The evidence is mounting that 2022 has seen a regime change for interest rates. Quantitative tightening (QT) is the new quantitative easing (QE). Everyone should stress-test their mortgage and other debts to see how they’d handle higher rates.

There are two main things to consider:

• The cost of servicing debt (a function of interest rates, plus spurious add-on charges)

• The ability to get debt if you need it (how willing are banks to lend)

Both will likely get worse for most borrowers as money tightens.

Of course if the screw is really turned we will see second-order effects.

For instance markedly higher rates could cause the housing market to slow or unemployment to rise. That could hit your finances directly (you lose your job) or indirectly (a stock market or house price crash).

Keep going with such extrapolation, however, and you begin to sound like the economic nerd cousin of Stranger Things’ Dustin Henderson.

“High rates will crush growth even as de-globalization fuels hyper-inflation, spinning us into a stagflationary death loop that sees Jeremy Corbyn and Boris Johnson re-elected as leaders of extra-radicalized parties that wage running battles in a crumbling Trafalgar Square.”

I’d draw the line several steps before reaching – let alone acting upon – such conclusions.

It’s not that things can’t change radically. (Nor that you shouldn’t have a Plan B, just in case).

Things can definitely change a lot:

• In the 1970s it was hard to get an expensive mortgage to buy a cheap flat in a depopulating London.

• In the 2010s it was easy to get a cheap mortgage to buy an expensive flat in a booming London.

However it’s very difficult to make even short-range economic forecasts accurately.

Massive shifts? Trying to see everything proceeding as you have foreseen – ten years away – is a fool’s errand.

Rather, like judging the weather, it’s usually better to assume more of the same – summer, say, as opposed to winter, or vice-versa – and to focus on the disposition of any clouds on the horizon.

Higher interest rates

What makes doing so tricky this time – and what has roiled markets in 2022 – is that we probably are in a new season.

That’s the regime change bit, right? But I don’t yet see that we’ve fast-forwarded from a balmy June into the depths of a winter solstice.

So far quantitative tightening has mainly been felt in interest rates.

Take the five-year gilt yield as a rough-and-ready driver of rates for fixed-rate mortgages.

The yield on this gilt is back to 2014 levels:

Source: MarketWatch

Correspondingly, five-year fixed-rate mortgages have become more expensive.

Tack on 1-1.5% for the bank’s trouble of lending to you rather than Her Majesty’s government and the typical five-year fix is now above 3.5%. (Albeit you can do better if you shop around.)

That’s not too terrible, but some pundits see things getting far worse.

One analyst recently told What Mortgage:

“Given the speed of rate rises this year, as the mortgage market catches up it is not unrealistic to see the average five-year fixed rate at 5% next year.”

This is not an outlandish prediction, though I’d be surprised. While today’s rates are in unfamiliar territory for anyone who has only been saving and borrowing for the past few years, they’re still historically low.

We only have to expand out the view above to 15 years to see the five-year gilt yield above 5% in 2008:

Source: MarketWatch

You’ll remember 2008 was the watershed for a little thing called the Great Financial Crisis. Its aftermath saw yields plunge and the start of the quantitative easing that we’re now exiting, via quantitative tightening.

So 5% yields – and maybe 6-7% five-year fixes – are possible if we truly have left behind the great sloshing post-crisis money splurge.

Note though that the market does not currently see 5% as remotely likely, judging by signals such as the yield curve:

Source: Bank of England

Sure, there’s no anticipation of a return to recent ultra-low yields. But there’s no fear of 5% interest rates, either.

Indeed as of the Monetary Policy Committee’s last meeting in June, market pricing for the Bank of England’s Bank Rate was 2.9% by the end of 2022, peaking at 3.3% next year.

Is that a spike in your inflation graph or…?

The elephant in the room is, of course, inflation. High inflation that persists for longer than anticipated could see more interest rate pain inflicted than is currently priced in.

Hardly anybody saw inflation or rates being where they are now, this time last year. So the market is hardly infallible.

And trying not to see high inflation these days is like trying to tell your brain not to think of a pink elephant:

Source: Office for National Statistics

Just this week inflation hit a 40-year high of 9.4% in the UK. It has gone bananas, to use the technical term.

Market predictions for another big rate hike from the BOE hardened on the latest inflation report. However for those of us not trading day-to-day moves in the bond market, higher Bank Rates were already effectively priced in.

The key questions now – which I do not propose addressing in this post – are (1) whether inflation is still a relatively short-term spike, and (2) whether more rate hikes will do much to bring it down anyway.

There’s lots of opinion to digest out there. Call it right and you can be more confident about where mortgage rates will go.

Personally I believe inflation is more likely to be significantly lower in a year or two than higher. I still see most of the inflation as an aftershock of the stop-start pandemic, albeit with additional factors such as fiscal stimulus and war.

More importantly, the market agrees. And for what it’s worth the Bank of England still believes we’ll be back at around 2% inflation in a couple of years:

The rate of inflation is forecast to keep rising this year. But we expect it to slow down next year, and be close to 2% in around two years. 

That’s both because the main causes of the current high rate of inflation are not likely to last, and because we have raised interest rates several times over the past few months.

True, I’d take that prediction with a fistful of salt. Both on the grounds of the Bank of England’s wonky forecasting record and because I do not believe that it will do ‘whatever it takes’ to bring inflation back to 2% if it has to.

Given the already surging cost of government borrowing and the likelihood of a deep recession if rates go a lot higher, I suspect the Bank would countenance elevated inflation at, say, 3-4% for a time as more palatable.

Admittedly 3-4% is not in its mandate. But it could probably obfuscate.

What’s more, the two candidates to be our next Prime Minister appear (as best one can tell) to have different views on both balancing the books and monetary policy.

Then there’s also the ongoing friction burn from Brexit – slowing growth and adding to inflation at the margin.

Doing my own stress tests versus higher interest rates

So that’s a snapshot of the scenic features in today’s economic landscape. I concede it’s a cloudy picture. And possibly I have my finger over the lens.

But what does it mean for our mortgages?

I went into detail about stress-testing your mortgage a few weeks ago. We especially focused on rates. Please go back and read it (and the comment thread) if you’ve not done so already.

This rest of this post is the promised follow-up as to how my thinking is evolving around my own controversial mortgage.

My situation is unusual – interest-only mortgage, got it weirdly, self-employed, and (sort-of) financially independent – but hopefully my musings will be food for thought.

Or just plain voyeurism! I mean, it could be a bit of a thriller for viewers.

The fixed-rate term on my mortgage expires in February. That’s unfortunate, given Bank Rate could be peaking shortly thereafter.

With a bit of luck however five-year yields and beyond will already be dropping by then. Albeit perhaps because recession is looking more likely, which may in turn make banks more reluctant to lend cheaply.

Clearly there were easier times to refinance an interest-only mortgage. Such as most of the past four years.

 

My mortgage: naughty but nice

I got my interest-only mortgage for a variety reasons.

Most obviously, I wanted my own home!

But I also wanted to keep my tax shelters intact, rather than withdraw money from my ISAs to buy a flat mortgage-free. If I’d done that then much of my painstakingly accumulated ISA tax-shield would be lost forever.

I also judged cheap mortgage debt would help ease the pain of any unexpectedly high inflation that emerged from the near-zero rate era.

Inflation erodes the value of debt, in real terms1. All things equal this makes the debt less of a burden over time.

Look at that inflation rate in the chart above. With inflation where it is, I’m currently earning roughly 7% in real terms on my mortgage. That’s incredibly attractive, all things being equal.

But of course all things are rarely equal.

For starters, to benefit from the negative yield I must be able to make my mortgage payments. Running a mortgage that I could otherwise pay off from my investments means assuming a risk that effectively levers up my portfolio.

That is, I am borrowing to invest via my mortgage. And the cost to do so rises with higher interest rates.

This brings up the second aspect. What did I do instead with the money that I could have used to pay off my mortgage?

I have had it invested, mostly in equities.

For the first four years this was a boon. But the wheels have come off this past six months.

I’m still up on where I would have been in cash terms – without adjusting for the extra risk I took by investing and taking on debt – thanks to my gains over the first three and a bit years.

However share prices have been falling for months in 2022 even as higher interest rates make funding their ownership more expensive.

And that means investing via the mortgage doesn’t look like the no-brainer it was as recently as November.

Higher interest rates: fine, within limits

To cap it all, my income from work is severely down over the past 18 months or so.

That was by choice – I sort of drifted into living the financially independent lifestyle. As the market soared in 2021 I stopped renewing my freelance gigs. I didn’t formally decide to quit work.

Why this happened and whether it should have is for another post. The point is I’m tending to think as if I’m living off a sustainable withdrawal rate (SWR) on my assets. Even though in reality I still do have some earnings.

Of course, there’s one huge comfort when running a big portfolio alongside a big mortgage. If you really must you can sell whatever you need from the former to cover the latter.

To my mind this makes what I’m doing pretty safe. I’d certainly prefer it to paying my mortgage with a salary and no savings.

Ideally though, I want the portfolio to continue to grow to meet future demands, FIRE-style. Hence I think of my mortgage payments as coming out of my notional SWR rather than drawing down capital.

• At my current rate of 1.99%, the payments are easily covered by earnings, let alone the portfolio.

• At a rate of 4%, which I judge a good bet for February – up from the 3.5%-ish my bank is touting today – the monthly mortgage payments would still be less than a third of my vague SWR.

• A mortgage rate of 6% does get uncomfortable. Note there’s no immediate danger at all. I could continue for decades at this rate, and the chances are good that withdrawals would be covered by portfolio growth. In that case I’d still grow richer. But ‘probably’ starts to loom larger in the long-run picture.

Obviously I have other living costs besides the mortgage. Even a blogger has got to eat!

But I am presuming I’d revert to my old graduate student lifestyle if I have to – if there’s a long bear market and no income rebound – which is actually plenty swanky for me.

Would investing rather than repayment still be worth it?

The always-contentious issue of having a big interest-only mortgage while investing is tilted by higher interest rates, too.

Regular readers will remember I shared a spreadsheet for calculating the benefits (or otherwise) of investing instead of paying off a mortgage.

We’ve established in the comments over the years that this mostly comes down to personal attitudes.

However there’s no denying the allure of the interest-only mortgage fades as rates rise.

• At a 2% rate, running a £500,000 interest-only mortgage compared to a standard repayment mortgage could deliver an additional £542,000 in net worth after 25 years, assuming 7% returns.

• With a 6% mortgage rate, that (theoretical, not guaranteed) extra gain falls to just £84,000.

This are simplistic sums that ignore inflation, the jagged path of real-world investment returns, and the significantly higher risks of running a mortgage.

On the other hand, 7% returns are much lower than what I’ve achieved over the past ten years (albeit in a bull market!)

The point is that the savaging inflicted by higher interest rates on ballpark returns is clear.

My gut feeling is that at rates much above 4% I’d probably switch to repayment.

Money’s too tight to mention remortgaging

My unusual circumstances – my bank’s CEO initiated my home loan process, remember – make my remortgaging situation potentially tricky.

However I recently spoke to my bank. Its staff confirmed in a worst case I would automatically go on to the standard variable rate.

The agent also claimed I’d be able to switch to a new fixed rate a couple of months before my current term expires – without having to go through that unusual application procedure again.

But I’m still wary. I’m outside the normal Venn diagrams. And the specific employees who sorted my loan have since moved on.

Moreover this agent was not an expert, just a front-line trooper. (The call I made was recorded. I might need that in a push!)

Refinancing is a formality for most people. Even more so now mortgage affordability stress tests have been weakened. But my odd circumstances make it a bigger concern for me than higher interest rates.

The good news is the investment portfolio that backs the repayment of my loan is (for now) still well up since I got the mortgage in 2018. Even after this year’s declines.

Nevertheless in early 2022 I moved much more than I otherwise would into lower-volatility assets:

• I’m trying to increase the odds I will look like a good credit risk to the bank. In my situation that means keeping my net worth up for the remortgaging window in February.

• I want to reduce volatility on a big chunk of my portfolio just in case I want to pay down my loan. Perhaps because rates surge or the bank decides it now has a problem with me.

It may even turn out that moving on to the standard variable rate for a while won’t be my worst option come February.

Plan B if the computer says “no chance”

In general I’d always favour fixing, for the certainty of payments.

But my remortgaging window seems likely to open shortly before an inflection point for rates. It could be worth giving it six months (presuming this doesn’t impair my ability to actually fix again, due to my odd situation.)

What’s more, most fixed-rate mortgages come with restrictions on over-payments. There are none on my bank’s standard variable rate, however. That would enable me to reduce debt – and risk – quickly if I felt wobbly.

If push comes to shove – if I don’t want to make big repayments or I can’t secure a halfway decent fixed-rate residential mortgage – I’ll possibly even switch to a buy-to-let mortgage, turn my flat into an investment property, and spend a few years living abroad.

This might seem dramatic, even for a Plan B.

But remember I’m a single guy and I work from home.

Truthfully I should probably be taking advantage of the whole Digital Nomad opportunity anyway!

Five years a mortgage slave

Finally some psychological and emotional reflections.

One of the more unusual reasons why I got my mortgage was to see how I managed as an active investor carrying a lot of debt.

How would I feel with this potentially deadly obligation on my balance sheet? Could I cope? Would it change how I invested? Would it be worth it?

Well I’ve learned I don’t love it and it’s probably not good for my stock picking.

I was concluding this even before the recent market falls.

For instance I’m pretty sure I wouldn’t have sold Tesla (and various other dumb things I did in 2018) if I wasn’t discombobulated by my then-new mortgage.

And while in theory even a modest return that’s leveraged by an interest-only mortgage can deliver great returns with lower stock market risk, in practice I’m still drawn to riskier growth shares.

This reality also made it easier to shift a large proportion of my assets out of equities entirely and into what I dub my new ‘low volatility’ portfolio in early 2022.

As mentioned it has tamped down the overall volatility in my net worth, as well as making me confident I can make big or even total repayments in February 2023 if I need to.

I’m also happier focusing my now right-sized equity portfolio towards riskier equities with this buffer at my back.

Given this year’s declines, I lucked out with the timing. But if I still feel I need to keep a large slug of safer assets even after I have successfully remortgaged for another five years, say, then it could be a drag on my returns.

It might be a sign I am having emotional trouble scaling my risk profile via the mortgage as I age, as a couple of astute readers have already suggested.

Mathematically, too, a lower expected return portfolio might compare poorly versus simply paying off my debt. Especially given higher interest rates.

Running a mortgage at a rate of less than 2% and investing is a different proposition compared to higher interest rates at 4-6%, as we’ve seen above.

The historical return from shares is only 9-10% remember. The case for investing versus paying off your mortgage is weakened, even if it still makes theoretical sense in a spreadsheet.

My original plan was to run my big mortgage for the full 25 years to take advantage of the return spread and inflation.

But I’m starting to think I’ll probably pay it off sooner than I’d imagined. 

I’m in no rush to decide on this, especially now shares are cheaper. Falling share prices increase their expected returns, even absent any stock picking alpha I might rediscover.

However if and when markets recover I may well redirect future spare cash flows towards the mortgage.

I’m only human after all, it seems.

Time will tell. Stick around to see how the story ends!

1. That is, inflation-adjusted. [↩]

What caught my eye this week.

Long-time lurkers around these parts may remember the cult FIRE blog Sex Health Money Death.

That’s ‘cult’ as in the author carved out a niche for himself, you understand, not in that he carved anyone up for unsavoury ends…

Indeed Sex Health Money Death was the first early retirement blog I can ever remember conceding that quitting work to aimlessly kick about the house all day in your early 50s might not quite live up to the marketing hype.

Laconic posts about lonely trips to the gym and banter-less hours stretching out every afternoon were typical of this unique voice in blogging. Fans even looked past the fact that there was never any sex – a classic bait-and-switch.

Alas Sex Health Money Death eventually chucked in both the blog and retirement, and went back to work.

But now he’s back! His first recap reports that:

I certainly didn’t want to moan about retirement in a blog, but maybe I could share some of the challenges and what positive things I have found to come from them.

Off the top of my head, in the last year I’ve learned loads about pensions and developed a hard-won withdrawal strategy that I’m finally comfortable with; I’m way fitter than I’ve ever been; I’ve massively expanded my cooking repertoire; I’ve discovered Youtube DIY videos and saved hundreds of pounds in repair costs; I’ve learned a bit about gardening; I’ve read more books than I ever have; I’ve worked hard to increase my social circle; in any given week I average 15,000 steps a day, double what I used to do when working; I make time for audiobooks and podcasts; my golf handicap….nah, you don’t want to know about that. 

In short, a good retirement takes effort, as does a good blog and a healthy sex life. Although on reflection perhaps I’d rather hear about that golf handicap first.

Welcome back SHMD! And have a good weekend everyone.

From Monevator

The Slow & Steady Passive Portfolio update: Q2 2022 – Monevator

Crowdfunded valuations and some investment trust NAVs still need to come down – Monevator

From the archive-ator: When to buy insurance – Monevator

News

Note: Some links are Google search results – in PC/desktop view you can click to read the piece without being a paid subscriber. Try privacy/incognito mode to avoid cookies. Consider subscribing if you read them a lot!1

Average standard variable rate mortgage in UK tops 5% for first time since 2009 – Guardian

China economy shrinks on zero-Covid policy – BBC

More bank closures named by Barclays and by Natwest and RBS – Which

Tech talent shortage is crimping UK tech sector growth – BBC

US inflation hit 9.1% in June, far worse than anticipated – CNBC

Spain announces free rail journeys from September until end of year – Guardian

UK retail sales fall at fastest rate since lockdown – BBC [graph from Yahoo Finance]

Products and services

Zopa Bank launches Best Buy easy-access account paying 1.5% – ThisIsMoney

How much could you save on car insurance by paying annually? – Which

Open a SIPP with Interactive Investor and pay no SIPP fee for six months. Terms apply – Interactive Investor

How to switch bank accounts – Be Clever With Your Cash

Is a hub shared by several banks really the answer to mass branch closures? – ThisIsMoney

Homes for a heatwave, in pictures – Guardian

Comment and opinion

The era of Great Exasperation arrives for investors [Search result] – FT

Luck vs skill – Kevin’s Newsletter

The US yield curve is inverted again – Morningstar

How to feel rich even if you can’t get rich – Financial Samurai

If this is your first bear market, there’s no need to panic – Washington Post

Neglected investing ideas – Humble Dollar

Why are so many middle-aged people leaving work? – Prospect

The upside of downside – Compound Advisers

Why a higher fiduciary duty helps everybody [US law but relevant] –  Morningstar

Commodities never belonged in your portfolio – Washington Post [via Abnormal Returns]

Position size matters, especially with volatile allocations like Bitcoin – Elm Funds

This time it’s different (/worse) mini-special

The market risks are growing – DIY Investor (UK)

Limits to growth and declining living standards – Simple Living in Somerset

An update on ‘country risk’ for investors in 2022 – Musings on Markets

Crypt o’ crypto

The cryptoland adventures of Alan Howard [of Brevan Howard fame; search result] – FT

Leading lender Celsius files for bankruptcy, withdrawals still suspended – Ars Technica

Crypto isn’t really a hedge against equity risk – CFA Institute

Naughty corner: Active antics

On bullshit in investing – Noahpinion

The best infrastructure trusts to shelter your money from inflation – MoneyWeek

Why this week’s high US CPI print was not a shock – Calafia Beach Pundit

Some hedge fund strategies delivered good returns in the rotten first half – Institutional Investor

The [admittedly wild] data suggests the US is not in recession. Yet. – Peterson Institute

The implosion of the once-booming SPAC sector – ExecSum

Covid corner

Infection levels reach new record UK high for the pandemic, estimates show – Independent

Tim Harford: a riskier approach to new vaccines will pay off [Search result] – FT

Kindle book bargains

Amazon Unbound: Jeff Bezos and the Invention of a Global Empire by Brad Stone – £0.99 on Kindle

Secrets of Sand Hill Road: Venture Capital and How to Get It by Scott Kupor – £0.99 on Kindle

Mother of Invention by Katrine Marçal – £0.99 on Kindle

Be Careful What You Wish For by Simon Jordan – £0.99 on Kindle

Environmental factors

How to buy great fashion that doesn’t cost the earth – Guardian

Fires ravage Portugal as another blistering heatwave scorches Europe – Axios

The ULEZ effect: diesel car ownership down by a quarter inside the zone – ThisIsMoney

Humans need to value nature as well as profits to survive, says UN report – Guardian

Tory leadership contenders skip ‘game-changing’ climate change briefing from Sir Patrick Vallance – iNews

Off our beat

The $100 trillion global economy in one chart – Visual Capitalist

Will these new algorithms save you from quantum threats? – Wired

She thought a job was waiting for her in Europe. Then she met her trafficker – Vice

Why Sri Lanka is having an economic crisis – Noahpinion

How to use a walnut to repair scratches in old wooden furniture – Lifehacker

Web3 is about saving us from totalitarianism as much as it’s about crypto – Dror Poleg

And finally…

“In general, it is easier to make money owning businesses with strong franchises than ones with weak franchises.”
– Anthony Bolton, Investing Against the Tide

Like these links? Subscribe to get them every Friday! Note this article includes affiliate links, such as from Amazon and Interactive Investor. We may be compensated if you pursue these offers, but that will not affect the price you pay.

1. Note some articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”. [↩]

Down is the new up in 2022 in the stock market, especially for once high-flying growth stocks.

Yet private company valuations have taken their sweet time to adjust to the new reality.

This includes crowdfunded shares on platforms like Seedrs* and Crowdcube, as well as the unlisted holdings of some investment trusts.

Despite a deep bear market in publicly-traded growth shares, I’ve seen some private ones raise money in 2022 at higher valuations. Perhaps even more than they achieved in the 2020-2021 euphoria.

Sure, the companies may have made solid progress since their last funding.

More users, higher revenues, and/or their products have new features.

But such valuations still seem fanciful, given that the multiples paid by public stock market investors – where, crucially, everyone can see what everyone else is paying – have crashed.

A fast-growing unlisted fintech that valued itself at, say, 80-100x revenues in mid-2021 should not expect the same valuation multiple in 2022.

Possibly not even the same order of magnitude.

Road to nowhere

I don’t begrudge their management teams if they can still raise money at high valuations, mind you.

Most such start-ups – and even some of the unlisted growth holdings of specialist investment trusts – are loss-making.

That’s often by design, especially in the (fin)tech sector.

Instead of tuning their operations for profits, they aim to scale fast.

Their business plans anticipate they’ll tap easy money to fuel this expansion.

Until recently, the deal had been that if you can show sufficiently fast growth, investors will show you the money.

Often these start-ups have less than 12 months of funding in the tank – as calculated via the aptly-named ‘burn rate’ – before they run out of road. Hence their need for regular injections of cash.

So it’s generally good for a company and its shareholders to sell precious equity at the highest valuation possible. Especially now market turbulence is seeping into the real economy, making growth and future funding even more uncertain.

It’s not about being greedy. A higher valuation gets more money in the door today. That buys more time for growth, while giving up less equity – much of which will be needed to sell in future rounds.

Yet an unrealistically high valuation probably isn’t great for the firm’s new investors.

I know this might seem stupendously obvious.

But there’s a contrasting school of thought that – within reason – it doesn’t matter too much what you pay for seed-stage investments.

Most of them are destined to more or less go to zero, anyway.

In light of this, even new investors might prefer to put money into a start-up that raises money at an inflated valuation, if by doing so the firm greatly extends its runway and hence its odds of finding success. (Or even just survival.)

You’ll likely lose money either way, whether you invest at a grossly high valuation or something more realistic.

But if you don’t lose, it will be because the firm is one of the minority that finds and wins its market and multi-bags1.

With such winners, you won’t care too much that you paid 20-30% over the odds when you bought in.

Our biggest ever sale

I understand this logic – which has driven even professional venture capital (VC) in recent years – but I don’t entirely buy it.

Not least because we’re probably not talking about a 25% overvaluation, given comparable valuations in the public markets.

The vast majority of listed high-growth/tech stocks are down 50-90% from their peaks – thanks to the regime change we’re going through due to higher interest rates and inflation.

Below are a few random examples of just the year-to-date falls.

I’ve definitely not cherry-picked rare duds here. And many such companies were already well down as 2022 began:

In light of such declines, an unlisted fintech that has raised new money at 25% above its last round could be in the order of 150% to 1,000% or more overvalued.

And indeed we are starting to see this now in some high-profile valuation adjustments.

Take the Swedish ‘Buy Now Pay Later’ firm Klarna.

Klarna just raised $800m at a valuation of $6.7bn. Which sounds like a decent chunk of change, until you remember it got money from Japan’s SoftBank last year at a valuation of nearly $46bn.

On Monday Klarna’s CEO took to Twitter to express sentiments similar to my points above:

Today Klarna announces an $800m financing round during the worst stock downturn and challenging macro in decades.

We are not immune to public peers being down 75-90% and hence our valuation is down on par.

The CEO doesn’t want his company’s valuation plunge to be seen as a Klarna-specific problem. Nor even as a blight on Buy Now Pay Later space.

Fair enough, I haven’t got a strong view except in that I passed on the chance (as a lah-dee-dah ‘sophisticated investor’) to invest in Klarna myself at that higher valuation, when a private holder offered a tranche of shares last year.

However the markdown is a wake-up call to investors in private companies deluding themselves about the current value of their portfolios, due to them not being marked-to-market or even liquid.

A butterfly flapping back to earth

One investor in private companies who has had to take notice of Klarna’s valuation collapse is the London-listed investment trust Chrysalis Holdings.

This fund came to wider attention in January. Back then its owner – the giant Jupiter – disclosed  the trust’s managers were to be paid an eye-watering £60.5m after blistering returns in 2021.

As CityAM reported:

[the managers] generated stellar returns for the firm in the past year with a 57 per cent increase in net asset value per share, after backing firms including fintech darlings Wise and Starling Bank.

Nice work if you can get it, but questions were asked about how these performance fees had been structured to allow such a colossal payout to two employees.

That particular potato is even hotter given Chrysalis’s share price slump in 2022:

What has happened here is largely that the market no longer believes Chrysalis’ unlisted holdings are worth as much as they are being carried for on its books.

And given that its biggest holding was Klarna – whose valuation has just been slashed by 85% remember – we can only applaud Mr Market’s foresight.

Until recently, Chrysalis’ official net asset value (NAV) had only declined modestly in 2022.

But the share price predicted different.

I’m not familiar with exactly how the trust calculates its NAV. Typically though, NAVs are based on the most recent valuations achieved by all the different portfolio companies.

(Sometimes – and especially controversially – even when it’s an existing investor that is putting more money in at a higher valuation – thus marking up their existing holdings).

On Monday Chrysalis reported that:

As announced on 23 May 2022, the Company’s net asset value (“NAV”) per ordinary share was 211.76p as of 31 March 2022.

It is estimated that the revised valuation of the Company’s investment in Klarna due to this funding round, along with the movement of listed assets and FX post-period end, would result in a decrease in the NAV per ordinary share of approximately 32p as compared to the Company’s last reported NAV per ordinary share.

The resulting NAV would therefore be 179.50p

Note that 45% of the portfolio is currently profitable and 51% of the portfolio is now either profitable or has sufficient cash to reach profitability. The remaining 44% of the portfolio, excluding cash, has approximately 15 months of runway without raising further capital.

This trust is therefore currently valued at roughly half its latest NAV – a very large discount.

Perhaps the magnitude of this discount is unwarranted. Or perhaps as the market clearly fears more of the portfolio will be revalued down in the months ahead.

Either way, if you own investment trusts with holdings of unlisted companies that are trading at big discounts to stale NAVs, I wouldn’t go ranting about the ‘irrational market’ right now.

NAV-er mind

Chrysalis is a striking example of a delayed NAV decline, made more contentious by the fee controversy.

But there are plenty of other investors in unlisted companies – whether directly or via funds – who are in denial about valuation adjustments.

At least with investment trusts, the canny stock market can knock down share prices to anticipate declines in the value of the underlying holdings.

Seeing your shares plunge to a steep discount is no fun for existing shareholders. But it is better for anyone pondering a purchase.

I’d argue it leads to better functioning capital markets, too.

In contrast, VC and private equity funds that are not listed – and so not marked-to-market – may continue to comfort their investors with yesterday’s valuations for illiquid holdings.

At least they can until new funding rounds for their holdings put the boot of realism in.

Even the ever-popular Scottish Mortgage trust is trading at a discount, reflecting in part uncertainty about its unlisted holdings.

Not a big enough discount in my view, incidentally, given that some other tech trusts that invest purely in the public markets – where prices and hence valuations are nailed-on – are on even greater discounts.

(This illustrates that discounts aren’t just about uncertainty over private valuations. Fearful investor sentiment is also in the mix, and is quite capable of fostering a widening discount.)

Don’t go down on us

Intriguingly, professionals operating in the venture capital sector may be among the strongest voices urging the companies they’ve backed to keep reaching for higher valuations.

Venture capitalists in general abhor what they call a ‘down round’ – fund raising at a valuation lower than the last one achieved.

There are some pertinent reasons for this.

VC managers don’t want to tell their backers that their investments have been marked down but are still going concerns.

It looks bad for one thing.

Worse, flailing investments may well call on additional funding and still end up getting nowhere.

Given the structure of VC returns, you’d probably rather cut bait on losers and double down on winners than back a kennel of declining dogs.

Hence some VCs may prefer to put extra money into a company at a higher valuation – and mark-up their existing holding – rather than get more shares at a lower price. (Otherwise known as a bargain to you and me.)

If the capital markets recover then the higher valuation may become credible again. No harm done!

There can be operational issues with a down round, too. For instance, if you’ve granted options or restricted equity to employees at a higher valuation, then a down round is at the least a headache.

But I think it’s mostly a reputational concern for VCs.

Share options and other incentives can be repriced, after all.

And at the seed stage even the founders (and hence major shareholders) of many of these start-ups live at best a middle-class life, despite owning and running companies valued in the millions.

I knew one who was living in a flatshare despite an (illiquid) multi-million pound shareholding, for example.

The point being that the valuation doesn’t affect the founders’ day-to-day life much, nor their businesses. So if a down round is needed to get money in to keep it going, then I say so be it.

But VCs have different concerns. This sets up some interesting conflicts of interest.

At the least I’d urge any start-up CEOs that read Monevator to cut extraneous headcount and non-core outgoings, in order to reduce your burn rate and extend your runway.

It’s possible the risk aversion we’ve seen in 2022 will abate. And there is still lots of cash sloshing around in the bank accounts of rich people (and some funds for that matter) seeking high returns.

But if you don’t survive until such better times then all that’s moot.

Startup founders smelling the coffee

The good news is there has been more evidence of realism recently, even in the frothy crowdfunding space.

Besides job cuts and hiring freezes, I’m seeing cap table restructuring and the like. This may involve tidying up the crowdfunded investors into less unwieldy or onerous structures.

Doing so could make it easier to raise money in the future from professional investors. It can also cut management cost and hassle by easing communication and decision making.

I suppose there will be cases where small investors give up rights in these restructurings, and it comes back to bite us.

But overall I think it’s a sign that the better management teams are getting their ducks in a line.

Another option some start-ups are pursuing are so-called Convertible rounds.

This article is long enough already, so I won’t go into the mechanics here.

But to over-simplify it’s a way of raising money today without establishing a new valuation. Instead investors get a potential discount on a future conventional raise. (The exact terms vary widely).

Convertibles are appealing to founders and shareholders in a weak market, because they sidestep the drawbacks of a down round.

But there’s a Wiley Coyote running off the cliff element to them.

The convertible has a limited amount of time to, well, convert. At that point money handed over by investors becomes equity. It’s a moment of truth where a valuation is established.

Perhaps the climate for fund raising will look better in six to 12 months. But at the moment it seems to me more likely to be worse.

Inflation is still running rampant, roiling share prices, and increasing the odds for more near-term interest rate hikes – even despite a shifting consensus towards a recession as a consequence.

Don’t fool yourself

Of course much of this gloom depends on whether you believe what the public markets have been saying about valuations for the past year.

If you think the stock market sell-off of growth companies is overdone, maybe you can be more optimistic about unlisted company valuations too.

And the turmoil certainly throws up opportunities, as ever.

For instance last month I was able to grab shares in the fintech investment trust Augmentum, which had briefly plunged far below NAV despite a very cash-heavy portfolio.

And as crowdfunded valuations are adjusted down, more attractive options will emerge there, too.

But right now I am more cautious and pessimistic about private valuations than public ones, for all the reasons we’ve discussed above.

Indeed I’ve applied an additional discount to how I value my existing crowdfunded investments.

This is the opposite of what a professional VC fund would do, as I’ve noted.

And at the other extreme, I know even some readers who crowdfund and angel invest themselves who assume their investments are worthless until they see an exit for cash.

But I’m only answerable to myself.

I don’t see the point of self-delusion by pretending I own assets valued at more than they’re worth.

Equally, I don’t believe they are worthless. (Not least because of the tax benefits.)

I’ll run through this markdown in a future post. Subscribe if you’re interested to ensure you see it!

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1. That is, its valuation at least doubles and possibly many times more than that [↩]