This article was originally published in Barron’s magazine.
Q1 hedge fund letters, conference, scoops etc
Markets are buoyant this week on the Fed’s hints of potential rate cuts. But interest rates have been low for more than a decade already and there are downsides to persistently low interest rates: such rates have in the past caused the creation of bubbles. These are then rapidly deflated by rate hikes, recessions, or hiccups in the corporate bond market. There’s reason to worry we’re in a low-rate-fueled bubble today: just look at the venture capital market.
When it comes to debt and interest repayment, there are three categories of companies. Conservative companies can make interest payments and pay off debt when it comes due from their cash flows.
Then you have speculative companies—they can pay interest from their cash flows, but they constantly have to roll over debt.
And then you have the Ponzi-like companies. They can’t cover their interest costs, never mind their debt. They are relying on the kindness of tomorrow’s capital markets. These companies are hoping to one day get to scale through growth and turn into speculative and then conservative companies.
Today a significant number of Silicon Valley companies seem to live in a hallucinatory, Ponzi-like state. They are typically not financed by debt but by equity. Their equity sugar-daddies are venture capital firms, which in turn are financed by pension funds that are sick of hedge funds’ underperformance and are looking for uncorrelated returns. I think they’re just looking for any returns.
So this is how it works. A startup has an idea, and they are raising, let’s say, $10 million in the first round of financing (usually called “series A”). A private equity firm gives them $2 million at a $10 million valuation and says “Grow!”. They hire some engineers to develop a product, but they know that if they are to get more money, they need to show growth. How do you get growth? You spend money on advertising. So some of the $2 million goes to Google and Facebook to drum up customers.
Sometime later, they have burnt through the $2 million, and there is still no profitability. They need more money. But now they have proved the concept and have more users and higher revenues. Here comes Series B. And now this company is valued at $100 million. The venture capital firm owns 20% of the startup and can show a 10x return to its investors. They give another $10 million for another 10% of the company. Again, part of the money goes to improve the product and another part goes to acquire users on Google and Facebook, with more, maybe, to Amazon’s AWS (web services) to host the product.
In an environment where returns in debt markets are 3% or 5%, hedge funds are not doing much better, while venture capital gives astronomical returns. Who would not want a piece of that? So you’ll have rounds C, D, and F and G and beyond, and each one comes at a higher valuation. Most importantly, the higher valuation is driven not by higher profitability but by higher revenues. Who cares about profits when the supply of financing seems to be endless?
Paraphrasing the great Peter Drucker, you will value what you can measure. Since capital is abundant, who cares about profitability—revenue is what gets measured.
At some point this music will stop. Conservatively financed companies don’t rely on the kindness of markets; speculative companies need capital markets to function; Ponzi-like companies need capital markets to stay crazy.
I am not sure what will cause it, but we will reach a point when future funding rounds may not come, or if they do they’ll be at much lower valuations. Billions of dollars will be lost.
What’s more important from an everyday-folk perspective is that we’ll discover that companies like Facebook, Google, and Amazon (through its AWS division) will suddenly report lower revenue growth numbers as startups have less VC money to funnel their way. We’ve seen this play out before, in the dot com bust of 2000. For example, in 2001, Cisco Systems’ revenue declined dramatically after a big chunk of its dotcom customers went out of business. Its valuation followed suit—it declined, a lot!
Just to be clear, neither Facebook, Amazon nor Google are trading at 200 times earnings, as Cisco did in 2001. The decline in revenue growth will be less pronounced than Cisco’s during the dotcom bubble. But their revenue growth rates will decline and rebase to a lower number, and this is risk almost certainly not priced into their lofty valuations today. When the little fish die off, the sharks go hungry.
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley) and The Little Book of Sideways Markets (Wiley).
His books were translated into eight languages. Forbes Magazine called him “The new Benjamin Graham”. To receive Vitaliy’s future articles by email or read his articles click here.
