Article by Jason Zweig

The biggest casualty of the postponed initial public offering for We Co., parent of the office-sharing business WeWork, isn’t the company or its bankers. It’s the myth that private markets are superior to public markets.

Investors have long been told that the stars of the financial universe are hedge fund, venture capital and private equity managers. These supposedly visionary geniuses are said to be immune to the short-term thinking that poisons the public markets. Investment horizons should be longer, risks lower, returns higher.

Since 2008, pension funds, university endowments and other giant investors have poured roughly $2 trillion into private vehicles on that promise. Individual investors have seldom been allowed past the velvet rope—but, as the We debacle shows, that isn’t always a bad thing.

Not long ago, We’s venture-capital backers valued it at $47 billion. The proposed IPO faltered when public investors signaled they wouldn’t value the company much above $15 billion—implying the supposedly sophisticated private market had been pricing We at roughly three times what it is worth.

Second Opinion
High-value startups often fall in price when they go public, though We Co.’s prospective drop is sizable.

We’s monarchical executive perks, unorthodox accounting and kooky management style almost seemed to bemuse private-market investors. The company lost nearly $1.4 billion on $1.5 billion in revenue in the first half of 2019. Public investors didn’t find any of that amusing.

No wonder, in a videoconference earlier this week, We’s founder and chief executive, Adam Neumann, told employees the company has “played the private-market game to perfection,” as my colleague Eliot Brown reported. Public markets, he added, were a different story.

A spokesman for We declined to comment. Mr. Neumann’s remark, though, shows how hollow the narrative about the superiority of private markets is. They may be more prone to error than public markets are—not less.

Markets work best when they are both deep and wide, integrating sharp differences of opinion from many people into a single price at which investments can trade.

Private markets, however, are shallow and narrow, despite their enormous size.

Non-registered securities offerings totaled $3 trillion in 2017, estimates the Securities and Exchange Commission—twice the size of public offerings for stocks and bonds.

Yet in these clubby circles—non-traded real estate, infrastructure portfolios of airports and highways, venture capital that nurtures startup firms and private-equity funds that buy up entire companies—relatively few investors determine what investments are worth, often based on similar viewpoints. Short selling, or betting that prices will fall, doesn’t exist.

“Normal markets consist of pessimists, neutral people and optimists, who can take either side of a trade so the price can settle to some kind of equilibrium,” says Michael Mauboussin, director of research at BlueMountain Capital Management LLC, an investment firm in New York. “But that’s not the case in a private market, where it’s difficult to sell and pessimists can’t easily express a view.”

So pricing is primarily in the hands of optimists.

According to PitchBook Data, 66 companies valued at $1 billion or more have done initial public offerings from 2011 through mid-September 2019. A third of those IPOs came at prices below the value set in the companies’ last round of private funding. Bloom Energy Corp. , Cloudera Inc., Domo Inc., Reata Pharmaceuticals Inc., and Zynga Inc. all launched IPOs priced at least 40% lower than the valuation in their final private-funding round, according to PitchBook.

Perhaps that’s because conventional valuation methods may overstate what private funds’ venture holdings are worth. Often, several share classes are valued equally even though they aren’t all entitled to the same payoffs.

Or perhaps the brilliance of the private market is overstated. Consider a recent survey of nearly 900 venture capitalists.

Asked whether they “often make a gut decision to invest” in a fledgling company rather than relying on analysis, 44% of venture-fund executives said yes.

Which financial metrics do they use to analyze investments? “None,” admitted 9% of respondents. Only 11% quantitatively analyze past investment performance. A similar survey of private-equity executives found that they “do not frequently use” the methods that are standard among public investors for discounting the future cash their holdings might generate.

Are “unicorns”—those startups already worth more than $1 billion in the private market—overvalued? Yes, said 91% of venture capitalists who don’t have any unicorns in their portfolio. And yes, said 92% of the VCs who do.

No one disputes that when private investments pay off, they pay off hugely. But the gap between the best and the worst is vast. And, on average over time, they don’t tend to outperform public markets by wide margins—especially when adjusted for risk, the boost that borrowed money can give and the inability to withdraw your capital at will.

A few investors with oceans of capital, great connections and superb analytical skills may be able to pick the winners in private markets. Most others, large and small, shouldn’t feel as if they’re missing out on a sure way to strike it rich.