By William Dowling and Jonathan Scherr
In Part 1 of this series we discussed why we will launch a systematic fund and briefly mentioned a few of the many challenges we anticipate having to overcome in this endeavor. In this post and in posts over the course of the coming months, we will unpack some of the operational hurdles to bringing systematic investing to the private markets. Today, we’ll touch on one of the biggest hurdles in this effort – determining the value of private companies at scale. It’s a big challenge, but Helio helps us tackle it.
An efficient mechanism to determine the value of a company is essential to creating a working systematic strategy. In traditional private equity, investors spend many hours evaluating market sizes, company performance, and competitor strengths and weaknesses to project growth and arrive at a ‘base case’ view of the likely future performance of a company. With these projections, they might use comparable company analysis or simple multiples to arrive at a valuation. Obtaining the information to project performance for even one private company typically requires building a relationship with the company and the trust of the company’s CEO that the investor has a real intention to invest. On top of that, determining the right comps for a valuation analysis is often more art than science, requiring informed judgment about the situation. Now imagine repeating this time-consuming process for the 150+ companies that would be part of a systematic portfolio and having to drive alignment with founders who might have a completely different perception of the value of their companies.
The sheer magnitude of this type of task would be overwhelming for any financial firm – even one staffed with an army of analysts working around the clock. It becomes especially challenging when you consider that all the data, in addition to being accurate, has to be timely. If revenue from one company in a portfolio is collected this week, but revenue from another company is not collected until next month, that could negatively impact models that use revenue as an input to measure companies against each other, leading to suboptimal assessments of value – resulting in either investing at too high a price or missing an opportunity for offering too little. The importance of finding timely and reliable data to determine valuations is not lost on us; in fact, it is central to our business thesis.
First stop in systematic investing: CPG
Given the need for reliable valuations at scale, we believe that the consumer goods sector is the ideal entry point for systematic investing in the private markets. Underpinning this belief are two aspects of CPG that make it uniquely suited to value systematically.
First and foremost, there is an ample supply of data in CPG. Information is available for companies on everything from distribution, to brand, to product reviews, to sales, to ingredients, to attributes, to labels, and much more.
Secondly, because many consumer companies operate with relatively similar business models (they sell physical goods they manufacture to individual consumers, making revenue a simple function of the units sold to end customers and the price of those units), modelling a company’s valuation is easier than in other sectors, particularly when you can make use of the wealth of data mentioned above. Consumer valuations are based on projections about a business and then multiples put on top of that. While companies may differ in their channel strategy or margins, the broad business models they embrace, especially within categories or industries, are very alike. Together these attributes make automated valuation of a broad number of companies possible.
Helio is our machine learning platform that collects billions of data points on 1.3 million companies in North America. We have models built on top of the data that categorize these companies, evaluate their strength across an array of metrics (brand, distribution, product, and financials), and predict their revenue. We have revenue predictions for almost every one of the consumer companies we track.
There are two key inputs that typically go into an early-stage consumer valuation exercise: a prediction of the operating performance (revenue and profit/loss) and the valuation of that performance, often thought of in consumer as a multiple of revenue. As an example, imagine that we are interested in valuing Halo Top – a privately held ice cream company. With Helio, we can establish in less than a second that there are 894 ice cream companies operating in North America. Not only that, but we can tell how many of these companies share similar attributes (maybe with Halo Top we’re looking for ice creams that describe themselves as healthy). Most importantly, using the models we’ve built, Helio approximates revenue for these ice cream companies.
On the valuation front, because consumer companies operate similar business models, we can leverage a combination of historical transaction comps and Helio’s assessment of the future growth and risk to determine reasonable valuation multiples, which can vary by category, based on the hundreds of companies we have worked with in the past. We are able to adjust our valuation using Helio’s projections of risk associated with future growth, allowing us to further refine our assessment of a company.
These capabilities will allow us to value almost every North American consumer company in a matter of seconds. Those predictions will, of course, have a level of uncertainty associated with them, as do all model outputs. Some of these can be controlled with confirmatory diligence, some can be lessened through deal structuring, and the remainder can be mitigated through diversification, allowing us to build a compelling portfolio.
Systematic investing in the private markets suddenly looks a whole lot more doable.
More to Come
The ability to value private companies at scale is just one of the ways we think Helio will help us overcome the hurdles to bringing systematic investing into the private markets. There is also a great deal of technical work required to make investments, construct a portfolio, service the portfolio, support the founders, and facilitate exits. More on all of that to come.