If a Bubble Pops in Private Markets, Does it Make a Sound?
In late January some friends and I attended “Product Debaters,” an in person meet up and debate associated with the website Product Hunt, an online forum for posting, upvoting, and discussing new technology products. The service has taken off recently, raising $6.1 million in October of 2014, led by Andreessen Horowitz. The Product Debaters session I attended was the second event of its kind — hosted at an open office tech incubator replete with beer, pizza and ping pong tables. The event featured a panel of 8 debaters who matched off in a series debates — topics ranged from the efficacy of email marketing to the prevalence of selfie sticks. The winner of each round was determined through audience applause. The loser was eliminated while the winner advanced onto the next round, culminating in a final round between the best two debaters that night.
Up until the final round I had really enjoyed the event. The atmosphere was fun and relaxed. The discussion was sharp, quick, and timely. It felt less like a networking event and more like a hobbyist meet up. The two debaters who had made it into the final round were two of my favorites — both proving themselves to be articulate and very intelligent. The final debate of the night was simple and straightforward: “Are we in a bubble?”
Unfortunately for me and the rest of the sober audience (maybe I was the only one), by the time the final round occurred, both debaters had put away enough booze such that what was previously a debate of logic and reason had degenerated into inebriated passion and direct appeals to the audience for votes.
Do you catch my drift?
It’s a question everyone wants an answer to: “Are we in a bubble?” Specifically, are we in a technology bubble? Tech companies are raising money and being bought at sky high valuations. Often times these rich valuations are afforded to companies with little to no revenue (What about profits you say? Ha! Profits are old fashioned), and sometimes to companies without even a PLAN to monetize. User growth and user engagement are any entrepreneur’s ticket to venture capital cash. But just because tons of people send vanishing messages on your app doesn’t mean you’re company is worth $15 billion.
Unlike the dot-com boom — most of this “frothiness” is contained within private markets. The S&P 500 Information Technology subsector is trading at 16.3x forward earnings, relative to the S&P 500's forward P/E of 17.4. That is because the companies that have big weightings in these indexes: Apple, HP, Oracle, Microsoft etc. aren’t what people are referring to when they talk about the tech bubble — they are talking about startups. Snapchat, WhatsApp, YikYak, Nest Labs, the list goes on and on…
It’s as much startup culture as it is the startups themselves that get people talking about a bubble. Casual dress, free breakfast, lunch, dinner, snacks, drinks, decked out offices, it’s all a part of the recipe. Over the last few years of living in San Francisco, I’ve seen this culture dominate more and more aspects of this city. Everything from rents to restaurants, billboards to Burning Man, startup culture’s omnipresence is enough to think “No way, this cannot last.”
But it has, and it continues thrive. Venture capitalists — the source of funds that keep this train rolling — are killing it. According to the research firm Prequin, the overall venture capital industry returned 25.9% in the 12 months ending June 2014 (it’s worth noting that the S&P 500 returned 24.4% over the same period).
As long as VC’s are putting up those kinds of numbers, it’s hard to see an end to this influx of cash into small private companies. The beautiful thing about the VC model is that it’s built to fail. 99 of the companies in a 100 company portfolio can go to 0, provided the remaining 1 gets bought by Facebook for north of $20 billion. The Fund then distributes cash to LPs. LPs sign up for the Fund II. The Fund II goes and invests in 100 companies, 99 of which go to 0… you get the idea.
But even some venture capitalists are getting nervous about a bubble. Bill Gurley, General Partner of Benchmark Capital warned in September of 2014 that startups were burning through cash at an unsustainable place. Adam Valkin, partner at General Catalyst chimed in more recently: “My own view is that we have one, two or three very good years ahead. But then we should be cautious, because there’s no example in history where the cycle doesn’t come to an end and a drag us through a very painful period. There’s no reason that it won’t be the same in this case, and that the pain won’t be as bad or worse.”
Mechanics of a Bubble
What is a bubble? Stated simply, a bubble happens any time an assets market value deviates materially to the upside relative to its fundamental value. So detecting whether an asset is in a bubble is as simple as determining the fundamental value of that asset and comparing it to its market value. Determining the market value is pretty straightforward — what value does the market assign to the asset? Fundamental value is a little bit more tricky…
The more information we have regarding the characteristics of the asset (and the fewer assumptions we need to make), the more likely we are to arrive at an accurate fundamental value. A US treasury obligation that pays a fixed coupon and returns principal at a set date sometime in the future is an asset whose fundamental value is relatively easy to determine. We can discount the future cash flows back to present, assume little to no credit risk, and determine what the asset is worth — say $102.50. If that asset were to appreciate in price beyond $102.50, given no material change in circumstances, rational market participants would sell the asset until it returned to its fundamental value. It is reasonable statement, in my opinion, to say that US treasury obligations are fairly resistant to asset bubbles given the determinability of its fundamental value.
We can continue out the spectrum of the (domestic) investable universe, ranked from known characteristics and fewer assumptions to unknown characteristics and many assumptions. I might rank them as such:
US treasury obligations -> investment grade credit -> high yield credit -> blue chip dividend paying stocks -> other publicly traded equities -> private businesses -> startups -> gold/bitcoin
Intuitively, I’d like to believe that the less we know about an asset and the more assumptions we need to make when valuing that asset, the more susceptible that asset is to bubble like conditions. Given that startups are not transparent, do not have established track records / business models, and their value is largely attributed to predictions about future profitability, it seems to me that a bubble in startups valuations is more than possible, but almost probable. I’m tempted to agree with Mr. Gurley and Mr. Valkin.
But Mr. Gurley and Mr. Valkin have a twisted incentive to warn us about this impending bubble. As the returns on VC capital have increased, more and more investors are flocking into this formerly niche subsector of the investable universe. Three of the world’s largest mutual fund managers: BlackRock, T. Rowe Price and Fidelity Investments have all begun investing in hot private tech companies. Mr. Gurley elaborated in a recent blog post: “Over the last few years, the late-stage (pre-IPO) market has become the most competitive, the most crowded, and frothiest of these financing stages. Investors from all walks of life have decided that “late stage private” is where they want to play.” Mr. Gurley goes onto explain that investing in IPO’s and late stage private companies are very different, effectively saying that the latter should be left to the experts and that the rest of the world should only get to play in the public markets, where public filings and the SEC and auditors can make sure that everything is safe and nobody gets hurt. What Mr. Gurley doesn’t mention is that the influx of capital from non-traditional venture capital investors makes his life more difficult, in that entrepreneurs are less likely to take his cash, and at less favorable terms, than they would be otherwise.
Mr. Gurley’s conclusion is that we are in a “risk bubble” and not a “valuation bubble.” I guess the difference is that valuations are within a reasonable range but that companies and investors are taking on too much risk. I would think that if companies and investors were taking on too much risk, valuations would be high, but Mr. Gurley knows better me.
I agree with Mr. Gurley, I think we are in a bubble. But I don’t think we are in a “risk bubble.” I think we are in a “growth-enhancing bubble” a term coined by French economist Jacques Olivier. Olivier argues that “the impact of bubbles strongly depends on the type of assets on which they arise.” He goes on to say that “speculative bubbles in equity markets can be growth-enhancing. The intuition is that a bubble on equity can raise the market value of firms, thus enhancing firm creation, investment, and growth… A speculative bubble in the equity market essentially plays the same role as a subsidy to research and development (R&D).”
That’s the thing, this massive influx of capital into private startup companies has taken one of the healthiest elements of our capitalist system: creative destruction, and put it on steroids. There are more firms being created, and more firms failing today than ever before. What’s more is that startup culture has removed the stigma associated with failure. Failing is a good thing — much like how a forest fire clears smaller trees and brush, and the ashes fertilize and nurture the growth of newer stronger forest — the remnants of a failed company: intellectual property, ideas, processes, skilled employees, are recycled into the system and help a new crop of companies flourish in a healthy, well-funded environment.
Furthermore, because the “bubble” is mostly contained within private markets (public companies like Lending Club, Twitter and Box are trading at very rich multiples) I have a hard time imagining a scenario by which US economic growth is severely impacted by lowered valuations and/or tightening access to venture capital. No one’s 401k is invested in YikYak, and Mr. Gurley and other well off accredited investors like him can afford to lose a couple of million or two if things turn sour. From a jobs perspective, startups are not big employers, and they tend to hire young mobile people who are more likely to rebound and find work following a layoff.
Sam Altman, president of startup accelerator Y Combinator described the formula of startup success as: “something like idea x product x execution x team x luck, where luck is a random number between 0 and 10,000.” A good economic system does not punish a firm with a great idea, product, execution and team, who happened to draw a 0 in terms of luck. A good economic system gives those people second, third and fourth chances. We should be empowering as many skilled entrepreneurs as is reasonably possible, in hopes of maximizing the draw of a high luck coefficient.
For developed economies, technological advancement is the most important factor with respect to generating economic growth. Given a slowly growing and aging labor force, limited resources, and diminishing marginal returns on capital investment, the efficiencies, new products, and higher quality goods and services produced through advancements in technology are going to be the primary source of economic growth for years to come. Yes, maybe valuations are rich from on a fundamental level, and maybe investors and companies are taking on too much risk, but the system as a whole is booming and we are all better off for it.
Disclaimer: Very little of the above constitutes “original thinking.” Pretty much all of it was ripped from one of the intelligent folks listed below.
Alden, William. “Venture Capital Outpaces Buyouts in Investment Returns.” The New York Times. 21 Jan. 2015.
Alden, William. “Silicon Valley Boom Unnerves Some Venture Capitalists.” The New York Times. 2 Feb. 2015.
Altman, Sam. “How to Start a Startup.” Stanford University. 2014.
Austin, Scott. “Meet the Hottest Tech Startups.” The Wall Street Journal . 18 Feb. 2015.
Blanchard, Olivier J., and Mark W. Watson. “Bubbles, Rational Expectations and Financial Markets.” National Bureau of Economic Research. 1982.
Gurley, Bill. “Investors Beware: Today’s $100M+ Late-stage Private Rounds Are Very Different from an IPO.” Above the Crowd. 25 Feb.2015.
Kutasovic, Paul. “Economic Growth and the Investment Decision.” CFA Institute. 2012.
Olivier, Jacques. “Growth-Enhancing Bubbles.” International Economic Review. Feb. 2000.
Treynor, Jack. “Bulls, Bears, and Market Bubbles.” Financial Analysts Journal. 1998.