Ideas Farm: What comes after Molten’s meltdown?

Molten Ventures (GROW), known until 2021 as Draper Esprit, is a London-based venture capital firm. Unlike most early-stage investment houses, it is listed (since 2016). And while this listing comes with “a real overhead, in terms of reporting, checks and balances”, notes chief executive Martin Davis, the model “is the best way to build trust with investors”.

Trust is an awkward topic in the world of VC right now. When times were good during much of 2020 and 2021, the sector could barely put a foot wrong. Big investors, intoxicated by the ‘tech winners’ narrative and keen for a slice of anything that claimed to be innovative or disruptive, fell over themselves to park cash with the early-stage specialists. Ballooning fund sizes and valuations duly followed.

Skip to November 2022, and things are decidedly more chastened.

Because VC firms typically invest hoping to make their money back several times over, worries about the cost of capital are less acute than for other companies and investors. But getting more than you put in requires a consistently strong strike rate in a notoriously risky asset class. Compounding this, when fundraising and M&A are both stymied by fears over crystallised losses, liquidity quickly evaporates.

The focus has also turned from ‘10x’ star stakes to flops. Sequoia Capital, one of the largest and most successful names in early-stage funding, is among a clutch of investors now writing off their investments in the bankrupt cryptocurrency exchange FTX. High risks may be a feature of the sector, but the revelation that FTX had apparently zero internal controls or accounting processes has raised serious questions of VC funds’ own controls, due diligence processes and sometimes opaque fair value assessments.

Does the picture look any happier in the listed corner of the sector? Judging by Molten’s share price, there’s little sign of it. The market reaction to this week’s half-year numbers was little more than a shrug, despite the FTSE 250 group’s disclosure that the gross portfolio fair value decreased by just 12 per cent in the six months to 30 September. By contrast, Molten stock is down 56 per cent in 2022.

This looks like a meltdown. One reading of this year’s drop – and the stock’s 47 per cent discount to net asset value (see chart) – is that investors do not trust the fair market value Molten has assigned to its investments. Given capital is largely deployed to illiquid holdings, it seems sensible to apply a bit of a haircut. But there are a few reasons to think that the rout might now be overdone, and that the 80 per cent ‘melt-up’ rally since October’s nadir could have further to run.

For one, the vast majority of Molten’s initial investments are structured as preference shares, which provides greater protection than common shares if a portfolio company struggles. This acts as a kind of parachute when valuations dip – unlike traditional equity funds focused on listed growth companies, which must mark to market.

Second, gearing looks manageable at both the company level and within the portfolio. Even if Molten were to draw down its entire facility, debt would only be a tenth of net assets, while Davis says 70 per cent of core investments have enough cash to get through the next 18 months.

Lastly, though most speculatively, sentiment towards long-term focused growth investing might finally be turning. Davis sees signs that the cost of capital is stabilising and that 2023 could herald a return to the kind of deal-making that would settle some investor nerves.

So, are the shares cheap? Their three-year Z-Score, a self-referencing measure which measures how much their discount or premium strays from the average, is currently at -1.28, meaning the discount has rarely been wider. Not only is Molten cheap in classic price-to-book value territory, it is cheap against its own trading record.

A year ago, market sentiment was overly bullish. But it now looks to have swung too far the other way.