Fringe Notes!
अहम् ब्रह्मास्मि

Theory of Asset Bubbles: Its all about Color of Money! – Part III

Startups

Fidelity has marked down value of its investment in snapchat by 25% and there are some other markdowns reported by investors as part of annual/quarterly accounting procedure and it has sent a wave of glee all across globe among all startup watchers/experts and commentators as markdown by Fidelity is sure sign confirmation about the bursting of private tech bubble and like 2001, we will soon be witnessing dead unicorns all around us. However, nothing can be farther than the truth.

The one thing the experts are missing while thinking of 2001, is the fundamental shift happening in the world economy due to mobile/tech and automation which is similar to the social transformation as it happened during the industrial revolution. The impact of the present wave of innovation will be far more severe, permanent and disruptive on society. The change is real and is happening, though a lot of arguments (Luddites, Software taking over jobs) have remained same as they were during the industrial revolution. Unfortunately, we all are looking at this new paradigm through our old colored glasses of Industrial revolution and using the same metrics to measure new dimensions. Hence Fidelity writing down the value of SnapChat only means that Industrial revolution accounting rules are not in sync with Machine age accounting!!

However, the single reason why this startup bubble won’t burst despite questionable business models of many players is nothing related with massive machine revolution, or new business paradigm but a simple technical matter that is “Color of money” or simply put “type of capital” being invested in these startups. In 2001 dot-com bubble, that continues to overshadow all the advances made by internet business, almost 90% of the companies were listed and were funded by public money while in 2015 the numbers have just reversed as almost 90% of the companies are funded by private capital or the alternative investment pool. This private capital coming from alternative investment pools seems quite high but still is a tiny fraction if one considers the overall investment capital pool.

In recent times, AUM with alternative investment pools has been growing at a healthy pace, however, it still constitutes less than 25% of all asset class. Further this 25% constitutes Real Estate, Hedge Funds, Buy-out funds, Energy & Commodity funds, Private equity (Venture capital is a tiny subset of Private equity), and hence money invested in tech companies (through venture capital and some hedge funds) is tiny compared to overall investment pools. ( to give some perspective, Venture funds in US invested close to $48 billion in 2014, and all over the world the total capital deployed in a year is less than $60 billion while in 2008, the money allocated by USA Govt for bailout of banks was $700 billion ( actual amount came to $460 bn). Hence liquidity is not going to dry up very soon, as money flowing in the venture / new tech space is still very marginal and even few losses here or there won’t shift the needle.

The second big reason or rather main reason due to which probability of a bubble burst is negligible is that on account of investments by VC/PE industry, these companies are remaining private without any need to access public markets and as of now there is enough capital waiting on the sidelines to keep these companies private for foreseeable time.

So how is this private capital is impacting the bubble burst? A bubble burst in any economy is defined when there is a sharp contraction in the value of an asset and when this contraction is happening all across the sector with the majority of assets. This sharp contraction in value is generally driven by liquidity crisis as survival of a business generally is not a function of business model but rather that of liquidity in the system (some may argue that liquidity is a function of business model but that is not always the case).

Now, this liquidity crisis is created either by debt call or a sudden crisis in the environment which creates panic and overall negative sentiments and thus end up choking money supply to a company.

A liquidity crisis can hit any company, however, a privately held company is in a much better position than a public listed company in handling it. Since listed companies are under intense public glare, quarterly earnings and disclosure norms sometimes perpetuate a liquidity crisis as any miss in revenue/profitability estimates or cancellation of a large contract create a run on the stock and in turn leads to a crisis with an already struggling business. Disclosure norms/insider trading rules create inherent disadvantage to a public listed company in the following manner a) Other than management, nobody has access to financial performance and hence a bad quarterly result can create massive shock/panic due to sudden drop in stock value b) As almost all data, especially negative ones are in the public domain, management has not much room to maneuver/ hard bargain with investors and  c) short sellers /option traders perpetuates the crisis by short selling thus creating a further run on the company stock. All these actions lead to a sharp drop in share prices which in turn create a panic among all stakeholders i.e suppliers, creditors, clients, customers employees, and investors.

These kinds of shocks further put pressure on other companies in the same sector and many times lead to a contagion effect if that sector is facing strong headwinds and may result in re-rating of sector thus leading to the massive drop in asset value. These actions lead to chaos as mob mentality takes over the rationality and completely chokes the money supply resulting in an unwarranted fire sale or financial crisis.

In comparison to public listed companies, a privately held company is generally protected from all the trauma caused by the pressure of quarterly earnings, disclosure norms and public glare. All this restricted public info is given an inherent advantage to unlisted companies when it comes to negotiations for the capital, terms as well as in managing information flow etc. Moreover, as  the investors are much aware of the direction and performance of companies and are generally in knowledge of the crisis in advance, they are able to work out solutions while closely working with management be it fundraising, M&A or right pricing the company stock as we saw it happening with startups like Myntra, LetsBuy, TaxiforSure etc

Hence the possibility of a large-scale panic where the majority of startups will go bust is remote for the reasons mentioned above as investors/founders will continue to negotiate and create liquidity situations in case of strong headwinds without external panic. They will also be helped by the fact that the amount of capital deployed & the value of business is not more than 25% (Uber valued at $50bn+ has raised  $ 8.2 billion (16%), Flipkart valued at $15 bn has raised $ 3.15bn (21%)) and emboldened by LP clause, more and more hedge funds are waiting at sidelines to enter these markets.

However, it does not mean that no company will go down under as the private markets work in a discrete manner showing bursts of activity, then freeze and then again hectic activity. The evidence of this can be seen from the investment pattern as seen in Indian e-commerce market where after showing initial euphoria in 2011/12, funding market just froze for e-commerce in 2013 and then again became super active in the latter part of 2014. Hence rather than bubble burst, we will continue to see these cyclical investment patterns and any company with not enough cash to survive these short bouts of nuclear winter will go down irrespective of business model, insane consumer happiness, superior unit economics or growth as we have seen with IndiaPlaza.com and host of other businesses. If there would have been a bubble, all of the companies would have been able to raise money at their terms but we are yet to see evidence of this.

It will be good for experts to remember that an asset bubble is more a function of the nature of capital deployed rather than that of business logic.

This behavior probably explains why Indian real estate bubble never burst so far and in fact will never burst despite noises being made about this burst since 2006. In India, debt by PSU banks is almost like quasi-equity which is permanently structured and can never be recovered due to over friendly regime of bureaucrats, policymakers, politicians and Indian courts (lender to Kingfisher can very well attest to that). As the debt is never called, it does not create liquidity pressure and all we witness is cyclical movements market (hectic activity and total freeze) while maintaining the asset prices at the same level.

Hence contrary to common perception, no bubble is going to burst but a Darwinian world will continue to evolve in the true sense given the nature of capital as well as of the market. For experts, keep writing and voicing opinions; after all, what is life without talk and gossip, only a few vices allowed without any medical warning.

 

The Other two parts of this articles are at this link

Part 1: Anatomy of coming Startup bubble: The missing argument – Part I

Part 2: Startup Bubble: Case of misplaced Schadenfreude – Part II