Market Watch: The asymmetry of US and European valuations

There was a jubilant (socially-distanced) moment last week when the SPAC brotherhood welcomed Bernard Arnault of LVMH fame into their fraternité. If you don’t know who LVMH is, then you’re either (i) not raising your better half’s bar of expectation high enough, or (ii) single, which may in part be related to (i).

In addition to Arnault, the other SPAC co-founder – UniCredit’s former CEO Jean-Pierre Mustier – heralded the inception of this newly minted €250m vehicle, stating that ‘…there is in Europe a need for growth capital’. Notwithstanding the dynamic duo’s stable-locked-horse-bolted moment, is there really a need for growth capital? Europe has been happily trudging through thick and thin growth capital cycles for the last few decades without any dearth of VC, PE or family office interest. And, incidentally, what was the best year ever for European growth capital? 2020. The Covid year (TM).

No, Europe doesn’t actually need additional growth capital. What Europe needs, and likely what Mustier was subtly referring to, is higher growth capital valuations. In other words, Europe needs investment rounds (or more appropriately their ticket sizes) in line with their stateside ‘bros’.

The differences across continental valuations are staggering. Just by example, we recently completed investment in a successful and profitable European business whose valuation is in single-digit millions. At the same time, we’re negotiating a stateside seed round (in other words, pre-revenue, and pre-product) for a similar start-up whose on-paper market capitalisation is already in high double digits. In other words, a US-based inception company is already worth at least five times its (profitable) EU-counterpart.

Which continent has got its valuation right? At the moment both are correct, namely because both markets are prepared to accept both respective price-ranges. But the asymmetry has become more pronounced recently – especially in gambling circles – because the Americans are buying up European capital in droves.

Thank globalisation for that, at least while it’s still around and before it’s replaced with a more protectionist form of democracy (yes, even under the Democrats). This short-term spending spree is taking advantage of the different ways in which markets on either side of the Atlantic value their assets – crudely speaking; whether a company is valued on its present, or its future.
The emergence of SPACs
At some point this imbalance will correct itself. European assets will inevitably increase in relative value not just because of supply/demand forces (ie: if the Americans cut a big cheque, then why not pad the business out to fill it) but also because of higher purchasing power by these newly-minted EU SPACs. Which will be good news for early-stage investors, but the real hallelujah will be for the fund managers running these billion-euro ventures under management. And at that point – likely within a couple of years’ time – a really interesting fight will break out.

Because for a SPAC to thrive successfully, within each of these well-balanced, geo-distributed funds, there will need to be a series of equally well-performing gaming assets, growing linearly within well-defined revenue targets, operating within well-precise KPIs, managed by well-balanced leaders. This might not sound like a such a big deal (VCs do this all the time), but in reality for highly-leveraged funds, it’s a very dangerous act to pull through without any serious casualties.

To fully explain this risk, it’s worth paraphrasing a (hilariously offensive) tweet emanating from the GameStop rush a few weeks back – and dumb the story down for the simians among us. A traditional venture capitalist growth fund would typically contain 20 investments in companies at relatively similar stages in their lifecycle.

On average, one of these 20 would hopefully become highly successful, three to four would exit at a value above their initial investment, six to seven would deliver flat growth, and the remaining 10 would die a (hopefully entertaining) death. This failure rate may seem like a lot, but it’s actually the market norm (5-10% success rate) for early to mid-cycle businesses. Given how European gaming assets have traditionally been priced, this fund would have typically cost €50m to set up, and thanks to this one soft unicorn, delivered a net return of €400m upon its exit.

With SPACs, this risk is geared up a notch. These same 20 assets would have cost €250m to set up, but the exit valuations don’t increase proportionately, and the entire fund would ‘only’ typically return €1bn on exit if successful. Given that the likelihood of failure is the same, the risk of SPAC implosion, or a fund returning less than its original investment, is far greater.  And, with SPAC funds on average 10 times the size of traditional investments, this becomes very serious, very quickly.

And incidentally this is why SPACs (like derivates before them – remember what happened to those?) have only really been reserved for – get this – a special purpose. Special Purpose implies just that; only used in those rare instances that need to bypass traditional floatation and/or usual regulatory mechanisms. Remove one too many protective layers, then you’re at the mercy of market forces that will day-trade their way into profiting off the swings in your asset value. Which is never a good thing when you’re pushing for long-term growth. And that’s of course assuming that all the companies in your fund are still growing…

What’s to be done, then? Should SPACs be banned outright? No – at least not entirely, there will be some proper legitimate uses for SPACs especially in gaming, as developing stories will reveal later this year. But given the higher risks, SPACs do place significantly more pressure on fund managers to pick nascent frontrunners to reside within each fund.

As with traditional investment – including betting – it’s almost always a better strategy to make smaller, calculated bets across more diverse markets than to bet the entire pot on one. Because when you’re reviewing prospective start-ups, how likely are you to spot a unicorn in the farm?