September 29, 2016

Discounted Venture Capital

I posted on Seeking Alpha about my investment in Crossroads Capital (XRDC), a busted venture capital BDC trading at ~60% of book value, with 70% of market cap in cash. It has a messy portfolio, but not a lot needs to go right for signficant upside. For those with the means and/or the investment mandate, getting an NDA and buying the individual portfolio companies from XRDC might be the better option. Crossroads Capital hired Setter Capital to market its holdings. Setter Capital specializes in the fascinating private equity secondary market.

Here are a few residual thoughts on deep value investing in the busted BDC/private equity/venture capital space.

There is a bit of irony in a deep value liquidation play with assets that consist of preferred shares in growth oriented venture capital investments. Venture capitalists bet big on change, while value investors generally focus on mean reversion, yet as Marc Andreessen pointed out, there are actually similarities between the philosophies underpinning value investing and venture capital. Both styles of investing emphasize fundamental analysis, long term thinking, and ignoring market noise, while taking advantage of some sort of mispricing.

The negative press about declining valuations of technology startups also creates an interesting value investing set up. Although its true, some questionable companies had previously raised capital at absurd valuations, many startups, including those in XRDC’s portfolio are legitimate revenue generating, growing businesses that are also often unlevered. For companies with real products there hasn’t been a dramatic crash. Rather they have continued operating, albeit have had to make adjustments, and have not been able to raise repeatedly raise capital at record valuations. To quote Matt Levine: “The Enchanted Forest has gotten a bit less enchanted, a bit more sensible. The unicorns have knocked off the wild partying and gotten down to work.” Seems like there could be more opportunities out there to buy growing businesses at dumpster dive prices, by providing liquidity to earlier investors that need to exit.

Venture capital valuation (or anything else level 3 under GAAP) is controversial. Generally people aren’t actually buying and selling equity at the accounting value. Ultimately what matters is the cash that can be received upon exit.

Source: http://dilbert.com/strip/2012-07-12

Furthermore, the terms of venture capital investment might not always treat outside investors well:

Source: http://dilbert.com/strip/1996-03-15

However, a lot of venture capital investments are preferred equity with quite favorable liquidation preferences. The prospective buyer will conduct due diligence on the operations of the business, and the rights of the particular security. With an investment in XRDC one can determine the aggregate valuation paid by an outside investor(about 3x EBITDA after subtracting out all the excess cash in the BDC), and can compare valuations with other BDCs holding the same security (top holding is marked over 20% higher by another BDC), but there is limited public information on each individual security. Based on research of public sources, several of the portfolio companies appear to be doing pretty well, but a couple are also in trouble. My working hypothesis is that the absurdly large discount creates a “heads I win, tails I don’t lose that much” scenario. However, cherry picking the best companies out of XRDC’s portfolio and buying them directly would be even better.

I look forward to more opportunities like this.