Startups: Market Action, Valuations & Bears
August 2015’s public market volatility seemingly spurred new creatures in Silicon Valley’s ever-weirder lexicon. Brad Feld highlighted the Unicorpse. Mattermark CEO Danielle Morrill introduced “Zombie Unicorns”. Finally, Dan Primack echoed Hunter S. Thompson’s LSD laden classic, “Fear and Sadness in Silicon Valley”.
This week, Tomasz Tunguz, my favorite VC blogger, set data against these images. He suggests that we are in an odd time, but not because of the lofty valuation, fundraising, or capital deployment stats alone. Rather, it’s the discrepancy of the seemingly healthy metrics (large amount capital funded to startups) against the unhealthy ones (shrinking numbers of IPOSs) that make the puzzle difficult to piece together. And this is the key. The discrepancy itself is the story.
One of the biggest perks of business school is access to great speakers. Two weeks ago, Howard Marks interviewed Stanley Druckenmiller (Thanks Wharton!) about his storied macro-investing career. Some folks in Silicon Valley are likely familiar with Howard Marks, but my guess is few know Stanley Druckenmiller. This should change.
Between 1981 and 2010, Druckenmiller generated returns close to 30% annually for his investors in Duquesne Capital. More impressively, he never lost money on an annual basis. Yet, what’s most intriguing is Druckenmiller’s approach. Instead of relying on typically cited top down macroeconomic indicators like GDP, employment statistics, and wage growth to evaluate the economy, Stanley used bottom-up leading indicators such as changes in credit spreads or divergences in stock verticals (especially retail and housing) to understand where the market was headed. These indications, based in changes in underlying asset classes, are called market action. Studying the changes in market action is what enabled Stanley to identify and profit enormously in both the 2000 Tech Crash and 2008 Housing Bubble.
Bear with me for a quick technical sidebar. John Hussman, a lesser-known hedge fund manager, explains the connection between market action (internals) and market valuations well:
“When the uniformity of market internals conveys risk-seeking among investors, undervalued markets tend to soar, overvalued markets tend to remain stable or become more overvalued, and measures such as overbought readings and bullish sentiment may act more as trend-following indicators than as contrary indicators. Overvalued, overbought, overbullish conditions can be unreliable warnings in that environment, particularly when the Fed is actively encouraging yield-seeking speculation. In contrast, when divergence and breakdown across market internals conveys a shift toward risk-aversion among investors, overvalued markets tend to collapse, undervalued markets remain vulnerable to losses, and measures such as oversold readings and bearish sentiment act more as trend-following indicators than as contrary indicators. Undervalued, oversold and overbearish conditions often do nothing to halt further losses, even when the Fed is easing very aggressively.” (full text)
Druckenmiller and Hussman’s idea of market action is not restricted to public markets. On the contrary, the connection between market action and valuation is the critically important relationship to understand what is currently happening in Startupland. Valuations are the current point of obsession. The terms “Unicorn” and “Decacorn” say it all. However, in the short-term, valuations don’t make or break markets. It is investors’ actions and risk-appetite that do.
STATE OF THE VALLEY
Keeping in mind the idea of market action, let’s look at the state of Silicon Valley. Mattermark’s Q3 Report highlights the diverging market action currently developing in the startup ecosystem. The report indicates deal volume is down 27–29% YoY in 2015. 2015 has seen 1000 less deals funded than 2014. The biggest drops are in the Seed, PE, and Late stage markets.
However, against this backdrop of declining deal volume, round size and total capital deployment are up. Significantly. The first 3 quarters of 2015 saw 41% more capital deployed than 2014. This is most apparent at the Late Stage (75% increase). To reiterate, Late Stage deal volume dropped 7% YoY, but total capital deployed to the Late Stage increased by 75% YoY. It’s surprising to see these metrics so inversely correlated, and the breakdown in market internals here suggests something is going on.
Yet, odd market action is not limited to the Late Stage. Strange things are happening in Early Stage investing as well. While Seed/Pre-A investments were down 47% from 2014, record amounts of money are coming onto sites like AngelList. Just this week, AngelList announced a $400MM partnership with an upstart Chinese VC Firm: CSC Upshot. This isn’t a knock against AngelList, who is providing an important vehicle to help early stage companies. It’s simply another observation of shrinking deals set against increasing capital allocation. Similarly, massive sovereign wealth funds are now leading Series B/C investments. It seems that with enough capital, large investors believe they can set up a “unicorn mining” operation.
IPOs (aka “the new down round”) tell a similarly confounding story. Comparing IPO volume to the number of private market companies with “public level” valuations indicates another divergence in market internals. 2014 saw 275 IPOs in the USA, raising collectively close to $90B. Yet in Q1’15, the same quarter the S&P500 first broke $2,100.00, US IPO volume dropped to just 34 companies raising $5B, an amount smaller than any quarter in 2013 or 2014. Through October 2015, there have been 147 IPOs, which is approximately 64% of the same YTD 2014 amount. Yet, on the private markets, Fortune’s Unicorn List currently shows close to 140 “Unicorns”. The rate and amount of money going to these companies only seems to be increasing. Again, the market action seems inversely correlated to what would be anticipated in a “healthy” startup environment.
With all this divergence, what’s going on? Some of this inevitably stems from the current ultra-low interest rate environment. The lack of yield available to investors has pushed unfamiliar money into private tech markets. Marc Andreessen’s recent “Grand Unifying Theory” explains it well: “[Investors] tell the public company CEO, ‘Give us the money back this quarter,’” (and) “They tell the private CEO, ‘No problem! Go for 10 years!’” Cheap debt is driving earnings optimization through record share buybacks on the public markets, while private companies are being funded with warchests to grow for the long term. Again, we’re noticing a theme: divergence in market internals from what would typically be expected. How much of this is tied to zero percent interest rates? I’m not sure, but ultra-low interest rates are definitely driving additional speculation in the private tech markets.
The key takeaway about market action is that it conveys a change in sentiment. It doesn’t in-and-of-itself signal a bubble, but instead reflects the underlying risk-appetite investors are displaying. When ultra-high valuations meet diverging market action, things have a tendency to fall apart quickly. I believe this is what is driving many of the large Late Stage rounds. Smart money is preparing for a less friendly economic period, and padding private balance sheets to survive the winter.
No Silicon Valley “Boom or Bust” story is complete without an animal these days, so to conclude I bring you the “Bear”. Bears are incredible animals. They eat everything from honey to walruses. They can run nearly as fast as a Thoroughbred and swim in open ocean for 100 miles. When rookie investors leave food on the table at the campsite, bears join the picnic. However, when winter comes and the free food dries up, bears can hibernate for months at a time to endure brutal winter conditions.
Unlike the Unicorn, which requires a fictitious story to exist, the Bear is unconcerned with the prevailing sentiment and economic conditions. It is practical, has great unit economics, runs a minimal burn, adheres to a long-term vision, places the customer first, and avoids solving mythical problems. Amazon is a model Bear. It lost 90% of its value after the Tech Crash, only to build it back nearly 100x. Today it continues investing every dollar of operating cash flow to build a long-term business that can still, two decades later, provide shareholders multiples on their investment.
It’s not coincidental Bears thrive through and out of Bear market cycles. They are companies learn to forage for talent, hunt for sales and dollars, and survive on limited resources when things are not plentiful. Unlike Unicorns, Bears are real. With valuations sky-high and market action in Startupland degrading, we will likely soon see who is a Unicorn and who is a Bear.