Are Scottish Mortgage’s unquoted valuations ‘detached from reality’?

Scottish Mortgage is headed for a painful second half of the year as the valuations of its unlisted holdings catch-up to their listed counterparts, which have suffered 70-80% mark downs in the most severe cases.

The £12bn trust’s fall to earth this year has been well documented, as one by one its biggest holdings have gotten caught up in the swift and savage growth stock sell-off. Moderna, which some speculated could be Baillie Gifford’s next big winner after Tesla, is currently down 38% year-to-date, while other top 10 holdings Nvidia and Illumina have stomached even bigger losses of 44% and 48%, respectively.

A consequence of this is its unlisted holdings are now a greater proportion of NAV. Unlisted investments represented 24.9% of total assets for its financial year ended March 2022, but, following further hits to its quoted investments, this has crept above the trust’s 30% investment policy limit. Investec estimates private company exposure was as high as 34% of NAV by the end of April.

Northvolt, a private battery supplier for electric vehicles founded by a former Tesla engineer, is now among Scottish Mortgage’s largest holdings at 2.5% of NAV.

SMT top 10 holdings share price performance ytd (%)

Source: Baillie Gifford; share prices as at 28 June 2022

Scottish Mortgage unquoteds marked up 7%

Part of the reason Scottish Mortgage’s unquoted exposure has drifted to its current level is because many of its private holdings have not suffered the same devastating markdowns as its quoted investments.

Excluding new investments, Portfolio Adviser found the value of its private holdings was marked up by around 7% in the year to 31 March 2022. By the last three months of its reporting period, markets – and growth stocks in particular – were already in a tailspin due to rising inflation, promises of tighter monetary policy, supply chain challenges and Russia’s invasion of Ukraine.

Fourteen of Scottish Mortgage’s unquoted holdings were written down during the period compared to 23 that saw their valuations revised upward. Of these, nine took a sub 10% haircut, while the remainder were written down between 16-21%, apart from a stake in Ant International which was sliced by 43%.

On the flipside, the trust’s holdings in online payments processor Stripe (46%), Elon Musk’s rocket company Space X (63%) and marketing tech firm Brandtech (80%) enjoyed substantial boosts to their valuations. The value of its stake in The Production Board, a venture foundry that targets green businesses, shot up over 120%.

‘Valuation lag’

Alan Brierley, director of investment company research at Investec, says the late-stage venture capital market, which Scottish Mortgage plays in, was still relatively buoyant by the end of the trust’s financial year in March. But markets have deteriorated considerably since then.

Year-to-date Scottish Mortgage has seen around 42% wiped off its shares, which now trade at £7.43 a pop, a 15% discount to its net asset value, according to data from the Association of Investment Companies. At the end of March, shares were still trading at £10.26 apiece.

Like Schiehallion, a Baillie Gifford trust that also targets late-stage growth companies, Brierley thinks there is a “valuation lag” and a “significant disconnect” between Scottish Mortgage’s private holdings and the experience of public companies with high growth characteristics.

This is one of the key reasons Investec downgraded Scottish Mortgage from ‘buy’ to ‘hold’ earlier this month.

“The valuations of these companies bear no resemblance to the other quoted investments in the portfolio or those that were held by Baillie Gifford that have floated in recent years,” Brierley says.

Publicly-listed comparators have suffered steep falls

Eyewear retailer Warby Parker and biotech firm Ginkgo Bioworks, two private Scottish Mortgage holdings that went public last year, are both down over 70% since listing on the New York Stock Exchange. Online payments firm Wise, another holding to cross over from private to public, is down over 60% since smashing records as London’s biggest tech IPO last July.

Publicly-listed companies that are similar to private holdings in the trust have also seen their share prices tank. Coinbase, a rival crypto wallet provider to one of Scottish Mortgage’s newer private investments Blockchain.com, is down 78% as the cryptocurrency crash continues.

Virtual healthcare firm Teladoc, which counts Baillie Gifford as one of its largest shareholders, has fallen 58% so far this year. A newer competitor ZocDoc is among Scottish Mortgage’s unquoteds.

Another possible comparator for Scottish Mortgage’s unlisted exposure is the Goldman Sachs Non-Profitable Tech Index. It tracks a basket of innovative tech companies listed in the US, including Pinterest, Teladoc and Plug Power, which, unlike the Faangs and other mega-cap names, do not generate huge cash flows or earnings. The index fell by 30% from 300 to 200 in the year to 30 March 2022 and by mid-June was down around 60%. 

Some of the noise in listed markets is starting to filter into private company valuations, Brierley says. Klarna, for example, took a 67% haircut to its valuation after scaling back its upcoming fundraising from $1bn to $500m.

Speaking on Scottish Mortgage, Brierley says: “Now, I’m told that these companies are still performing well. But as we go into the second half of the year, I fear there will be a reconnection with the valuations of these companies moving more in line with what’s happening in the quoted markets.”

‘Trigger events’

Valuations for Scottish Mortgage’s private holdings, and all of Baillie Gifford’s trusts with unquoted exposure, are carried out by internal committees with input from an independent third party, IHS Markit.

The private holdings are re-valued on a rolling-three-month cycle, with a third of the unlisted holdings valued every 30 days. However, pricing is monitored daily by Baillie Gifford’s private valuations team.

The valuation committee applies techniques that are consistent with the International Private Equity and Venture Capital Valuations (IPEV) (2018), a best practice guide for valuing unlisted companies.

When calculating fair value of private investments, the company’s last funding round is typically used as a starting point. But other ‘trigger events’, such as an IPO, a takeover approach, a change in company fundamentals or a fall in the share prices of publicly listed companies used as comparators can also prompt a revaluation of the holdings.

However, Brierley says, in the absence of a recent trigger event, private company valuations “can become detached from reality”.

“Harbourvest came out with an NAV for the end of May but they’re flagging up that the bulk of that is from underlying valuations at the end of last year. So, to a certain degree the NAV […] is a little bit stale.”

“The reality is, there’s only going to be a price discovery when these guys come back to market,” he continues. “And that’s what’s happened with Klarna. If these companies don’t need capital, then they can keep going along and the valuations are at elevated levels.”

All but four Scottish Mortgage private holdings written down

Stewart Heggie, investment specialist on the Scottish Mortgage team, says trigger event valuations have been taking place “frequently”, chiefly due to losses sustained by public market comparators.

Between 1 January 2022 and 31 May 2022, 90 lines of Scottish Mortgage’s private company holdings have been reviewed. However, this excludes LPs and new acquisitions.

All but four of Scottish Mortgage’s investments have seen their valuations sliced over this time frame, with the private holding spread ranging from +80% to -78%.

“Every investment has been valued at least twice, which wouldn’t normally be the case during more stable market performance,” says Heggie.

“In fact, 50% of the portfolio has been adjusted four or more times during these five months, with the average decrease down 21% on a per share price basis.”

But these losses have been offset by the “small number of positive contributors”, such as Space X, which saw its valuation soar to $127bn last month, following an announcement it was looking to raise $1.7bn in new funding. Musk’s rocket company “has continued its path of excellent operational performance and possesses an even larger opportunity due to the fall out with Russia”, says Heggie.

“Revenue growth and liquidation preferences (mainly hold preference shares) continues to temper the decline in valuations amongst the private holdings which is the norm when looking at PC investments,” he continues.

“We should note that whilst these numbers reflect the number of adjustments made, the actual number of valuations reviews of all holdings was much higher, with full private company portfolio reviews being run weekly in some cases, but did not always result in an adjustment being required.”

IPEV guidelines too flexible

The frequency of pricing reviews in a volatile market environment is not really the issue. What matters is whether they accurately reflect the magnitude of changes in the market backdrop.

Peter Sleep, senior portfolio manager at 7IM, says the IPEV guidelines have been written to give a good deal of flexibility to investors to smooth valuations through the cycle.

But during times of market volatility, this means they don’t always pass muster.

In this way, it’s not unlike the valuation difficulties open-ended property funds when markets went into a freefall post-Brexit vote and the Covid-crisis, Sleep says.