We recently analysed the biggest accounting scandals in 2023, headlined by collapsed cryptocurrency exchange FTX.
We pointed out that the largest business failures linked to accounting fraud in 2023 occurred in private, rather than public, companies. Various conditions brewing in private markets over the past few years have finally come home to roost amid relentless monetary tightening around the world.
Various conditions brewing in private markets over the past few years have finally come home to roost
Rising interest rates disproportionately impacted private capital markets where problems are less visible than in public capital markets.
This piece examines those problems. The upshot is that financial stress in the PE industry is significantly greater today than it was in 2019. This explains, at least in part, why accounting scandals have shifted from public to private companies.
Background to crypto scandals: Trouble in private markets
Cryptocurrency scandals dominated the financial headlines for much of 2023, culminating with the conviction in early November of Sam Bankman-Fried, the once-lauded founder of FTX.
FTX was one of the largest frauds in history, and it wasn’t the only cryptocurrency platform charged with fraud in 2023. And problems in the world of cryptocurrency should not be seen as isolated events but rather are indicative of a broader problem in private markets.
Failure rates in tech start-ups have always been high, largely because most tech startups are loss-making. A staggering 95% of all blockchain startups fail, most in the first year. Some 25% of all tech start-ups close down during the first year, and only 10% survive in the long run.
Startups are bigger than ever before and hence problems at startups have become more noticeable.
Failure rates among tech startups have not changed in recent years, but the deal size of start-ups has changed enormously. Startups are bigger than ever before and hence problems at startups have become more noticeable.
Before 2013, the concept of unicorn companies—startups valued at more than US$1 billion—was still relatively rare. In 2013, venture capitalist Aileen Lee coined the term to describe exceptional billion-dollar US software startups. At that time, only 39 companies met her criteria, including names like Facebook, LinkedIn, and Twitter.
Soaring valuations
By 2017, there were still fewer than 100 unicorns globally. After 2017, however, the number of unicorns grew exponentially because investors and financiers became convinced that interest rates would remain near zero for an extended period and that private equity would always deliver superior returns than public equity markets.
In the unfolding private equity mania, the unicorn landscape transformed dramatically as private startups began to attract similar or even greater valuations than listed peers. According to PitchBook, as of October 1, 2023, there were 1,348 active unicorns worldwide.
To give some idea of the pattern, in 2017 there was barely a handful of unicorns in India. In 2018, 10 were added, followed by a further 8 in 2019, 12 in 2020, 44 in 2021 and 26 in 2022.
The problem with unicorns, as with all tech startups, is that many are unprofitable
The problem with unicorns, as with all tech startups, is that many are unprofitable. Continuing the Indian example, as of March 2023, 69 Indian unicorns were loss-making. A lack of public data in other jurisdictions makes it difficult to determine the global percentage of unprofitable unicorns, but the number is undoubtedly high and likely exceeds 50%.
Some unicorns, such as WeWork, have collapsed in spectacular fashion. Others have collapsed under severe governance failures, with Theranos being the most prominent example.
Back to top
Funding strains in VC land
As you might imagine, the explosion in the number of billion dollar-plus-startups, many of which are loss making, imposed an increasing funding strain on the venture capitalist ecosystem.
With the sharp rise in funding costs after 2020, the venture capital market entered a steep decline. Global VC funding fell by 35% in 2022 and suffered a similar deterioration in 2023.
The collapse in startup valuations and rising cost of capital also hurt exit valuations for PE firms. Since many PE firms own significant VC businesses, pain in the VC business has impacted the PE industry.
PE firms responded to funding pressure in the old-fashioned way: By borrowing even more. PE firms traditionally add leverage by increasing debt in the companies they buy.
COVID-19 served as a catalyst for an added layer of leverage known as NAV financing. With NAV financing, PE firms borrow against the NAV of the assets in their funds, using the funds to support their underlying investments. A typical loan-to-value ratio is 25%-to-30%.
Rising PE leverage
In addition, a third layer of leverage known as Manco loans (management company loans) has proliferated in recent years. Manco loans are taken out by the management companies that oversee PE investment funds.
These loans use management fees and equity income streams as collateral. Sometimes they are taken out by the general partners of the management companies. Interest rates on Manco loans can be as high as 19%.
The PE industry thus now has three layers of leverage where traditionally there was only one. There is debt in acquisitions, at the fund level and now at the management company layer. NAV and Mano financing always existed but not to the degree we observe today.
This additional leverage is indicative of financial stress. In the Transparently.AI risk manipulation engine, high leverage and other measures of financial stress are key indicators of account manipulation risk.
Lower oversight of private companies
There are no short sellers in the world of private equity and private companies face less regulatory oversight than public companies. Lower public scrutiny means that there is generally greater scope to manipulate accounts at private versus public companies.
What’s more, since PE firms and VC firms are focussed on exit and funding valuations, they share the same incentive structure as the companies they own. It’s possible that they don’t scrutinize their portfolio companies as much as they should.
During the 2019 Berkshire Hathaway shareholder meeting, Warren Buffett criticized the industry’s reporting practices, saying: “All they’re doing is lying a little bit to make the money come in.”
Financial stress in the PE industry is significantly greater today than it was in 2019
Put it all together and we have arrived at a situation where financial stress in the PE industry is significantly greater today than it was in 2019.
This broad picture explains, at least in part, why accounting scandals have shifted from public to private companies. FTX and the other cryptocurrency scandals were a part of this bigger unfolding picture.
Back to top
