When you get money for borrowing money
On April 4, 2000, we completed the business plan for btov (then operating under the name “BrainsToVentures”) — coinciding with the beginning of the collapse of share prices on NASDAQ. When we were online with the Internet platform “BrainsToVentures” several months later, we were in the middle of a bloodbath.
Every week, another well-financed, well-known startup announced its bankruptcy. Our start couldn’t have been rougher. “The Internet” as a foundational innovation disappointed many at that time and while in 1999 almost everything was financed that started with “www” or contained an “@”, in 2001 the consensus was very quickly reached that “touch & feel” was needed for some areas of life — and that’s why you wouldn’t ever buy shoes or clothes on the Internet. We know what has become of Amazon and Zalando — even though the latter was only founded in 2008 in the context of the financial crisis.
Changes in a society and entire industries therefore take time. Nothing new about that either. But what about the biblical 7 fat and lean years? Shouldn’t we have seen in a phase of collapsed stock markets again long ago? A geometric look at the waves of the market would at least suggest that. Until a few weeks ago, I thought so in the belief that the stock markets would have to undergo a massive correction. I don’t think that anymore or at least have an idea why this time there is a fundamental difference which may be the cause of the delay of the correction. Namely: the interest rate environment and thus the bond market — the “antithesis” of the stock market. A great deal of capital has historically been shifted between these two asset classes, depending on interest rate trends, the market situation and the economy.
Until a few weeks ago I have always argued that the move in the last 10 years from 6–8% interest rates down to 0.5% was much more serious than the one from 0.5 to -0.5% in the recent past. This is relatively correct, but wrong in view of the long-term effect of compound interest. While wealth multiplies with positive interest rates, negative interest rates tend towards zero. If I get money for borrowing money, then it is reasonable to assume that money is worth nothing. Just to illustrate the compounding effect of interest, the following calculations show where capital of USD 100 is invested for 30 years.
At an interest rate of 6%, the original USD 100 is then USD 574. At an interest rate of 2%, it is USD 181 and at -2%, almost half has disappeared and USD 54 remain. What does that mean and how can we classify the current situation? The current environment is presumably one that
1) has never been there since the creation of central banks and leaves economists astonished,
2) plays into the hands of governments because they seem to perform well with their budgets and
3) makes assets shift to those who are already wealthy in a massive way.
I am very excited to read something really forward-looking on point one — and of course I look forward to any hints on it. As far as governments and their budgets are concerned, we can be curious to see how independently central banks really will behave in the coming years. On point three — the shift in assets — I would very much like to go into it from my perspective as a venture capitalist (VC).
The starting point of my thinking is a news item that irritated me this summer: SoftBank is lending its managers USD 20 bn (!), which they will then invest in SoftBank’s next Vision Fund. After Vision Fund 1, which was the biggest VC fund of all time, Vision Fund 2 aims to reach a size of an even bigger USD 108bn. If the fund should yield “only” 1.5x (yes — in our VC world we talk about multiples and not in percentages), the Vision Fund management team would realize USD 10bn as profit on their own investment in addition to the Carried Interest of presumably USD 5–10bn. This is an unimaginable income for a group of a few investment managers, especially since it can be assumed that the majority of that gain will concentrate on top management and that this will not be their last fund. Of course, SoftBank management also takes on considerable risks that many people do not want to take upon themselves. This is the case and it is also good that courage to take risks is rewarded. And it remains to be seen whether the determined SoftBank bet with risky, capital-intensive investments such as WeWork will really work out.
However, it is also the case that “normal savers” have no systematic access to the investment opportunities compared to an investment manager at SoftBank. Due to its sheer size, SoftBank can participate in nearly all the fastest growing technology startups in the world, as there are not many investors who are able to invest hundreds of millions or even billions of dollars. On the other hand, pension funds that are only allowed to invest in liquid stocks via stock exchanges now have access to growth companies much later. As a reminder: Amazon, Apple, Microsoft or SAP went public when they were worth about half a billion to USD 1.5bn. Companies today tend to go public much later. It makes sense to them — they can focus on their product and clients longer without being exposed to public quarterly results. These late stage investments however are often linked to minimum returns through ratchets or convertible loan constructions, which is not possible with IPOs. This means that equity often takes on the character of bonds.
What does the current situation mean for institutional investors such as insurance companies or pension funds? Let’s take the “second pillar” I’m familiar with in Switzerland for our thought experiment. Compared to the first pillar, the “AHV”, which is financed on a pay-as-you-go basis, this part of the Swiss pension fund system is a purely capital-based construct. But: the “conversion rate” is currently 6.8%. For every CHF 100,000 saved in retirement assets, this conversion rate results in a pension of CHF 6,800 per year. If all the funds of these pension funds were invested in “safe investments” such as the recently issued 30-year bond of the Federal Republic of Germany at -0.5% p.a., the equation would obviously not work out. Even if you take mortality into account the pension fund has to produce returns of at least 4.5% annually. Let us therefore assume that “only” 50% would be invested in these investments — the second half of the capital would then have to yield around 9% per year — net of all costs. That raises questions. Probably the conversion rate would have to be massively adjusted in times like these — and so would expectations. And we would have to invest more in real assets such as equities, but for sure without seeking the great salvation of high-growth startups with an over-allocation in this asset class. We ourselves experience again and again painfully how failure feels as a professional VC. And when countless new VC companies spring up in times of cheap money, the bankruptcies will shoot into the sky again like after the bursting of the dotcom bubble.
But the big question remains: How and why do we get out of this low interest rate environment again? The idea of Nobel Prize winner Milton Friedman to simply distribute money (by helicopter) to the entire population will be more tangible than ever before — even if the picture seems crazy. And we should win pension funds as VC fund investors — with tiny amounts and an awareness of the retirement needs of millions of workers.
