. Kaplan, and Ruediger Stucke, 2014, 24. Robert S. Harris, Tim Jenkinson, and Steven N. Kaplan, 2014, “Private Equity “Has Persistence Persisted in Private Equity?: Evidence From Buyout and Venture Capital Performance: What Do We Know?,” Journal of Finance 69, no. 5: 1851-82. Funds,” University of Virginia Working Paper. 25. Ibid. Although measuring the systematic risk of private companies is difficult, the authors’ results remain consistent even when higher risk levels are incorporated into their analysis.

38 Journal of Applied Corporate Finance • Volume 27 Number 3 Summer 2015 Figure 3 Different Company Funding Progressions

A. Without PIPOs Venture Round #1

Early Seed Funding Large-Scale Capital Infusion - “Zero” Stage Venture Round #2 - Initial Public Offering - Angel Investing - PE Buyout

Venture Round #3

Typical Time to IPO: 3-5 years B. With PIPOs

Venture Round #1 PIPO Round #1

Early Seed Funding Large-Scale Capital Infusion - “Zero” Stage Venture Round #2 PIPO Round #2 - Initial Public Offering - Angel Investing - PE Buyout

Venture Round #3 PIPO Round #3

Typical Time to IPO: 10+ years

The Role of PIPOs in the Overall PE Market A typical incubation path for a newly formed business The preceding summary of the research literature on PE organization is to experience two or more relatively small investing underscores the potential role of private invest- capital infusions (i.e., funding rounds) in the private market.30 ments in correcting weaknesses in both the operations and At some point, though, the company will need a more the governance structures of public companies. As Figure substantial “liquidity event” to accelerate the growth of the 2 suggests, LBOs are frequently the catalyst for organi- firm’s operations and, perhaps, to allow the original owners zational changes that need to be made. Further, there is to sell a portion of their otherwise non-marketable ownership evidence that firms that have undergone an LBO tend to stay interests. While a large PE buyout fund may be the source of private. For instance, one study has reported that there were this liquidity, this is traditionally the role that IPOs have filled close to 14,000 firms in LBO ownership in the mid-2000s, in the financial markets. However, with the sizeable inflow as compared to fewer than 2,000 in the mid-1990s—and of new equity capital that an IPO brings come the attendant the same study found that 69% of the firms taken private problems of running a company in the public arena (and between 1980 and the beginning of 2007 were still private under public scrutiny). And, of course, the irony for many at the end of 2007.29 of these companies that do choose to go public is that those So, how does a PIPO funding round fit into this story? same problems will eventually have to be addressed in the Clearly, by its very nature, a PIPO is not a method of taking future by another LBO. a public company into the private market; the firms that use Therefore, the primary role that a PIPO transaction appears these transactions are already private. Instead, by allowing a to serve in modern capital markets is to provide companies with non-public company to stay private longer, PIPOs permit the the opportunity to continue to be run privately for an extended firm to keep the more effective set of PE-related management period of time before they need to seek public sources of equity. and governance procedures in place longer. This is the essen- In the technology sector, for instance, between 1999 and 2014 tial contribution that PIPO deals make within the scheme of the median time for a new venture to undergo an IPO event the overall market for PE investment capital. after inception increased from four to 11 years as the incidence

29. Anuradha Gurung and Josh Lerner, eds., 2008, “Globalization of Alternative In- and David Gladstone and Laura Gladstone, 2002, Venture Capital Handbook, Prentice vestments” World Economic Forum Working Papers, Vol. 1. Hall: Upper Saddle River, NJ. 30. Stefano Bonini and Vincenzo Capizzi, 2015, “The Effects of Private Equity Inves- tors on the Governance of Companies,” Bocconi School of Management Working Paper;

Journal of Applied Corporate Finance • Volume 27 Number 3 Summer 2015 39 Table 1 Summary Statistics for the needed to develop a company from an earlier-stage business to Unicorn Transaction Sample one that is more mature was traditionally provided by either larger companies that strategically acquired those smaller Total Number of Unicorn Firms 142 firms or from the public market through IPOs. Now, however, Firms by Vertical Market Segment: emerging growth companies have begun to raise significant Technology: Internet 80 amounts of capital in private funding rounds, or PIPOs, that Technology: Software 35 allow them to remain privately managed until they become Technology: Financial 10 more established businesses with higher valuations. Technology: Hardware/Systems 7 We have gathered myriad financial details on a collec- Healthcare 8 tion of 142 firms that qualified as unicorns as of August 31, Other 2 2015. Specifically, in order to be included in the sample, a

Aggregate Sample Market Value ($ Billions) 622.9 company must (1) have always been private, (2) have received Mean Firm Market Value ($ Billions) 3.7 at least one funding round of institutional capital, (3) not Median Firm Market Value ($ Billions) 1.6 be a divisional buyout of a public company, and (4) have Minimum Firm Market Value ($ Billions) 1.0 an estimated market valuation of $1 billion or more. The Maximum Firm Market Value ($ Billions) 51.0 identity of and data for our sample of unicorn companies were gathered from several sources, including Wells Fargo, Number of Firms With a Value of: CB Insights, and CrunchBase, as well as our own research. Exactly $1.0 Billion 38 Although we have endeavored to assemble a compre- Between $1.0 and $4.9 Billion 82 hensive list of sample firms, there are always challenges in Between $5.0 and $9.9 Billion 10 gathering data on private equity investments.32 Private compa- Greater Than or Equal to $10.0 Billion 12 nies and their investors maintain high levels of confidentiality regarding their financial and operating performance. For Median Year of Company Founding 2008 example, there are several privately held businesses for which Earliest Year of Company Founding 1994 we were able to identify the amount of the most recent Most Recent Year of Company Founding 2014 funding round, but not the total amount of capital raised. of big-scale private equity rounds proliferated.31 In that sense, We did not include those firms in our sample. these additional PIPO funding transactions fill a gap in the Despite these challenges, we believe that we have identified a natural progression that a new venture goes through between representative list of unicorns that has been cross-checked against accessing smaller private funding rounds before seeking a larger multiple data sources. Table 1 provides summary data about the public launch. That is, PIPO deals provide a company with number of firms, the industry classifications and market valua- at least some of the benefits of a large-scale public funding tions of those firms, and their founding years. The 142 unicorn while allowing it to continue to operate in the private market companies in our sample have a mean and a median market and thereby avoid (or at least significantly postpone) many of valuation of $3.7 billion and $1.6 billion, respectively. The aggre- the public company governance problems that the PE market gate value of all of the firms in the sample is $623 billion, and has corrected in the past. Further, this also suggests that the the vast majority of them can be classified within some vertical PE funds and other institutional investors that provide PIPO market segment of the technology sector (e.g., internet, software, financing are likely to participate in the valuation creation hardware), with internet-based businesses being by far the most process longer as well, thereby potentially enhancing their own prevalent (80 of 142).33 The highest valuation is $51 billion for return performance. Figure 3 illustrates the equity funding Uber, and the second largest is China-based Xiaomi, at $46 progression for a new business venture, both without (Panel A) billion. However, the distribution of valuations is heavily skewed and with (Panel B) the presence of PIPO transactions. toward the smaller firms in the sample. As Table 1 and Panel A of Figure 4 illustrate, there are only 12 companies with a valuation The Emergence of PIPO Transactions and the greater than $10.0 billion and ten with a value between $5.0 Anatomy of a Unicorn and $9.9 billion, but 120 with a value between $1.0 and $4.9 As noted previously, PE investors have typically focused on billion.34 Consistent with the concentration of unicorn firms in early-stage investments through VC funds or on buyouts of the internet market segment, Panel B of Figure 4 indicates that mature business through LBO funds. The growth capital this industry category represents a sizeable majority of the aggre-

31. Bender, Evans, and Kupor (2015), op cit. classifications are determined, but to be consistent with prevailing industry standards, 32. See Kaplan, as interviewed by Chew (2009) op cit, in which Kaplan notes: “No we have used the categories provided by Wells Fargo and CB Insights. one has the data on returns to all PE funds. And for that reason, none of the conclusions 34. Just as a group of lions is called a pride and a group of deer is called a herd, a of these studies—mine included—are completely definitive, or known with certainty. The collection of unicorns is referred to as a blessing. Thus, our sample of unicorn companies findings are all conditional on the data available.” can generally be regarded as a small blessing. 33. Admittedly, there is some subjectivity as to how these vertical market segment

40 Journal of Applied Corporate Finance • Volume 27 Number 3 Summer 2015 Figure 4 Distribution of Market Valuations Across the Unicorn Sample

A. By Individual Firm $55

$50

$45

$40

$35

$30

$25

$20 Market Value ($ Bil) $15

$10

$0 1 6 21 31 41 51 61 71 81 91 11 16 26 36 46 56 66 76 86 96 111 116 126 131 136 141 101 106 121

B. By Vertical Market Segment $450

$400

$350

$300

$250

$200

$150

$100

Aggregate Market Value ($ Bil) $50

$0 Other Healthcare FinTech Hardware/Systems Software Internet gate market value in the sample as well (i.e., $392 billion of $623 distributed upon the occurrence of a liquidation event. Any billion in total). proceeds, net of those preference payments, are then distributed One very interesting feature of the sample is that there are pro rata to all common shareholders. 38 unicorn companies with a valuation of exactly $1.0 billion. To see how this might work, assume that a company negoti- Clearly, reaching this valuation benchmark is considered to ates a $100 million, Series C preferred stock financing round on be important for many firms, if for no other reason than the a $900 million pre-money valuation for a post-money valuation marketing and recruiting benefits that unicorn status conveys. of $1 billion, which would allow the firm to attain unicorn Bill Gurley, Managing Partner at Benchmark, has warned, status. The new investors in this case would own 10% of the however, that: “In trying to achieve a $1 billion valuation, some company. Further assume that immediately after the capital entrepreneurs cut deals with investors—such as financial terms infusion, the company receives an offer to be acquired for $1 that promise investors a certain return on their money—that billion, which the board of directors decides to accept. If the in reality make the valuation lower.”35 Entrepreneurs can, for PIPO financing round provided no preference payment, then example, exchange either higher preference payments or warrant the total proceeds provided to the shareholders would be the coverage that effectively lower the net proceeds to both prior full $1 billion, which was the post-money valuation of the investors and the entrepreneurs in order to achieve higher gross company. The Series C investors would then receive 10% of valuations. Preferred stock agreements almost always include the total proceeds from the sale (i.e., $100 million), which terms which provide for a preference payment that must be equals their original investment. If, however, these new inves-

35. See Benner (2015), op cit.

Journal of Applied Corporate Finance • Volume 27 Number 3 Summer 2015 41 Table 2 PIPO Funding Information for the to note from these data is that funding round sizes for unicorns Unicorn Sample are substantial. The mean and median sizes of the most recent funding rounds are $228.6 million and $145.0 million, respec- Mean Size of Most Recent Funding Round ($ Millions) 228.6 tively. The funding rounds range from a minimum of $5.0 Median Size of Most Recent Funding Round ($ Millions) 145.0 million to a maximum of $1.1 billion for Uber’s most recent Minimum Size of Most Recent Funding Round ($ Millions) 5.0 round.37 Also, there are eight companies that have raised up Maximum Size of Most Recent Funding Round ($ Millions) 1,100.0 to $99 million, while the majority of firms in the sample (i.e., 92) have raised between $100 and $499 million. There are 42 Aggregate Sample Amount of Total Capital Raised ($ Millions) 75,728.1 firms, about 30% of the sample, that have accessed more than Mean Firm Amount of Total Capital Raised ($ Millions) 533.3 $500 million in equity financing, with 22 of them raising a Median Firm Amount of Total Capital Raised ($ Millions) 286.6 cumulative total of more than $1 billion. Minimum Firm Amount of Total Capital Raised ($ Millions) 30.0 Maximum Firm Amount of Total Capital Raised ($ Millions) 7,608.7 It is particularly instructive to note that were it not for PIPO transactions, the 134 firms that have remained private Number of Firms With Total Capital Raised of: and have raised more than $100 million would likely have Less Than or Equal to $99 Million 8 had to access funds in the public markets to raise that amount Between $100 and $499 Million 92 of capital. PwC reports that during the fifteen-month period Between $500 and $999 Million 20 ending in mid-2015, the median proceeds from technology- Greater Than or Equal to $1 Billion 22 based IPOs globally was $265 million, which is less than the median amount of total capital ($287 million) raised by tors had instead agreed to commit capital only if they received unicorn firms through PIPO financing.38 a 3-times preference payment, the post-money valuation of the Figure 5 provides supplementary information about the firm would still be $1 billion, but the net proceeds from the distribution of total capital raised across the 142 individual $1 billion offer would be only $700 million after the $300 companies in the sample (Panel A) as well as on an aggre- million preference payment (i.e., three times the new investors’ gate level by vertical market segments (Panel B). Internet commitment) is deducted. Further, the Series C investors would companies have raised almost two-thirds of the total capital also receive their 10% pro rata distribution of net proceeds, or represented in the sample (i.e., $49.0 of $75.7 billion), which $70 million. So, with a 3-times preference, the new investors once again is not surprising since most of the unicorn firms agree to a higher gross valuation, but the impact of the higher come from this industry group. In terms of the level of PIPO preference payment significantly reduces the net valuation of fundraising in individual firms, Uber has raised the most the company.36 capital, at more than $7.6 billion, while at the other extreme We also reviewed when each of the unicorn firms in our the Chinese firm Fanli has accessed just $30 million. Despite sample was founded. The average firm was established in 2008, the funding disparity between them, these two particular but the earliest launch was 1994 and the most recent was 2014. companies serve to highlight the fact that unicorns are very There are four companies in the sample that were founded in much a global phenomenon. In fact, our collection of 142 2014: three are based in China and one is based in the U.S. unicorn companies contains firms headquartered in 16 Many of the companies have, therefore, been operating for countries. There are 53 firms domiciled outside of the United more than five years, but many of these firms have been able States, in countries that include India, China, Israel, South to achieve valuations of at least $1 billion in very short periods Korea, Singapore, Germany, and England, among others. of time. In fact, 21 of the sample firms were founded in 2012 Figure 6 provides the geographic dispersion of regions or later, representing a total market value of $70.6 billion with throughout the world in which these companies are located. more than $5.4 billion in total capital raised. Nearly 63% of the sample (89 firms) is headquartered in the Table 2 provides more specific summary information about United States. China is home to nearly 15% of the sample, the most recent funding rounds and the total amount of capital with a total of 21 unicorn companies, while the Europe, raised for these unicorn companies. The most important thing Asia-Other, and “Other” regions follow with 14, 11 and

36. There are other ways to manipulate the reported value of a company in order to a 37. It is also worth mentioning that besides the equity funding rounds discussed produce a unicorn outcome. For instance, warrant coverage also affects the effective earlier, Uber also acquired a $1.6 billion round of debt financing on January 21, 2015 valuation of the firm. Assume that the same company agreed to a $100 million Series C and has raised total debt and equity capital in private market transactions of approxi- round with no preference payment but with 100% warrant coverage, which would pro- mately $7.6 billion. vide the new investors with options to purchase $100 million of the company’s common 38. PwC, 2015, Global Technology IPO Review: Q2 2015 (www.pwc.com/gx/en/ stock at the pre-money price per share. If the company then sells for more than the technology/publications/global-technology-ipo-review.jhtml). post-money valuation, the investors will exercise their warrants, which will dilute the 39. Europe includes England with 4 companies; France, 1; Germany, 3; Holland, 1; interests of the prior investors by somewhat less than an additional 10%. The returns to Luxembourg, 1; Russia, 2; and Sweden, 2. Asia-Other includes Australia with 1 firm; the Series C funding round will therefore increase as the acquisition offer price increases. India, 6; Singapore, 2; and South Korea, 2. Other includes Brazil with 1 company; Unlike the preference payments, warrant coverage reduces the net proceeds to investors Canada, 2; and Israel, 4. Interestingly, Scotland, which has actually declared the unicorn as the value of the company increases. to be its official national animal, does not currently have any unicorn companies located within its borders.

42 Journal of Applied Corporate Finance • Volume 27 Number 3 Summer 2015 Figure 5 Distribution of Total Capital Raised Across the Unicorn Sample

A. By Individual Firm $8,000

$7,000

$6,000

$5,000

$4,000

$3,000 Total Capital Raised ($ Mil)

$2,000

$1,000

$0 1 6 21 31 41 51 61 71 81 91 11 16 26 36 46 56 66 76 86 96 111 116 101 106 121 126 131 136 141 B. By Vertical Market Segment $60

$50

$40

$30

$20

$10 Aggregate Capital Raised ($ Bil)

$0 Other Healthcare FinTech Hardware/Systems Software Internet

7 companies, respectively.39 Thus, it appears that unicorn The Supply and Demand for PIPOs companies are distributed globally even if the majority of them The research literature we summarized earlier highlighted the are headquartered in the U.S. market. Beyond that, nearly transformative power that PE investments can have on public all of the companies in our sample have global operations or firms with ineffective management and governance struc- markets that they serve, regardless of where they are based. tures. We also argued that PIPO investments have the ability Finally, our analysis of the 142 companies that have to forestall these problems by providing privately held compa- used PIPO financing to the extent that they qualify as nies the opportunity to remain out of the public markets for unicorns shows that these firms have thus far been able to a longer period of time. But given that these arguments could remain private for an average of nearly seven years so far. have been made at virtually any point over the past 25 years, They have also been able to raise total funding amounts the specific question that remains to be addressed is why are that exceed the median amounts raised through global PIPOs emerging now as a viable funding vehicle? technology IPOs over the past few years. Ultimately, the We think that the answer to that question must consider ability of these privately financed businesses to maintain several economic forces involving both the supply and or exceed their current valuations will depend upon their demand for large-scale private capital infusions. That is, operating results and their ability to generate strong future there are reasons that growing companies might prefer to cash flows. Companies that are not able to achieve their raise private capital instead of going public, but there are operating objectives will find their valuations reduced and also reasons that investors might be increasingly interested capital more difficult, or at least far more costly, to acquire in making private company investments. in the future. The emergence of PIPO funding arrangements and, as a

Journal of Applied Corporate Finance • Volume 27 Number 3 Summer 2015 43 Figure 6 Geographical Dispersion of Unicorn Company Headquarters

100 89 90

30 21 20 14 11 10 7

Number of Unicorn Companies Unicorn of Number 0 Other Asia-Other Europe China US result, the creation of some unicorn firms may be a part of a Analyst Coverage and IPO Activity. The introduction of longer-term trend. Professor Jay Ritter has documented that Security and Exchange Commission’s (SEC) Regulation IPO volume has declined in the U.S. since 2001 and has FD in 2000 and the Global Settlement in 2003 have both identified several potential causes, including heavy-handed contributed to the decline in the number of analysts following regulation, reductions in analyst coverage, market conditions, smaller companies. Analysts provide an important conduit and economies of scope.40 Although we will discuss each of through which prospective public investors receive informa- these below, they can be viewed primarily as demand-side tion about public companies. With fewer analysts, there is less drivers of the PIPO story. information available to the market and less interest in smaller company IPOs. It has been estimated that there might be as Forces Behind the Demand for PIPO Funding: many as ten additional small company IPOs per year if there Heavy-handed Regulation of Public Companies. The past was greater analyst coverage in this segment of the market.42 several years have seen the imposition of a number of regula- IPO Costs and Risks. There are substantial direct and tory changes that impact the way in which public companies indirect costs of going public. Direct costs include investment must operate. Arguably the most attention-getting of these banking underwriting fees, which are typically 5-7% of the regulatory adjustments resulted from the passage of the amount of capital being raised in a public offering. In addition, Sarbanes-Oxley Act (SOX) of 2002, which requires that a company must pay significant legal, auditing, printing, road CEOs and CFOs personally certify that their financial show, and other fees during the process. The indirect costs statements and operating results comply fully with the Act include loss of operational discipline as senior management and or face criminal penalties, jail, and potential claw-backs of others in the firm become focused on successfully completing compensation. Certainly, companies have found post-IPO an offering. After an IPO event, there are ongoing compliance SOX compliance costs to be material, if not outright prohibi- costs, an increased risk of litigation, and ongoing financial and tive. On May 20, 2015, for example, CFO.com reported that operational disclosures required by management. 58% of large firms reported spending more than $1 million There are also compliance and approvals risks associ- on SOX compliance in 2014. ated with going public. The SEC reviews public offering Recognizing that compliance costs were particularly documents, including registration statements under the burdensome on smaller companies, Congress amended the Securities Act of 1933. During the review and comment statute in 2007 to exempt these firms from many of the law’s process, which may last several weeks, the SEC may request requirements. However, it has been hard to determine the net additional information or require the company to amend its effect of these relaxed standards since they were implemented offering documents. Under certain circumstances, the SEC at the same time the financial crisis began to develop. Overall, may also demand that the company pull its offering. If the however, it has been noted that there has been no rebound SEC does grant its approval, there will then be additional in small company IPO activity since SOX was amended, demands placed on the CEO’s and CFO’s time, including suggesting that regulation must not be the sole deterrent to road shows, media events, and analyst presentations that do a company going public.41 not necessarily lead to operational improvements.

40. Jay R. Ritter, 2013, “Re-energizing the IPO Market,” in Restructuring To Speed regulations altogether and that these private funding sources emerged in force after the Economic Recovery, Martin Bailey and Richard Herring, eds. (Brookings Press). worst part of the financial crisis had passed. 41. See Ritter (2013), ibid. Of course, it is also worth mentioning that PIPOs provide 42. Ibid. companies with a way to raise growth capital while avoiding many of these public market

44 Journal of Applied Corporate Finance • Volume 27 Number 3 Summer 2015 Private company officers may be able to better limit deals.45 As noted earlier, remaining private longer allows these demands and focus more on value-increasing activities. companies to operate under a private equity governance Compared to a private offering in which investors can negoti- structure that may enhance management’s ability to more ate the agreement and draft definitive documents in a matter fully develop its company’s operating, sales, and revenue of days or weeks without public disclosures, the timing and models. As we have also argued, remaining private also ultimate success of an IPO process can be much more uncertain. allows a company to operate without disclosing sensitive Economies of Scope. Jay Ritter, as well as several of the financial and operational initiatives and results to the public investment bankers with whom we have spoken, has noted and prospective competitors. that there are fewer barriers to entry to launching compa- Private equity investors may be willing to invest in nies in the technology sector.43 Open source software, cloud growing private companies because they can more effectively services, outsourced development teams, and enhanced implement operational changes that enhance value. Addition- remote communication and collaboration tools have lowered ally, if they do not commit their capital, these investors the cost and increased the speed with which companies can risk missing most of the increase in company value, which be conceived and established. Ritter argues that being a increasingly occurs in the private markets before companies small company that grows organically is an inferior business go public. For example, it has been noted that while several of strategy compared with trying to grow rapidly by acquiring the largest technology firm launches in the 1980s and 1990s other firms or being acquired by larger organizations that can realized nearly all of their valuation creation in public markets quickly implement new technologies. (including those of Apple, Microsoft, Oracle, and Amazon), There is evidence supporting this Economy of Scope a significant portion of that value creation is now occurring hypothesis, which shows that since the early 1990s small in the private market before an IPO event (as in the cases of companies, whether recent IPOs or more seasoned firms, have LinkedIn, Yelp, Facebook, and Twitter).46 become increasingly unprofitable and that the frequency of Mainstream Acceptance of PE Investments. PE investing those firms being acquired within three years of going public has transitioned from a boutique business to a mainstream, has increased. IPOs of small companies have also produced increasingly important component of capital market activity.47 disappointing stock returns for public market investors in the Government and corporate pension funds, endowment funds, last three decades.44 insurance companies, sovereign wealth funds, and many other institutional investors now make PE investments a standard Forces Behind the Supply for PIPO Funding: part of their asset allocation strategies. In particular, a recent We have also identified a number of supply-of-PIPO-capi- examination of the strategic allocation policies of more than tal drivers that may help more fully explain current market 800 university endowment funds showed that the average conditions. allocation to various forms of private equity investments had Low Interest Rates and the Search for Yield. Since Decem- increased to 6.6% of assets under management in 2013 from ber 2008, the Federal Reserve has maintained a federal funds only 0.8% in 1990.48 target rate of between 0 and 25 basis points, which has effec- There are several reasons for these increased allocations tively dampened rates of return on financial assets and caused to private forms of ownership, including the need to meet institutional and private investors to seek higher yields in challenging spending goals—usually in the range of 7-8% per other investment vehicles, including a wide variety of private annum on a nominal basis—in the face of the lower return market vehicles such as real estate, natural resources, venture environment for traditional public market securities described capital, and private equity. For example, according to Preqin, earlier. Further, there is an increasingly pervasive belief among a leading provider of data for the alternative asset industry, institutional investors that private markets tend to be less private equity firms had raised more than $1.7 trillion from efficient than public markets for reasons such as less frequent the first quarter of 2012 through the middle of 2015 and trading and more costly information acquisition, and that this had more than $1.3 trillion in “dry powder” (i.e., uninvested increases the chances for capturing abnormal risk-adjusted capital commitments) at the end of 2014, all of which was returns through investments in these assets.49 In fact, this trend seeking attractive private investments. in which institutional investors consider more and larger direct Poor Performing Smaller Company IPOs and PE Gover- investments in private companies was emphasized in a recent nance. The recent poor performance of small company IPOs study that predicted that the venture capital arms of public we just mentioned has likely reduced demand for these corporations (such as Google Ventures, Comcast Ventures, and

43. See Ritter (2013), ibid; and Bender, Evans, and Kupor (2015), op cit. 47. Wruck (2008), op cit. 44. Xiaohui Gao, Jay R. Ritter, and Zhongyan Zhu, 2013, “Where Have All the IPOs 48. Keith C. Brown, Lorenzo Garlappi, and Cristian Tiu, 2010, “Asset Allocation and Gone?,” Journal of Financial and Quantitative Analysis 48, no. 6: 1663-1692. Portfolio Performance: Evidence From University Endowment Funds,” Journal of Finan- 45. Ibid. cial Markets 13, no. 2: 268-294. 46. Neil Randal and Brad Thawley, 2015, “VC/Growth Environment,” Teacher Retire- 49. See, for example, Andrew Ang, Andres Ayala, and William N. Goetzmann, 2014, ment System of Texas Working Paper. “Investment Beliefs of Endowments,” Columbia University Working Paper.

Journal of Applied Corporate Finance • Volume 27 Number 3 Summer 2015 45 Intel Capital) will become a major source of PIPO funding in funding rounds, the companies are approaching other institu- the future.50 tional investors with whom they have existing co-investment relationships, or the firms intend to approach targeted new Implications of the Trend Toward PIPO Financing investors who can provide strategic operating benefits as well The ability of companies to remain private longer under the as new sources of capital. potentially superior governance structure provided by PE inves- If institutional investors are limited in their ability to invest tors is likely to have several repercussions for participants in both directly in unicorn companies, we expect that they will increas- private and public capital markets. We summarize below some ingly seek to deploy capital with the leading PE managers that of the potential implications and areas for future research gener- have proven access to these transactions. If that is the case, these ated by our discussions with many of the corporate finance and investments might then become substitutes for small-cap public investment professionals who have contemplated the impact of equity funds as a way to gain ownership exposure to emerging PIPOs on company fundraising in the future. technology companies. Small-cap equity funds may also suffer Private equity investors will capture much of the value increase. from poorer performance, because fewer attractive small firms If privately held companies are able to raise capital in sufficient will be available to go public or those firms will remain private amounts to provide the funding needed to carry them through through their early growth phases and not go public until they the majority of their growth phase, they will be able to defer are already large companies. We would therefore expect to see IPO events and perhaps avoid them altogether. To the extent institutional asset allocation policies shift away from small- such companies are able to continue operating as private firms, cap public stock holdings and toward an increased reliance on investors in the public markets will find it increasingly difficult private equity holdings. to acquire stakes in, for example, promising technology compa- We are also interested in investigating the cross-owner- nies early in their development cycles, and instead be forced ship of unicorn companies among PE funds to assess if the to invest only after private equity investors have captured the market for these companies has become relatively closed (i.e., majority of a firm’s increased market valuation. limited access to new investment capital), or if there is broad As we have seen, Uber is now valued at more than $50 and meaningful diversity among the investment managers who billion. Assuming the company eventually does become publicly own them. The less diversity in the fund ownership structure, traded, the early suppliers of capital will earn many multiples of the more closed and less liquid the market may be. their initial investments. Subsequent investors, therefore, may PIPO funding may signal IPO success. With wider-spread have limited upside potential if most of the value creation in the development of the PIPO market, it may become increas- firm occurred while it was under private ownership. For those ingly difficult for smaller companies to effect successful public unicorns that do end up going public, we will be interested in launches. PE funds have historically had greater access to high- comparing the post-IPO return performance of unicorn firms quality corporate management resources, and can also perform with that of companies that went public before they achieved greater due diligence prior to their investments, than the average the status of having a $1 billion private valuation. public investor. Private companies that are not able to raise Investor preferences may change. To gain access to emerging sufficient growth capital through PIPOs may effectively be technology companies, public investors will either need to invest indicating to the market that PE investors found them to be in PE-oriented partnerships, which require that they be properly unattractive investment opportunities. Accordingly, it would be accredited, or to invest through mutual funds, pension funds, more difficult for these companies to then attempt to complete or other institutionally managed portfolios that have access to a successful IPO, because of the negative signaling effect of their private market opportunities. Established money management inability to complete a successful PIPO. We would expect more companies such as Wellington Asset Management, T. Rowe of these firms to be acquired by larger corporations, for IPO Price, and Fidelity Investments, among others, have all recently qualification standards to rise, and for the average size of IPO created fund products to invest in PIPO transactions. However, companies to increase. investing in private companies through intermediaries will limit Investment banking services and fees may change. If private the ability of investors to obtain meaningful exposure to specific firms are able to develop more fully their operating, sales, and individual companies, depending on whether the intermediary business models under private ownership, the placement risk has the willingness or ability to invest in any particular deal. associated with underwriting IPO transactions is likely to Institutional investors with whom we have met have decline considerably, which should in turn put downward indicated that it has been very difficult, if not impossible, to pressure on the underwriting fees that investment banks can invest in certain private companies for a variety of reasons: charge, which currently fall in the range of 5-7%.51 To offset Either existing investors are already completing in-progress this decline in underwriting revenue, investment banks may

50. Thomas Grota, 2015, “Corporate Venture Capital Will Come to Play an Even 51. See PwC, 2012, “Considering an IPO?: The Costs of Going and Being Public May Larger Role in Unicorn Financing,” CB Insights (www.cbinsights.com: August 14). Surprise You,” PwC Working Paper (September).

46 Journal of Applied Corporate Finance • Volume 27 Number 3 Summer 2015 find they need to shift to merger and acquisition advisory work large companies already, they would have had sufficient time or private placement services to generate additional income. to recruit experienced senior management with substantial Unicorns may be better able to withstand market volatility. operational experience. It would be interesting to address these Unicorn firms may be somewhat more insulated from market long-term performance issues in future research. volatility in that PE managers typically have sufficient capital Diversification of management ownership holdings.One commitments in reserve to continue to fund their existing significant advantage of public companies is a tradable market portfolio companies and new investment opportunities, regard- into which managers can sell some of their personal stock less of the prevailing public market environment. By contrast, a holdings—which they often receive as part of their incentive successful IPO depends upon many factors, some of which are compensation packages—in order to diversify their personal internal (e.g., the quality of the company’s management and its investment portfolios. To achieve similar diversification benefits, ability to follow a disciplined operational process) and some of we would expect to see managers of unicorn companies increas- which are beyond the firm’s control (e.g., general economic and ingly be able to sell some portion of their ownership interests equity market conditions). For example, in 2000, there were as new rounds of PIPO capital are raised. We also forecast the many potentially successful companies that were in registra- development, to the extent permissible by state and federal tion to go public, but when the celebrated “dot-com” bubble securities laws, of a broader market for the exchange of private burst and the stock market declined, most of these IPOs were company ownership stakes.52 abandoned. Many of those companies were then unable to obtain sufficient financing to cover their operating costs and, Concluding Thoughts ultimately, had to shut down. Until recently, managers of new and developing corpora- As we noted earlier, PIPO transactions have contributed to tions have had few alternatives for raising significant growth the fact that private equity funds are lengthening the time in capital other than through the IPO market, which entailed which they hold their portfolio company investments. Assum- accepting the potential costs and risks associated with ing they are able to continue funding their growth opportunities becoming a public company. Over the past few years, this in that manner, those private firms may be more insulated from situation has begun to change as privately held firms have changing public market conditions. Nevertheless, there were been able to access substantial sources of funds through an many cases, though, after the 2007-2008 market decline in arrangement known as a private initial public offering, or which private equity managers were either unable to collect PIPO. Indeed, helping emerging ventures remain in the promised capital commitments from their limited partners or private market for a longer period of time—and hence avoid were asked by those partners to return some or all of the capital the governance challenges that often negatively impact the that had already been committed. The market declines during value and operational efficiency of public companies— those years reduced public stock values by up to 50% in the is the primary benefit that these PIPO transactions have U.S. and by even more in other global regions. to offer. With PIPO financing available, the average time Even in those circumstances, however, private equity that companies can remain outside the public markets has may provide a more stable funding source than public markets. increased from less than five years to more than a decade. For instance, during the last two weeks of August 2015, the Further, with this longer period in which to harvest their S&P 500 index declined by in excess of 11% before recovering growth opportunities as private firms, a sizeable number by more than 6%. During that same period, four companies of the companies have been able to achieve market valu- completed PIPO funding rounds and became unicorns. ations in excess of $1 billion while remaining privately Long-term capital market performance of unicorn firms.If owned enterprises, a stature that was previously so rare as PE ownership provides companies with superior management to warrant the use of the term “unicorn” to describe them. and governance structures and PIPO funding opportunities Despite the many potential benefits to a company using allow them to remain in that position longer, then we would PIPO financing to continue operating in the private market, expect the long-term performance of unicorn companies to be a cautionary note about this phenomenon is in order. Given superior, all else held constant, to those firms that are unable the recognition that attaining unicorn status now receives to raise sufficient private growth capital. Further, we would in the capital market, there are tremendous practical conse- expect relatively few unicorns to ultimately become distressed, quences to a firm having a market value of $1 billion versus, bankrupt, or sold at a considerable discount to the valuations say, $980 million, even if the actual difference in these realized in prior funding rounds. We would also anticipate amounts is largely immaterial. Thus, as we showed earlier, less management turnover, particularly following any subse- managers of some companies may have the incentive (or quent IPO event, among the set of unicorn firms because, as otherwise feel pressured) to manipulate the market valuation

52. One extant market mechanism that allows private equity firms to sell companies forthcoming. Although motivated as an exit strategy for the current outside owners of a to each other is the secondary buyout deal; see Francois Degeorge, Jens Martin, and privately held firm, it is possible that the managers of the company could also see an Ludovic Phalippou, 2015, “On Secondary Buyouts,” Journal of Financial Economics, increase in the liquidity of their equity stake through this arrangement.

Journal of Applied Corporate Finance • Volume 27 Number 3 Summer 2015 47 process by agreeing to complicated and onerous financing funding or even aware that the company valuation may have terms in order to achieve a reported billion-dollar valuation. been manipulated. Of course, these terms can have a markedly negative impact With that caveat noted, it remains the case that on the net proceeds available to the firm’s existing investors, the ultimate success of all corporations—unicorns and entrepreneurs, and employees. These new conditions can non-unicorns alike—depends upon the quality of their also complicate the firm’s efforts to raise additional capital business and operational performance over time. The exist- because they create a more complex capitalization table and ing evidence strongly suggests that this performance can be any future investors will pressure the firm to provide them enhanced in a developing company by its ability to remain with similar terms. private and operate under the superior governance structure In addition, management’s focus on helping the company offered by PE ownership. The growth of PIPO financ- become a unicorn may distract it from the core objectives, ing arrangements that we have witnessed in recent years which are to generate new product offerings, increase its underscores the point that these transactions have become a customer base, create operational efficiencies, and generate preferred funding method for a rapidly expanding number positive cash flow, all of which ultimately will drive the funda- of firms. If this degree of capital market acceptance contin- mental value of the firm. However, if the valuations of the ues at the same pace, we would expect these private funding unicorn companies are inflated through the manipulation of transactions to expand into different industry segments and deal terms, there may be negative consequences if the ultimate have a lasting impact on the way corporations seek to finance realized values, either negotiated in subsequent capital raising their growth opportunities. rounds or set by the market upon exit events, are less than the inflated values contrived earlier. Potential new investors, KEITH C. BROWN is the University Distinguished Teaching Professor for example, often insist upon anti-dilution protections (i.e., and Fayez Sarofim Fellow in the Department of Finance at the University ratchets) in the funding agreements that can materially reduce of Texas at Austin. He also serves as an advisor to the Board of Trustees the ownership percentage of prior investors, management, at the Teacher Retirement System of Texas and to the Board of Directors and employees, if a subsequent financing round raises capital of the University of Texas Investment Management Company. at a lower valuation (i.e., a “down round”). Inflated valuations resulting from PIPO funding rounds with manipulative KENNETH W. WILES is a Clinical Associate Professor in the Department terms increase the risk that future capital-raising efforts will of Finance at the University of Texas at Austin, where he serves as Asso- result in down rounds and thereby have an adverse impact ciate Director of the Hicks, Muse, Tate & Furst Center for Private Equity on current stakeholders of the firm. This outcome can be Finance. He has also held senior management positions at public and particularly demoralizing for the firm’s employees, who quite private corporations, investment banks, and financial restructuring firms. likely were not included in the negotiation of the terms of the

48 Journal of Applied Corporate Finance • Volume 27 Number 3 Summer 2015