My Last Memo On The VC Bubble -- Now Is The Time To Get Out

“No one is satisfied with even exorbitant gains, but every one thirsts for more, and all this is founded upon the machine of paper credit supported only by imagination.” – Edward Harley

This is the last letter I will write about the excesses (read bubble) brewing in the venture capital (VC) industry and in some technology stocks in the public market which have ‘venture appeal’.

Why is this the last memo? First, I have spoken and written about this topic often. There’s little new left to say. Second, I do not like to repeat myself endlessly. It enhances what psychologists call commitment bias. This bias has led many to become ‘perma-bears’, i.e. those who always think the world is coming to an end. I’m not in that camp and do not want inhabit it. I’m simply pointing out that prices in VC and some technology stocks have reached truly manic levels. Purchases at these prices represent a speculation instead of an investment. Further, a bursting of this bubble will present a melancholy prospect for those investors who stay last. These are, in many cases, pensions, universities, endowments, and also mutual funds. It will also hurt employees of the venture-backed companies.

What has happened?

1.       Investors developed a strong preference for private assets

Heading into the Great Financial Crisis (GFC), hedge funds had been the vehicle of choice for wealthy investors and institutions. Most hedge funds mark their positions to market and their values fluctuate on every trading day and are reported to investors on a regular basis. During the (GFC), many investors saw the values of their investments drop as stocks and bonds fell. As these valuations sank, so did investors’ confidence.

Private equity, venture capital, private debt, infrastructure, and such other ‘private assets’ appeared to do much better. The word ‘appeared’ is important. The common theme uniting private assets is that these are marked to market based on underlying performance of the companies, which moves much less than the public markets for securities. Minor setbacks, political news, and fear do not lead to dramatic revaluations of assets downwards. Additionally, the valuations are provided by the fund managers themselves (or their hired consultants), creating a conflict of interest. As a result, even though the performance of the public and private market is often equivalent over long periods of time (adjusting for leverage), private assets give the appearance of smooth, high returns. Investors, having burned their fingers in the public markets, fell into the embrace of the private market.

In reality, investors are trading in very valuable liquidity in exchange for higher leverage, lower liquidity, and higher fees with a view to apparently smooth returns. Buying in the public market and closing one’s eyes to the daily fluctuations would arguably achieve the goals of private asset investing while maintaining liquidity.

2.       Investors developed a strong preference for ‘growth companies’, particularly in technology.

The ‘cure’ for the Great Financial Crisis required global central banks to drive interest rates to very low levels. Some sovereign bonds even traded at negative yields. When rates are that low, generating coupon income becomes nearly impossible and drives investors (whether individuals or institutions) to rely on capital gains to provide targeted returns. This was evident in rising bond prices, rising stocks, etc. which rose for two reasons. First, lower rates cause all assets to reprice upwards. Assets (whether homes, farms, or stocks) are worth more when interest rates are lower. Second, as investors piled supply-demand dynamics caused prices to go up.

Once prices are on the move that alone creates excitement separate from the fundamentals. Equities (whether publicly traded or ‘private’, such as venture capital and private equity) have an added element that makes them ideal devices for speculation. This is because, in addition to dividend payments (like bonds coupon), equities have a future element of ‘what could be’. A 7% coupon bond pays 7% no matter what. But a pharma company can invent a new drug and enhance the fortunes of its shareholders through increased dividends and earnings. A tech company many design new hardware or software. This potential of positive future developments makes equities especially susceptible to excessive and unwarranted optimism.

3.       New technologies developed concurrently

Investors’ receptivity and hope collided with a development that often ignites the fire of speculative excess, i.e. bubbles. That development was the emergence of a host of new technologies, such as smartphones, self-driving cars, drones, e-commerce, apps to do almost anything, ‘big data’, Artificial Intelligence, virtual reality, cloud computing, SAAS, etc. in the period between the 2009 and today. Hopes and dreams of grand returns lead investors to march into the abyss of speculative ventures, money in hand. They imagine a new world where everything will be different; say, robotic chefs, self-flying planes, mind-reading speakers, etc. The visions are sold to them by experts who take on different names in each speculative cycle but retain the same character – disruptor, ‘technologist’, founder, venture capitalist, or the plain old ‘visionary’. Not to say there aren’t true visionaries out there. But we should expect to get one Steve Jobs in a life time rather than one every Wednesday. 

Needless to say, some of these visions may actually come to pass. But the timing and profitability is greatly exaggerated by those promoting these ventures. Such promoters are sometimes fooling investors but, many times, are fooling themselves as well. One has to go back only to 1999 to see that many of the things envisioned at then came true, but not in 2000 or even 2002. They came true in 2016-2017. With the exception of Amazon, the imaginations of 1999 were accomplished not by companies who dreamed them (as most of those died in the subsequent crash) but by others who came after.

How do we know it’s a bubble?

These are many elements present today that were historically present in other bubbles (whether tulips, canals, gold, real estate, rail roads, government bonds, technology stocks, or countless others). These are briefly discussed below.

1.       ‘Something new’: Something new that engages the fancy of the investing public is usually the genesis of a bubble. As noted above, the period from 2009 to today has been especially productive in this regard. Exhibits include, smartphones, self-driving cars, drones, e-commerce, apps to do almost anything, ‘big data’, Artificial Intelligence, virtual reality, cloud computing, SAAS, etc.

2.       Prosperity: Speculative excess almost always occurs during times of prosperity. It’s difficult to get a bubble in the middle of 2008, 1974, or 1929. With unemployment at 3.7 % and stock market at an all-time high, we’re certainly feeling prosperous.

3.       Proliferation of promoters: As honey is to bees, money is to enterprising capitalists. Having seen money, fame, and success accrue to those who were early to start and  fund successful companies, a legion of ‘founders’, venture funds, investment bankers, consultants, and employees have descended upon the venture scene. An elaborate machine is at work to make all of the parties wealthy at the expense of investors. It works like this:

A ‘founder’ or a group of founders dream up an idea. A working product is quickly created, presented to venture funds and early stage investors, and is able to get funded. Goals are set for number of users and other such metrics, but not profitability. Accordingly, money is spent in promotions and sales/marketing to sign up as many users as possible (even though many might leave when the promotion period expires). The growth in users is relied upon to increase the valuation for the subsequent ‘round’ of funding, which is, of course, required to spend more to gather new customers. The business doesn’t generate enough cash flow or earnings to fulfil this very basic task of acquiring new customers. However, that is deemed to be okay because “old rules do not apply to the ‘Web 2.0 economy’, to ‘scaled businesses’, to ‘winner take all businesses’, to ‘flywheels’, or to ‘hyper-scale platforms’, etc.”, notwithstanding the fact that the proven large scale businesses (cable, telephone), platforms (credit card networks), and winner take all (rating agencies) businesses, and hyper scale platforms (search engines) were all profitable from the very beginning.

The higher valuation at a new funding round allows the earlier investors to ‘mark-up’ their valuations and show good returns on their investments though these, of course, are on paper only. These paper gains prove very useful in raising new funds. For e.g. SoftBank’s $100 billion Vision Fund apparently showed a 20% gain in just 5 months (even though it’s not fully deployed) which has allowed SoftBank to start working on raising a second $100 billion fund. The owners and managers of the venture funds take fees from these pools of investor capital and also take equity in the funded companies. The founders take more-than-decent salaries and also equity compensation (which is accordingly marked up at each funding). Same goes for the employees of the ventures who, though not perpetrators of the bubble, nevertheless temporarily benefit from it (on paper). The ‘eventual investors’, the endowments, pensions, universities, mutual funds, etc., see their capital accounts marked up and are quite happy with that. However, they do not have a ready exit, i.e. they cannot cash out their gains. That will have to wait for an IPO or a sale, if there is one. For now, of course, they don’t dream of ever wanting to get out of these investments (which have a rapidly upward sloping curve), a thought process similar that which led to them signing up for long “lock ups” to the hedge fund investments made in 2002-2006 (having tired of the tech bubble losses of 1999).

In the recent cycle investors have preferred to provide private capital. Conversely, companies have also preferred to stay private to avoid the scrutiny of the public markets. The focus on quarterly earnings (and, thus, short term focus) of public companies is blamed for this desire. There is some limited truth to this; limited by the fact that with dual-voting structures common in recent venture/tech IPOs, management is not necessarily beholden to Wall Street’s caprices. However, by staying private longer, the companies and their venture backers are also very happy to avoid facing the realities of life when they can’t decide their own valuations. As long as new investors can be lined up to pump new money in, venture companies can stay private and delay the day of reckoning.

Fundraising for venture has surpassed all limits. The Softbank Vision fund raised almost $100 billion to invest in venture companies. This one fund is larger than the entirety of the venture capital deployed in the United States in the year 2015. That would be incredible on its own if not for the fact that SoftBank is engaged in raising a second such fund! There’s no possible way to deploy this amount of money in venture companies. It’s indicative not of the need for venture funding, but solely that of the aforementioned incentives of promoters to raise funds on which fees can be charged, on which investment bankers may earn commissions, on which consultants and attorneys may levy their fees, and so on. The same funds, then invested at higher valuations allows funds to show more paper gains allowing for further fund raising. This cast of characters feast upon the infinite fund of naivety that exists during speculative episodes. Investors are most credulous near the peak.

4.       Rapidly rising prices: A rapid increase in prices is a characteristic of speculative bubbles. Due to the private nature of venture capital, this is not as obvious today as it would be in public markets. However, it’s very much present. A few examples, include the recent doubling of valuations of scooter companies, whose product has been limited/banned by many cities, is unsafe to use in rain, and whose target customers are engaged in defacing the product. Peloton tripled in 16 months. Snowflake and Stripe more than doubled in 18 months. Go-Jek and Meicai did even better doubling in 8 months. And SmileDirectClub bested everybody when its valuation went up 11 fold over 2 years to $3.2 billion. The common theme in all of these companies? A lack of profit to finance their own operations. Of course elaborate and reasonable sounding explanations are given as to why profits can wait four or five more years while the work of transforming mankind is carried out. But one plus one, by any rules of perverse mathematics, will never equal three and a quarter.

The abovementioned promoters of private venture companies have also resorted to using old tricks to beguile investors. When a private company goes public, it’s often beneficial to generate a ‘buzz’ around the IPO. This buzz allows for the price to rise rapidly, allowing the venture firms to show good quick profits on their investments. It also allows for insiders to offload stock at high prices and to attract employees. One way promoters do this is to IPO only a small portion of the total shares outstanding. Given the current euphoria in the market, demand easily overwhelms the number of shares available causing prices to skyrocket and attracting more buyers. The popular IPOs of StitchFix, Roku, Docusign, and Dropbox, among others, all IPOed less than 15% of their shares outstanding. By comparison, non-venture IPOs routinely sell between 30% to 60% of the float.

But how do the promoters get rid of the rest of their stock? Clearly, if it’s forced upon the market, prices will collapse. So they simply transfer it to the underlying investors in the venture funds at prevailing prices and show large gains. The problem of selling large positions in thus discreetly transferred to the investors.

The startup Brex exemplifies many elements of the bubble. Its business is extending credit cards to other startups who could not previously access such credit without a personal guarantee from the owners. Brex figured out that, without requiring a personal guarantee, the market for its cards would be very large! Brex extends credit based on the amount of money startups have in their bank accounts. Founded less than two years ago, with the product launched only four months ago, one co-founder said the company is on its way to “disrupting American Express.” Further, “if the company grows as much as we expect it to grow, it’s a $100 billion business.” How will it grow to be so large? “We don’t require a personal guarantee… and we can give people a credit limit that’s as much as 10 times higher…in literally five minutes”. And why should it succeed? “…because Silicon Valley companies are very good at spending money but making money is harder”, said the co-founder. In other words, given the large ‘addressable market’ of unprofitable venture companies looking for credit cards without personal guarantees, Brex has a bright future. It’s valuation promptly rose to a billion dollars valuation four months after its product launched!

On the public side, many unprofitable recent tech stocks have seen their prices double or more within the last 18 months. Examples include Okta, HubSpot, MongoDB, Alteryx, etc. Their businesses might be decent and may even do well over time. But the prices of these stocks are so high as to almost certainly give a bad result for the group as a whole.

5.       Weak protections, structures, and securities: In addition to actual fraud, plenty of moral fraud has been perpetrated upon investors. This often comes in the form of weak corporate and capital structures, voting, and remediation rights. In many cases, later venture investors demand rights superior to prior investors and can also sometimes block an IPO from happening.

In the public market, no one demonstrates the corruption of investor protections better than Snapchat. SNAP shares are divided into two classes, with the CEO/Founder owning one class and the public investors owning the other class. The public shareholder class has no voting rights whatsoever. The company which debuted at $17 and traded up to $27 on its first day 18 months ago, is now trading at $7 and barreling towards a liquidity crunch. Were it still private, more capital from uncritical investors might be pumped in (and perhaps the valuation raised on one account or another). But without the ability to change CEOs or, for that matter, vote on anything, no such bail-out has presented itself on the public markets. Unfortunately, SNAP is not an isolated case and examples of abuse of investor protections are not rare.

Of the popular IPOs referenced above, StitchFix, Dropbox, Docusign, Roku, all except Docusign debuted with multi-class structures where promoters will retain an outsized voting power even after selling much of their economic stake.

For an example of weak security, consider the case of self-driving car company, Nio. With a loss of $505 million in just the first half of 2018, a loss of $750 million in all of 2017, and revenue of just $7 million in the first half of 2018 and that of $0 in 2017, the Chinese startup went public in the US market at a valuation of $6.5 billion.

6.       Speculative Contagion: Speculative excess is a state of mind. As such, it is contagious like any human emotion. Consequently, speculative bubbles in history have occurred across many assets at once. Currently, in addition to venture capital, we are seeing speculative excess in crypto currencies, marijuana stocks, etc. All strata levels of society are involved. Even though venture funds are directly available only to wealthy individuals and institutions, crypto currencies and marijuana stocks have not exercised segregation based on economic class.

7.       Fraud: When investors get carried away and let their guard down, cons find it very easy to exploit their gullibility. We’ve seen this with high profile cases like the Theranos debacle but also in other small ways such as the recent Sequoia Capital ‘capital call fraud’. However, most fraud generally is exposed after a bubble bursts. So we should expect more news on this front in the future.

In the crypto currency space, which is also experiencing a bubble, fraud has been the rule rather than the exception. Even where there’s no outright fraud, we’re seeing exaggerated and misleading accounting practices, which are accepted by investors without asking very many questions (e.g. Tesla, WeWork, etc.). In the public markets, many companies are engaged in making almost comical ‘adjustments’ to their earnings to present a picture better than reality.

8.       Low interest rate: In the past four centuries, speculative bubbles have tended to build when interest rates are low. This factor is present today. The connection between rates and the desire/need to speculate was described above in the section, “What has happened?”

9.       A mass rush to become involved: The graduating classes of undergraduates as well as MBAs are shunning traditional post-graduation jobs to join the legions of startups and venture funds cropping up daily. Even established professionals have quit their industries to join startups. In the beginning investment bankers left to become tech executives. Most recently, Gary Cohn (ex-COO of GS and White House Economic Adviser) joined a block chain startup, Spring Labs. Further, in addition to large investors, mutual funds (Fidelity, T. Rowe Price, Wellington) have also invested in late-stage venture companies. Those owning these mutual funds have thus become involved, whether they know it or not.

On the other hand, to be fair, there are two elements of speculative excess which are not widely present to my knowledge.

1.       Credit: Buying and selling on credit is generally seen in bubbles. While we are not seeing this with venture capital, it’s not totally absent either. First, when the partners of a venture fund invest on behalf of their limited partners, they are not using debt. However, it has much the same effect as using other people’s money, which is what debt is. The venture partners are entitled to the upside in betting client funds but not the downside.

Further, SoftBank’s Vision Fund does employ leverage in the form of preferred shares. These were required to be purchased by the LPs as part of their equity investment, whereas SoftBank only bought the equity for itself. Thus LP’s provided leverage for their own returns and for SoftBank’s returns! Of course, SoftBank also has fees and carry on invested capital, which again is a leveraged payout as described above.

2.       Flipping: Buying assets solely with a view to selling them to the next person is a common characteristic of bubbles (such as crypto, tulips, canal scrip, consols, and marijuana stocks). However, we have not seen this in venture. That may be due to the difficulty associated with flipping venture investments, where the partners of the venture firms are expected to work with the investee long term on building the business.

How will it burst?

This is always tough to know. But to ignore the possibility is to shut our eyes to all prior history. Sometimes there’s a particular reason (such as mortgage rate resets in 2007) at other times there’s an external shock to the system which collapses the scheme (antitrust case against Microsoft in the year 2000). Yet other times, the bubbles simply collapse under their own weight. How it will end is not as important as it may seem. If we know there’s a fire in the movie theatre, knowing who will yell ‘fire’ is not as crucial as leaving as soon as we are able.

Yet, if I can make one observation on this topic, it is this. Bubbles only grow because risks are ignored. As a result, internal risk factors are not able to prick the balloon. Whatever kills the bubble will have to be an external shock as the market participants have already ignored almost all internal risks: competition, data breaches, regulation, expense growth, cap-ex growth, expanding losses. What will cause VC funds to stop funding? Only a lack of LP interest. What will cause that? Possibly something external. Once the external trigger is pulled, it’s the internal risks (heretofore ignored) that move to the forefront to finish the job.

There’s one additional peculiarity to the VC bubble. There’s no liquidity! Given that there’s very limited secondary trading, it’ll be very difficult for investors to get out of their investments as they watch them sink in value. However, the funds will try their best to not allow this sinking to happen too fast, seeing as the valuations are within their control (i.e. done by them). However, the pain, though delayed, must eventually come. Owing to low liquidity and control over valuations exerted by VC firms, the pace of decline is likely to follow the same trajectory as that described in Hemingway’s book, ‘The Sun Also Rises’. When asked, “How did you go bankrupt?” the Mike Campbell responds, “Two ways. Gradually and then suddenly.”

Who will be affected?

1.       Investors: One set of obvious victims is the investors. Unfortunately, this includes universities, pensions, not for profit endowments, foundations, etc. It also includes those who have purchased interests in special purpose vehicles or mutual funds that have invested in venture capital funds or directly in the underlying companies.

2.       Employees: Venture funded companies have attracted talent by the promise of equity awards, whether stocks or stock options. These employees are under the illusion that their equity awards have multiplied in value based on baseless valuations placed upon their employers by the venture funds. Each round of funding has diluted their equity interests. Should these companies collapse, the employees will find themselves without work, with equity they find out is worth much less than they imagined, and competing with the other freshly unemployed for a few job openings that remain.

What should you do?

1.       Investors: It’s easier to call attention to the difficulty than it is to propose a remedy. It’s not easy to get out of venture commitments. The best course is to find a secondary buyer if possible as an ounce of prevention should prove to be worth a pound of cure. Even a haircut of 10-15% to a current valuation (at which the investors will still likely realize gains if they sell now) will seem very modest compared to what they’ll get down the road. Further commitments to venture capital funds are to be avoided. Those owning mutual funds or special purpose vehicles, should consider selling. They should not think that they can identify ‘the top’. End of speculative bubbles come swiftly and even those aware of the bubble and waiting to get out can get caught. The other side of the coin is that investors will find opportunity in the washout, when the prices are right and the cream is separated from the crap. For e.g., if WeWork collapses, it might create real-estate opportunities in NYC and other cities.

2.       Employees: Employees are best served by taking advantage of this job market to find work with profitable, well-established firms, even if they have to leave some equity awards and bragging rights on the table as the cost of leaving their employer. At the very least, they should try to sell their employee equity on the secondary market that has emerged for such purposes.

“…the sudden Fall of our Stocks, without visible reason, is the Surprize of the world” – Applebees’ Journal, 1720

Disclosure/Disclaimer:

Under no circumstances should this communication be construed as investment advice or a recommendation to buy or sell any security, whether expressed or implied. Factual statements are believed to be truthful and reliable, but are not warranted against errors or omissions. Please do your own due diligence prior to investing.