Warning: More pain to come for the Listed venture capital funds

A few weeks ago, I dug up a statistic that genuinely took my breath away. It came from VC-oriented asset manager Sparkline Capital – “Of the 1,495 US venture deals in the first half of the year, only 4.9% have been down rounds – a historical low!”

My own view is that we are only in the early stages of a multi year process by which Venture Capital funds need to re-adjust their valuations for private businesses in their portfolio. And if that statistic is any guide, those valuations are going to need some massive adjustments. And this particularly applies to the main listed venture capital funds on the London market, many of which have already made some huge adjustments to their book carrying values. The handful of players in this space have already had a tough few months in share price terms at last – and worse may be to come. Since the beginning of the year, Chrysalis is down 75% while Molten Ventures is down 70%. These two funds trade at what seems like a huge discount to NAV: Molten is at 67% and Chrysalis at 61%.

But those discounts to NAV are using historic (many months old) valuations and its reasonable to presume that these are now way off the mark given the dire state of the market. The $64 million question is just how low can these valuations go?

In order to attempt any answer to this question, we have to start by asking how big a haircut on balance sheet valuations are needed for the listed VCs.

To help inform this process I’ve tried to pull together firstly the most relevant Year End 21 valuations (or thereabouts) for the main listed UK (and US VCs) plus the last /most recent stated or estimated (Numis) NAVs.

• Seraphim – estimated year end 2021 Nav 104pLast FY NAV 99.97p Change in NAV +1.9
• Molten Ventures – November 29th Interims NAV 887p, 31st March 2022 NAV 930p. Change Change +5%.
• Schiehallion – 31st Jan 2022 NAV £1.22. Last estimated NAV £1.30 (Numis). Change +6.5%
• Chrysalis – December 2021 NAV 237p. 30 June 22 valuation 163p. Change -31%
• Augmentum – 30th Sept 21 NAV 119p, 31st March 2022 NAV 130p. Last NAV July 22 155p. Change +30% since  Sept 21
• Sutter Rock / Suro (a US equivalent to Chrysalis – see next section) – 31st December 2021 NAV $11.72, last quarter NAV $9.24.. Change down 22%.

The mismatch between these NAV numbers – which are backwards-looking and bound to be out of date – and the share price declines listed in the first table above, I think tells us everything we need to know i.e investors have already made up their minds about valuation cuts and ably deployed the red pen!

I would say that only Chrysalis and its US-listed peer SutterRock/SuRo are anywhere near the mark on their likely portfolio valuations at this stage.

This brings me to where I think the landing point – the trough – for valuations might be. I was tempted to suggest a 90% valuation haircut from the end of December 2021 numbers. This was based on the premise that

a. That number sounded about right for an industry predicated on the ten-bagger rule – if one firm out of 10 generates a ten-fold return then why can’t nine firms out of ten lose nearly all their value and that one firm simply be worth what you paid for it?

b. We’ve seen some fairly large reductions in NAV for existing holdings in the book of the VC funds. Fintech Klarna for instance has seen its valuation decline by 85% from its peak level this year to its current level.

c. If I’m honest as an investor it feels right to me that whatever number VCs come up with at December 31st 2021 at the height of tech mania, then we should lop 85% of that number.

d. Last but by no means least, in terms of peer groups, year to date the NASDAQ composite index is down 31% year to date and Cathie Woods ARK Innovation ETF (ARKK) is down 60% year to date – why shouldn’t earlier stage, higher risk private companies have an even bigger haircut applied to their valuations?

So, let’s for argument’s sake settle on an 85% cut from year-end 2021 numbers – where would that put the NAVs of the funds mentioned above? Here are the results below – Note I have not made an allowance for any cash held on the balance sheet which will, of course, make a difference:

• US fund SuRo would be at $1.78 per share. The current share price is $3.84. BUT a huge bit of its current share price is cash. More on that next. Cash balance was $153m at June 30th versus market cap of $116m
• Augmentum. NAV would be at 23p. Current share price 93.5p. I think there’s about £31m in cash at the last year-end to add back into these numbers.
• Chrysalis. NAV would be at 35p versus current share price of 58p. Remember that there’s a fair bit of cash on balance sheet here – £48m at the last count. My estimate of possible value is £260m vs current valuation of £350m
• Schiehallion. NAV Ords 19.5p. There’s a huge amount of cash from the C class shares, currently invested in Treasury Bills.
• Molten Ventures.  NAV around 135p versus current share price of 303p. Year-end cash was about £75m by my workings vs market cap of £464m. My estimate of possible value is £300m.
• Seraphim. NAV at 16p versus share price of 53p. Around 25% of Nav is in cash which I reckon is about £57.7m. Current market cap is around £125m. My estimate of possible value is closer to £100m.

If my back of the fag packet calculations are right, then I think it’s fair to say that we have much further to go on these haircuts. Take the poster child of this sector in the UK – Chrysalis. My finger in the air is that we won’t see trough valuations until the fund is worth circa £260m which would represent another 28% decline from the current market cap. That said, if I’m honest I think that Chrysalis is much closer to the ‘mark’ when it comes to valuations having already taken some big hits on the balance sheet.

I see an average 25 to 35% further fall in share price to get to ‘real world’ NAV parity, although I think there will be an overshoot on the downside of another 10 to 15% as funds continue to trade at a discount. That implies falls of between 40 and 50% from current levels. I would also note that although these funds all hold a fair amount of cash I’m worried that they don’t have ENOUGH cash to be able to reinvest when the upcycle eventually comes.

Future growth play? Watch SuRo Capital

One fund vehicle does stand out in this analysis – US-based stockmarket listed VC SuRo (Sutter Rock) Capital. This is in effect a US version of Chrysalis and at one stage was a venture-oriented business development company or BDC before it transformed itself into a pure-play VC.

Currently, it has a portfolio of mid to late-stage tech businesses with the online education platform Course Hero the biggest portfolio holding (worth $59.5m for 29.8% of the portfolio) followed by Forge Global Holdings ($21m and 10.6%) and Blink Health ($11.7m and 5.8%).

Cash at June 30th as $153m but we probably have to lop off that number by roughly $13m for a recent tender offer for the shares plus running costs of the business.

There’s also an outstanding loan of 6% Notes due in 2026 worth $73m. Take off that loan, net out the share repurchases and I reckon the net worth of the business – assuming zero valuation for the portfolio companies – is about $65m, with around $125m to $130m in available cash. The current market cap of the business at $3.95 a share is about $120m. One other note – the fund has recently invested $10m in Series C preferred shares in WHOOP, a digital fitness and health coach business.

I like the fact that SuRo has all that cash-swilling around. Assuming it doesn’t waste that capital on hair-brained investment ideas, it should be in a brilliant position to invest in the next wave of startups once valuations are reset in the next year or so. Unfortunately, I don’t think that balance sheet strength is going to help SuRo in the short term – it will be perceived as vulnerable because of its focus on tech-focused late-stage pre-IPO private businesses. I can see the share price declining to $3 a share during the next 6 to 12 months as the next stage of market sell-off rolls into town. That would imply a trough valuation of less than $100m despite all that cash.

Value play – A misunderstood fund: Riverstone Credit Opportunities

Riverstone Credit Opportunities Income fund is a small, income-focused play that has fallen victim to a series of misunderstandings within the listed funds space here in the UK. Like many market observers, I had long assumed that the Riverstone Credit fund mainly lends money to businesses in the hydrocarbon economy, especially in North America. That’s clearly a big no-no for many investors, especially in the ESG space.

But after talking to the managers behind the fund, it emerges that that perception isn’t actually true. In fact, one could argue that if you care about impact investing for instance, then an investment in the fund could actually make sense. How so? Because, put simply, most of its current loan book consists of either ‘green’ loans or loans’ designed to make a legacy industry more ‘sustainable’.

The graphic below fleshes out this point. It shows the most recent loan activity on a loan-by-loan basis. The green emphasis is obvious – battery manufacture, solar development, plastics recycling, wind turbine fabrication, and reducing SO2 emissions. There’s also a sustainability-linked loan – the bad bit of which is that the business makes money from unconventional energy companies which use copious amounts of water in the production process. The good bit is that the water company is trying to reduce water usage.

In terms of total portfolio mix the fund is now exposed to 37% green loans, 12% sustainability-linked loans and 24% uncommitted (mostly cash awaiting investment). Another 27% of the loan book consists of ‘legacy’ hydrocarbon loans. If we exclude unallocated cash the share of green and sustainability-linked loans rises to just under two-thirds of the book.

So much for the loan book and its strategy, what about fund as an investment? In my last article here on Sharepad I suggested buying BioPharma Credit because it ticked some key boxes :

•  It produces an income yield which is very generous even in an era of higher interest rates. The dividend yield on offer is well in excess of any likely endpoint for the yield on risk-free assets .i.e well in excess of 6%.
• It has a track record of getting repaid. Remember, the easy part is lending money, the difficult part is getting that money back. BioPharma has an excellent track record in that part
• It lends money at high rates to borrowers who can usually afford the debt because its cheaper than equity
• Last but by no means least, most loans are floating rate and senior secured with early repayment penalties attached

Riverstone Credit also passes these tests. The management firm behind the fund has lent out $2.3 billion in 55 transactions to date and the loss rate over all those years is in the single digits. In the fund itself, there has only been one small loss out of more than 20 loans. In fact, many loans – as with BioPharma – have been repaid early.

Basic Facts: Riverstone Credit Opportunities Income PLC

• Ticker: RCOI
• Target yield around 7 to 8c
• Managers: Riverstone Credit Partners – have invested $2.3 billion in 55 transactions to date
•  RCOI’s target unlevered 15% gross IRR – 18.8% IRR on realized investments
•  NAV : $1.02
•  RCOI paid $1.7 cents for Q4 2021 and $2.0 cents for Q1 2022
• Current Discount – 16%
• Average duration of loans: 2.8 years
• Gross yield on loan from initial investment 12.3%
• 100% secured loan book all floating rate

As I write this, the shares are trading at around $0.81 a share against a NAV of $1.02. The shares have paid a quarterly dividend of 2c for the last two quarters and I think it looks like the fund will carry on paying at that level for the rest of the year. Even if we assume a lower dividend of around 7c a year (a rate that was paid in previous years) then the net yield is 8.6%, whereas if the dividend hits 8c a year (possible in 22) that’s a net yield of 9.8%.

Also, being a tad cynical here, the fund is sub-scale with a market cap below $100m. The fund has been busy buying shares but one has to wonder whether the message I mentioned earlier – this is not a legacy hydrocarbon lending fund – is getting through. That raises the possibility that at some stage unless the managers can raise fresh capital, they might be tempted to close the fund and then slowly run off the book and close down the fund. If that were to happen, there’s a good chance that investors would get closer to NAV on the wind-down, minus the inevitable last-minute stings in the tail as the loan book is run down. Given the 20% plus discount though those stings in the tail are probably manageable. My own hope is that the fund actually grows in size, especially after the managers have re-educated the market to the idea that this fund is actually an impact-focused lending fund.

There are some very obvious risks with this fund – I’d highlight the following:

• Currency risk if the dollar weakens
• Liquidity risk, in that the shares aren’t heavily traded and it’s a fund on the specialist fund segment of the market
• A recession and increased rates might push some borrowers into losses and trigger credit defaults
• Enery prices might tumble in a recession hitting the borrowers in the loan book, especially in the legacy hydrocarbon positions

I wouldn’t want to underplay any of these risks, but I think they are in the share price already. In the meantime, you might pick up some discount tightening and that dividend yield.

ETF Watch: How to invest in the UK economy?

This month I thought I want to introduce a new feature, highlighting one key investment idea which can be implemented by choosing an exchange-traded fund or ETF.

To kick things off I thought I would focus on UK-focused equities. The concept here is simple – you want broad exposure to businesses that are listed here in the UK and ideally also derive most of their revenues from the UK.

Why on earth would we want to focus on UK equities at the moment? Arguably because we are in the dog house at the moment. Sentiment is terrible, the economy is slipping into a deep recession and UK domestic equity benchmarks such as the FTSE 250 are sliding to new lows. It is truly a terrible time for many UK-listed businesses and the bears are on the warpath. That scepticism might be justified in the short term but investors will probably overreact with their bearish positioning and we’ll probably find that at some stage UK equities become oversold. UK equities are certainly under-owned at the global equity portfolio level and most of the main UK equity indices are now on any definition very cheap using fundamental measures.

At that point, UK equities might become attractive again – in fact, I sense that might even be true as soon as 2023. So, when (or if) that happens, how should we gain exposure to UK equities via ETFs?

The big table below is a simplified attempt to explain the most interesting ETFs out there – bear in mind that there are well over a hundred different UK equity funds on the market. In each fund, I have highlighted in the table I’ve detailed the top three holdings, the size of the fund and its total expense ratio. The data on tracking errors comes from Track Insight while the main data on returns comes from the excellent JustETf website.

I’ve also added a comment beside each highlighted ETF.

I’d make some obvious points:

1. The FTSE 100 and by default its close sibling the FTSE All Share index is bound to be dominated by mega large-cap stocks mostly with international revenue streams. That makes these indices less useful as measures of the UK domestic economy. If you want pure UK domestic economic exposure steer clear of these funds
2. By contrast, the FTSE 250 index is much more, though not exclusively, UK domestic economy focused.
3. I have also identified some more unusual strategies which consist of what I call smart beta strategies – which look for quality and/or value stocks. These can add real value but they tend to have portfolios that look very different and charges can also be much higher.
4. You’ll also notice some dividend-focused strategies and funds (FTSE Dividend Plus and Dividend Aristocrats. These are potentially safer havens in a more volatile market though it must be said that over the last decade or so dividend and value stocks have underperformed the broad market. Given a straight choice, I would favour the Dividend Aristocrats strategy over Dividend Plus indices
5. Cheapest? If you are looking for the cheapest FTSE 250 ETF it’s VMID from Vanguard while the cheapest FTSE 100 tracker is from IShares ticker ISF. The cheapest UK all-caps tracker is actually from Lyxor using a Morningstar index – this ETF ticker LCUK – only charges just 4 basis points i.e 0.04% pa.

Comment	Fund	Ticker	TER basis points	AuM £m	Top three stocks	YTD performance %	Tracking difference 1 year
Smart Beta All UK equities	First Trust United Kingdom AlphaDEX®	FKU	65	16.6	BEAZLEY PLC 2.57% BP PLC 2.50% 3I GRP. PLC 2.42%	-24.3	-0.007
Cheapest and Biggest UK Mid Cap	Vanguard FTSE 250 UCITS ETF	VMID	10	1302	F&C INVESTMENT TRUST PLC CF 1.34% GREENCOAT UK WIND PLC 1.12% WEIR GRP. PLC/THE 1.11%	-23.88	-0.0001
Second cheapest UK Mid Cap	iShares FTSE 250 UCITS ETF	MIDD	40	245	F&C Investment Trust 1.12% GREENCOAT UK WIND PLC 1.12% WEIR GRP. PLC/THE 1.11%	-23.88	-0.0037
Cheap All Caps UK tracker – similar to FTSE All Share index	Lyxor Core Morningstar UK	LCUK	4	324	SHELL PLC 8.21% ASTRAZENECA PLC 7.79% HSBC HLDGS. PLC 4.96%	-5.2	-0.04
UK All Share Tracker	SPDR FTSE UK All Share UCITS ETF	FTAL	20	528	SHELL PLC 7.72% ASTRAZENECA PLC 7.34% HSBC HLDGS. PLC 4.67%	-6.59	-0.07
Main MSCI UK tracker – all caps similar to FTSE All Share	UBS ETF (LU) MSCI UK UCITS ETF	UC64	20	1136	SHELL PLC 9.48% ASTRAZENECA PLC 9.01% HSBC HLDGS. PLC 5.85%	-0.91	-0.22
Cheapest FTSE 100 tracker	iShares Core FTSE 100 UCITS ETF	ISF	7	9834	SHELL PLC 8.89% ASTRAZENECA PLC 8.53% HSBC HLDGS. PLC 5.50%	-2.52	-0.02
Smart beta All UK Equities	WisdomTree UK Equity Income UCITS ETF	WUKD	29	8	SHELL PLC 4.97% BP PLC 4.72% NATIONAL GRID PLC 4.59%	-14.4	-0.45
Dividend weighted UK all caps	iShares UK Dividend UCITS	IUKD	40	738	IMPERIAL BRANDS PLC 6.07% BRITISH AMERICAN TOBACCO PLC 5.70% BP PLC 4.49%	-10.02	-0.31
Dividend weighted UK all caps	SPDR S&P UK Dividend Aristocrats UCITS	UKDV	30	131	IG GROUP ORD 6.09% LEGAL & GENERAL GRP. PLC 4.98% BRITISH AMERICAN TOBACCO PLC 4.90%	-13.51	-3.38
Smart beta / ESG All UK Equities	L&G Quality Equity Dividends ESG Exclusions UK	LDUK	25	38	ASTRAZENECA PLC 5.98% IMPERIAL BRANDS PLC 5.52% BAE SYSTEMS PLC 5.45%	-12.37	-0.09

David Stevenson