Instacart and Valuation Risk

When the grocery-delivery service Instacart became a public company in September 2023 it meant the culmination of a decade-long investment for seven public pension funds. The experience of these funds — along with at least a dozen more who followed them — provides a helpful case study of the pros and cons of state retirement systems investing in private equity.

Specifically, there are several lessons that jump out of the Instacart as private-company-to-IPO experience for pension funds:

1. First, private equity investments can generate positive returns. While skepticism about this asset class is warranted, there are some reasons why it’s become a popular form of pension fund investing.
2. Second, however, the positive returns (if created) are not always worth the risk of private equity investing. There are lots of ways to generate a return, so private equity returns need to be more than a less risky form of investing could produce.
3. Third, and even if the positive returns are high enough to warrant the risk, if the underlying valuation process that prices the investment along the way is misguided it can actually make unfunded liability problems worse.

The first two lessons above are relatively common points. The third lesson, though, isn’t necessarily intuitive.

Consider that there are pension funds who have made money on their Instacart investment who also have more unfunded liabilities today because of how their investment in Instacart was managed. Here’s how:

• In 2021, the valuation of Instacart by private investors was $39 billion. So the private equity firms who were managing public pension fund assets told those state retirement systems: “Value your stake in this company based on that $39 billion.”
• Each of those pension funds then counted their share of the private grocery company at that rate in their total assets, and reported that to actuaries. Those actuaries then took the total reported asset amount and used it to calculate unfunded liabilities and determine necessary contribution rates.
• But two years later when Instacart IPO’d they valued themselves at $10 billion — a 75% cut in value. Which meant that as of the date of public launch, pension fund investments in Instacart had declined by 3/4ths from whatever they thought they owned in 2021. Which meant they should have been asking for more contributions before and now they’d need to recognize slightly higher unfunded liabilities (all else equal).

This is what happens with the valuation risk associated with private equity investing isn’t adequately managed. And it has very real implications for public workers and taxpayers today—not just for pension funded ratios in the future.

This table provides another way to think about the way valuation risk manifests.

Instacart Investment Examples

Notice from this pattern that the valuation basis of Instacart was steadily going up over these first few years of external investment, as would be expected. By 2017, the general partners at private equity funds who had invested in the first three rounds of Instacart would be reporting to their pension fund partners that the investment was profitable.

By 2021, with the valuation of Instacart more than 10 times what it was in 2017, the investment return being reported back to pension funds in these first four early rounds was a very strong return.

However, by 2023, the valuation had declined by another considerable amount. When the dust settled, all of the pension funds investing in Instacart between 2013 and 2017 will have been able to get a positive return. But that return was not as much as reported in 2021. Which means the value of their investment in Instacart declined. Which means the value of their assets declined.

While the whole investment might have been positive, the intra-investment process meant that these pension funds ultimately will have to recognize a “loss” in asset values, relative to previous reports. And that means that they didn’t get appropriate contribution rates into the pension fund in the past—and that means the valuation process made unfunded liabilities worse than they should have been.

Let’s break this down:

1. How Did Pension Funds Invest in Instacart?

One of the private equity firms that participated in Instacart’s early stage, Series A investment round was Canaan Partners through their “Canaan VIII” fund.

That specific fund had a few dozen limited partners, including eight public pension funds, such as the Alaska Retirement Management Board (which manages commingled funds of a half dozen state pension funds), the Regents of the University of California (which includes money managed for the UC Retirement System), and the San Francisco Employees’ Retirement System. Some of the pension funds invested in Canaan VIII committed just $2 million to $4 million, while others were committing between $20 million and $35 million. (In every case the money provided was a small share of the multi-billion dollar portfolios of pension fund assets being managed.)

The Series A round in 2013 provided $10.8 million to Instacart, of which a portion came from Canaan VIII. The deal valued Instacart at $25.4 million. The following year Canaan VIII participated in the Series B round by putting in more money, this time based resulting in a $354 million valuation. Which meant the prior year’s investment had now generated a more than 10x return — at least, on paper, it was a profitable return.

In the coming years, Instacart would raise more money, including drawing in more private equity firms with pension fund dollars. The Series C round in 2015 included money from the “Khosla Ventures Seed Fund,” which was managing commitments from at least four pension funds including CalPERS. The 2017 Series D round included an investment from“Khosla Ventures V,” which has a half dozen public pension fund limited partners, such as the State of Michigan Retirement Systems (which is a commingled fund of assets from five statewide pension plans).

Each of these investment rounds raised the valuation of Instacart such that by 2017 the paper value of the company was $3.4 billion, and there were at least 18 public pension funds invested in the company (along with dozens of other private investors).

In March 2021, Instacart raised its final late stage round of investments. This transaction included more than three dozen investors (none of whom appear to include pension fund dollars) who collectively agreed the grocery-delivery business was worth $39 billion.

2.  Pension Funds Can Generate Positive Returns from Private Equity Investing

There are generally two ways that pension funds get a return from their private equity investments: either the private equity fund that they’ve allocated capital returns more money to them than sent out (likely using money from the sale of a company to another private firm), or shares acquired from a private company investment going public are sold at a date after an initial public offering.

Going back to that Canaan VIII fund — it was launched in 2007 and raised $650 million from several dozen limited partners. The fund made investments periodically over the following decade, some of which were successful and some of which failed. However, the net result has been positive. According to Pitchbook, Canaan VIII has distributed back to its limited partners around $920 million (as of March 2023).

One of those limited partners, the University of California (UC), reported that as of June 2022 their $35 million commitment to Canaan VIII had resulted in payments back of $50 million, with another $2 million in investments remaining in the private equity fund.

This narrow selection of data does show that private equity investing can work. UC provided money to Canaan Partners, which put the money in its Canaan VIII fund. That fund invested in dozens of companies, some of which failed, some of which were solid, some of which IPO’d. The net result was more money earned than invested.

Of course, this isn’t the only kind of result that comes from private equity investing. In the same 2022 report from UC noted that they lost money on a 2005 allocation to Perseus Partners VII (a $107 million allocation that returned just $34.6 million by the time that fund closed), but they doubled their money on a 2008 allocation to Ares Corporate Opportunities Fund III (a commitment of $73.7 million that turned into a distribution back of $144.5 million).

3. Positive Returns are Not Always Worth the Risk

CalPERS joined the ranks of Instacart investors through its $60 million allocation the Khosla Ventures Seed fund in 2009. That private equity fund deployed capital to nearly 100 companies such as Stripe, Jawbone, and the 2015 Series C investment round in Instacart.

At a glance, the Khosla Ventures Seed commitment looks like a winner for CalPERS. They’ve already received back $12 million, as of December 2022, and Khosla Ventures estimates that the value of the remaining investments they’ve made is worth another $102 million that will be distributed to CalPERS at a later point. Since this data is as of December, that would include the investment in Instacart.

The problem is that while getting $114 million back on a $60 million investment is positive, there are other ways that $60 million could have been invested. For example, a $60 million investment in the S&P 500 as of January 2009 would be worth over $400 million today.

CalPERS reports that the “internal rate of return” on the $60 million investment is just 6.6%. Similarly, Buyout Insiderreports that the internal rate of return on the Canaan VIII fund (with Instacart as a portfolio company) is returning around 9% for their pension fund limited partners.

That kind of investment return isn’t worth the risk. On the flip side, a 2015 investment by CalPERS of $400 million in the“Insight Venture Partners Growth-Buyout Coinvestment Fund (B)” has already generated returned distributions of over $600 million with another $900 million of value theoretically to be distributed in the future—which would be a 32% x return and exactly the kind of huge reward that retirement systems are looking for.

4. Overstated Valuations Can Turn a Positive Return into Funding Problem for Pension Funds

The retirement system assets invested by the University of California in the Canaan VIII fund have produced a 9.1% internal rate of return for UC, as of June 30, 2022. By any measure this is a nice return—not great, but positive and above their assumed rate of return. However, as of June 30, 2014 that same Canaan VIII fund was reported by UC to have a 16.9% return.

That means that unfunded liabilities in 2014 were (slightly) understated and actuarially determined contribution rates should have been (slightly) higher. One private equity fund isn’t going to make or break a pension fund, but if enough similar overstatements were made that could have had a damaging effect on the University of California Retirement System. Not only were overstated valuations in 2014 going to have given confidence to trustees that they should continue their investment strategy, but the overstated valuation meant less contributions than should have been made. And having less in contributions year to year is a key way that pension funds can go insolvent.

As already mentioned, the specific valuation of Instacart in 2021 would have fed into the valuation process for the private equity funds that were investors. That would have influenced the reporting on each private equity fund in their reports to pension funds. And that would have a damaging influence on the pension fund.

Again, no one company or private fund is going to make or break a pension fund. But if state retirement systems are not tracking their valuation risk, then a whole series of overstatements could create a problem.

5. What to Do About This

To improve the clarity of asset values for a pension fund, existing financial reports (ACFRs and valuation reports) should be supplemented with a section that breaks out asset reporting into two categories: the dollars that are market valued (as in the value based on market signals) versus valuation valued (as in based on estimated of what a normal sale would produce).

In practice this would not require any additional calculations or assessments other than to group assets into the two categories and report them.

Just as GASB reporting requires that liabilities be shown with a discount rate that is plus or

minus 1% — so that there is a range of values shown — so too would this approach be designed

to provide some clarity about the veracity of funded status metrics and measured contribution rates based on certain asset values.