Should Private Startups Be Issuing More Bonds?

I just spent the morning watching this interview:

Go to 1 hour and 11 minutes.

Michael Milken says, more or less, the following:

~“I worked at a firm that used to recommend stocks. Yet of the 100 best stocks they recommended, only 20 of them had corporate bonds, because the rest were not investment grade.”~ ← or something like that.

At the time, people knew that some equity investments were riskier than others, or had less opportunity than others, and so they knew that different prices should be applied to different companies. It struck Milken that: they could say these 100 companies were the best equity investments an investor could make… and yet, 80% of them weren’t even available in debt markets.

“Pricing” had not yet hit bonds. Companies were either risky, or not risky. At the time, if they were not risky, you could buy them for low yields, and if they were at all risky, they couldn’t issue bonds at all (the only reason a high yield bond might be traded is because it used to be not risky when it was issued, but had since become risky post issuance).

The point was — that there were many good companies in the world, who didn’t happen to be investment grade.

But did that mean you couldn’t lend to them at all? No! Of course not.

It just meant you should require a higher yield.

The conversation then fast-forwarded to today. And we can look at some of today’s largest startups. Uber raised $2B of debt. Yet the bond is rated B-. Uber is a company worth $50–60B. What are the chances the company ends up being worth less than $2B such that bondholders won’t get their money back at par? Yet — their debt is considered “junk.”

WeWork also issued $750M of debt at a B+ rating. WeWork owns real estate — and received an offer to be purchased for $16B. Is there really a world — despite how over-valued the equity is, where the company is worth less than $750M? Yes… but not a probable world.

And while rating agencies make judgments on the riskiness of companies, they are not exactly “innovative.” (By the way, they shouldn’t be).

But that lack of ability to innovate, means they haven’t been able to evolve their methods to evaluate a wave of companies that have been grown and valued differently than companies before them. Companies never used to reach $50B in private markets on the back of VC. And so the rating agencies just see them as “a startup.” But you can’t compare Uber to some $2B market cap company that makes $20M in EBITDA — because Uber’s not running itself to maximize profitability.

Rating agencies don’t know how to judge new companies built and capitalized in a way that’s never been seen before. So these companies get crappy ratings.

If you go on LendingClub, and buy consumer loans — you end up receiving a mid-to-high single digits yield. Yet I could get the same yield on the senior-most-debt of a company worth billions of dollars.

The bottom line is: VC’s have gotten really good at figuring out how to back the equity of founders, and help those founders build big companies that scale quickly. But they still haven’t learned how to put together an efficient capital structure. More companies, especially ones worth over $1B, should have debt that can be collateralized by the equity of the business.

It’s insane that reporters will say stuff like: “VC firms really need to get a 3x return on their investments to be considered good”… when many of these VC firms aren’t VC firms anymore. They are growth equity firms who own the senior-most security of multi-billion dollar companies. And those senior-most securities, especially if they are not levered, could yield anything about double digits and be a total home run.

The answer is not to keep bidding up preferred equity at higher and higher prices, but rather turn to different securities that can capitalize a business more efficiently.

Doing diligence on a bond issued by a startup, in some ways, is more challenging. If you buy a bond issued by a public company, you can look to its assets and to its equity value to ascribe an LTV (Loan to Value). And the assets are reported regularly, and the equity value is validated by lots of trading volume.

The problem with startups, is that for a company to receive a “value,” only one partner at one firm has to agree with that valuation, and so the equity value may not be what the sticker price says. BlueApron was worth over $1B and months later is worth $180M. And great firms backed that company! It would have seemed like a $100M bond issuance to a $1B company should have been fine. But in reality, you’d be in a tough spot right now if you had bought those bonds.

Whereas with a public company, everyday people buy, sell and trade the stock, which validates that there is a market for the equity.

So it’s complex. But it’s only complex because it’s new… and because a market hasn’t been formed yet. And that complexity or “newness” is why the first people who get into the space are going to make a real name for themselves. It’s part of why we’re so excited about SecFi, and what they’re doing.

For younger investors (people like me) it’s easy to look back and say: “man, I wish I had been a VC in the mid-nineties when everything was so easy.” And for people in the nineties, they probably thought about that with LBO’s in the late eighties, or junk bonds in the late seventies.

But what will people think about 20 years from now, in regards to the 2017–2022 time period. My bet is it’s this:

(1) A total dislocation happened, companies stopped going public and stayed private longer.

(2) Companies were becoming with $5-$10-$15 billion dollars on the back of preferred equity and convertible notes. There was no sophistication in the capital stack.

(3) And yet, despite VC’s having access to more money than they knew how to deploy into equity… all anyone did was complain about liquidity — rather than lend money to these companies so they could do stock buybacks from their employees, gather more ownership, relieve liquidity constraints for individuals and shareholders and be sophisticated capital allocators.