Odd Lots - This Is How The Unicorn Bubble Will Burst

Episode Date: November 12, 2018

So-called "unicorns" have become household names in recent years. Multi-billion dollar companies like AirBNB, Uber, and WeWork have become known for phenomenal growth, extraordinary valuations, and a general dearth of profits. That means these companies have been reliant on accommodative financial conditions to maintain their growth. So how might this all come to an end? See omnystudio.com/listener for privacy information.

Thanks for listening to Oddlots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast, Odd Lots on Amazon music. To another episode of the Odd Lots podcast, I'm Joe Wisenthall. And I'm Tracy Allaway. So Tracy, the last month in markets has been pretty interesting, wouldn't you say? Interesting is definitely one way of putting it. It's been massively volatile and I'm sure quite stressful for quite a few investors. Definitely stressful for several investors, but also I would say, you know, as it often is unfortunately good for us in the financial media business because some very good stories to write about, talk about, and dive into. Right.

There's been no shortage of headlines. That's for sure. One of the big things that we've been writing about has, of course, been the massive sell-off that we saw in technology stocks. Yeah, that's exactly right. Like, lots of things have happened in the last month and really all you. with many global markets selling off. But I do think what's really striking

and what felt different about this past month is how violent some of the selling has been in technology companies that here to four have seemed really maybe bulletproof. And I'm thinking of companies like Amazon, which was at one point worth over a trillion dollars and then very quickly lost about a quarter of its market cap, others like Netflix and Google,

and Facebook, which had been struggling since the summer, very much a different tone to the trading of these companies. And of course, it might just be a blip, but maybe it's a sign that just sort of that pure optimism that people felt towards these companies just started to fade. Right. And I think that's one reason why the month felt so stressful, because you saw these stalwarts, not just of the technology sector, but really of the entire market suffer during this downturn. So, you know, think about the major components in the S&P 500. The fang stocks like Facebook and Amazon and Google really make up a big proportion of that. Yeah, exactly right. And, you know, not to belabor this point, but these were also incredibly important stocks for hedge funds. And many of the successful long short managers were successful because they made big bets, concentrated bets on these companies.

So when they fell apart or when the stocks fell apart is really regained. havoc. Now, the other thing that's interesting to me is we live in a time where there are a lot of really big tech companies that are not public or they're tech-ish companies. So whether it's Uber, Airbnb, we work, a lot of these tech or tech adjacent companies that are gigantic, much bigger than many of the public companies out there that have sort of feasted on, you know, incredible growth and incredible access to private market money. And of course, of the questions that arises in light of the tech sell-off is if the public market is turning more negative on tech, then what does it mean for these companies that people are very obsessed with,

but that, you know, haven't really proven themselves to be durable businesses yet? Right, because they've all been sort of lining up with the expectation that if they wanted to IPO, there would be this huge amount of demand. And then suddenly the recent market route kind of puts that into question, although, well, I have a lot of thoughts about this. So I'm sure whatever we're about to discuss, it'll be a good conversation, Joe. Great. I think it will be, too. So all of that being said, I want to introduce our guest for this week's episode.

We're going to be speaking with Bill Janeway. The legendary economist, Hyman Minsky, characterized him as a theorist practitioner. He spent 35 years in venture capital affiliated with Warburg Pincus and his affiliated member of faculty at Cambridge University. And I recently read his book doing capitalism in the innovation age, which really speaks to what I think is the sort of question of the moment about the relationship between entrepreneurship and financial markets and speculative activity. He's a rare voice that can sort of combine firsthand experience with how the investing world actually works with a sort of economist's academic perspective. So in love,

of that, and in light of his experience, I want to bring in Bill. Bill Janeway. Thank you very much. Joe, it's great to be here and Tracy. Good to meet you. Yeah, the unicorn bubble is an extraordinary phenomenon. So let's first put it into a more general context. One part of that context, of course, is the maturation of the digital revolution, the fact that as Facebook and Google have demonstrated, it is possible to adjust markets numbered in the billions of use. users with extraordinarily little friction, little expense. So the notion that limitless growth may be available for other digital service businesses is plausible. But second, there's also a more narrow context, and that is that for nine years from the global

financial crisis until just within the last 12 months, the financial markets, the financial system and investors, have been operating in an unprecedented environment, an environment in which the risk-free real rate of interest has been effectively zero or even less. That has pushed institutional investors, principally mandated and chartered, to invest in liquid public markets, to behave in a way that, my view, is fundamentally unsustainable. They have been paying premium valuations relative to what's available in the public market to buy, and this is the key, to buy illiquid securities, securities they can't sell. Now, I'm not a great fan of business schools, but Finance 101 at any business school in the world will tell you that there is a value

to liquidity for an investor to be able to change her mind when she believes that circumstances have changed. But these investors, from the public market world who have been piling into the new unicorn wannabe digital giants have been, as I say, paying premium values to buy illiquidity. Now, before we dive further into that, and I love that sort of framing of that and the central tension there because you put it much better than I was, I just want to take a quick step back because I characterized you or it wasn't actually me, but I, You're characterized as a theorist practitioner.

So you spent several decades in tech venture capital. But you're also an academic economist. And I think that's rare because you often hear, you know, sort of investors claim that economists don't really understand how their world works. And maybe that's true in many cases. Tell us a little bit about your academic background and how it has informed your view of the investing game. Delighted to. So I took a Marshall scholarship to Cambridge way, way back, back in the mid-60s, and I did a doctorate in economics under the students of John Maynard Keynes.

And I, how shall I say, I internalized a set of pretty fundamental lessons, one of which is that in the world of finance and of economics, we are all doomed to be making decisions under conditions of uncertainty. We cannot know the full consequences of the decisions that we make that involve investing, money, resources, time, energy. And therefore, there is an powerful incentive to construct hedges, ways to protect ourselves when what we hoped wouldn't happen does happen.

This is where it links to my life as a practitioner. I learned in the trenches of venture capital investing in IT at the frontier from the late 1970s right through the great tech bubble that peaked in 2000. I learned two basic lessons. I called them the two fundamental theorems of venture capital. The first is corporate happiness is positive cash flow, a business that is generating more cash because its customers give it more cash than it costs to deliver them the product and service has achieved a kind of liberation from dependence on the problematic access to external capital

when needed. That's from the point of view, if you like, of the, how shall I put it, the rational, practical, commonsensical entrepreneur, which not all entrepreneurs are. The other lesson is from the point of view of the investor. It's what I call cash and control, the only joint hedge against the fundamental uncertainty of investing in early stage companies at the frontier of technology. Cash means you have unequivocally access to enough cash to buy the time to find out what's going on when what is going on is bad. And control means you have enough control to shift the parameters of the problem.

In my personal experience, that usually, not always, usually began by firing the CEO. Okay, let's switch back to the unicorn bubble. Here we have a set, and there are many, I think globally now it's considered there's something like 250 to 300 unicorns who are characterized by burning billions of dollars of cash per year in pursuit of limitless growth, the notion of actually working to deliver positive cash flow from operations is seen as a kind of needless constraint on the pursuit of that limitless growth. And on the other hand, the investors motivated, as we all know, by that famous phrase, FOMO, fear of missing out, have not just been providing the cash on extraordinarily attractive

financial terms. In many cases, they've been yielding control, governance, ownership to the founders of the company, no matter how much money those founders raise from investors. So, Bill, I already have a bunch of questions, but I guess my main ones, you were talking about liquidity earlier and this idea that investors may be underpaying for illiquid assets that they're assuming, I guess that means you think that they might have difficulty exiting their tech investments. And then secondly, you're talking about the value of cash flow in a company. And I guess my question is, why are investors so comfortable continuously pouring more money into unprofitable unicorns such as Uber. You know, you mentioned the fear of missing out, but I guess the question is,

at what point does the fear of missing out transform into the fear of not making any money ever? So just to be clear, Tracy, I was saying that these public market-oriented investors have been overpaying for illiquid securities and that consequently they don't have the opportunity to change their minds if they decide that maybe the future isn't quite as bright as it's supposed to be or as they hoped it would be. I do think that it's not just the existence proof of the fangs, of this enormous potential for establishing global or near ex-China global franchises, particularly in the consumer, the digital consumer economy. As I said at the beginning, I also think the broader financial context really matters. With risk-free real rates of interest, essentially at zero,

and even going out on both the credit spread and term spread in pursuit of greater returns, having had since 2008 very marginal opportunity to make any kind of positive real return, I think that investors have been reaching for risk. They've been able, they've been going further out onto the risk spectrum, which when it comes to the unicorns, has to be extreme uncertainty about what the outcome will be for whether it's Uber, which has challengers in many markets, which is facing regulatory frictions, which has the opportunity to see how the same social media that enables Uber to grow extraordinarily, also enables the drivers. to establish some countervailing market power in terms of the conditions under which they work.

These are really big economic uncertainties, which investors have chosen to ignore. If there's any catalyst for shifting that mindset, I expect it'll be the same catalyst that has had such an impact on the broad public tech stocks. and that begins with the return of access to real positive rates of interest. As treasuries move up, as the tenure, I think, is now up around 3.2%, as we see credit spreads open up for liquid junk bonds, and typically they sell in double digits. If you have 10%, 12% available in a liquid, more or less liquid junk bond market, I think that's likely to dampen the perceived need to go way out on the risk spectrum and behave in the way

they have been. So ultimately, just to clarify, now, if what we've seen in the month of October turns out to be just a blip and tech stocks continue to rally, then maybe this is all sort of an academic discussion. But at some point, the divergence between what public markets are telling us and the kind of access to capital that private markets depend on, it can't last. for too long. Eventually, there has to be some convergence. Yeah, look, the definition of a bubble, and this is some really great academic work, this is where I love to move back and forth from the world of the practitioner to the academic. There's some great work to first world-class economists, Jose Schenckman at Columbia, Jun Xin, at the Bank for International Settlements, have defined, in a way,

a signature of a bubble. That's when the price rises, demand goes up. When prices rise, demand's supposed to fall, right? But when in a financial bubble, when the price of the securities go up, demand increases, and we've certainly seen that in the world of the unicorns. What that means is that the price of the securities are being decoupled from any concern with cash flow, past, present, or future. Sooner or later, all bubbles burst. Sometime they leave behind really productive assets like railway lines or electricity grids or internet fiber. But they all busts. Now, the good news about this unicorn bubble is, first, as it when it busts, there's no leverage. The economic consequences are going to be very limited. Second, no doubt out of these 250 or

300 wannabe fangs, there will be several that establish themselves as long-term. sustainable, valuable businesses. You know, back in the tech bubble, Amazon raised $560 million in the end of the first quarter of 2000, about two weeks before the then all-time peak of the NASDAQ. If it hadn't raised that money under bubble conditions, it would have gone bankrupt within six months. Jeff Bezos learned the lesson.

He's got multiple levers for forcing gobs and gobs of positive cash flow whenever he wants to, whenever the market tells him, he needs to. In the meantime, he can invest for maximum continued growth, given that he can generate positive cash flow whenever he chooses. My view is that the unicorn boards and their entrepreneurs are going to be challenged to demonstrate that like Jeff Bezos, they have plausible paths to positive cash flow that are within their own control that don't depend on limitless access to the kind of capital that for a time has been available. The news doesn't stop on the weekends.

Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Ruffini. We'll bring you the latest headlines in-depth. analysis and big interviews, all the stories that hit home on your days off. And I'm Lisa Mateo. Watch and listen to Bloomberg this weekend for thoughtful, enlightening

conversations about business, lifestyle, people, and culture. On Saturday mornings, we put the past week's events into context, examining what happened in the markets and the world. That on Sundays, we speak with journalists, columnists, and key political figures to prepare you for the week ahead. Join us as soon as you wake up and bring us with you wherever your weekend plans take you. Watch us on Bloomberg Television. Listen on Bloomberg Radio, stream the show live on the Bloomberg business app, or listen to the podcast.

That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, radio, and wherever you get your podcasts. So is there anything special about tech in particular that makes it more of a target for easy money or for capital, just, you know, trying to find anything to invest in? because this easy money story, the search for yield, we've heard people talk about it across a variety of financial assets, right? Corporate bonds being probably the most prevalent example. People talked a lot about the shale oil story is actually a capital market story.

Is there something about tech here that makes it unique? Sure, it's growth. And the thing that makes it unique in this environment is that when you're investing in growth, the rate at which you discount the future really, really matters. And when you can discount the future at rates that reflect the Fed, and for that matter, the Bank of England's, the European Central Bank's commitment to very, very, very, very low to negative interest rates in the nine, ten years after the global financial crisis, it means that that future value, however speculative it may be,

just is much, much larger. And, you know, it's exponential. This is not a kind of linear exercise in arithmetic. If the rate at which you're discounting the future rises by 1%, 10 years from now, the value of a buck 10 years from now declines by a lot. And that's the biggest threat, I think. I think there are two threats, actually. One is this financial threat, this shift in the financial environment,

that differentially penalizes high growth investment opportunities. The second is the growing recognition or the increasing inability to ignore the frictions that do affect even these extraordinary new companies with their potentially billion user markets. I mean the regulatory frictions, the political frictions, which have been emerging around the world, not just in the United States, city by city, country by country over the last year or two. Before we go too much further, I want to go back something I've been thinking about listening to when you talked about your sort of academic history and having studied under the students of Keynes. when you talk about the lessons you've internalized, I have to say, in a way they seem obvious. Okay, companies should have access to positive cash flow. I mean, I think that would not surprise people. Control matters. The future is uncertain. None of these things strike me as being particularly

controversial. But how in your view do these insights differ from, say, what economists elsewhere may have thought? Well, that's a great question, Joe, because the fact is I went on my 35-year sabbatical from the academy because in the early 1970s, it became clear that mainstream academic economics and mainstream academic finance had kind of drunk the Kool-Aid. The Kool-Aid of the, where the building mathematical models that could be solved logically, and they were based on in both areas, both, based on the concept, the fantasy of what has been called in the literature too much, the rational representative agent, the agent in the market who has an omniscient view of the future, not just of what's going to be the result of her actions, but of the model, a model which accurately

explains how her, and remember she's the representative agent, she represents all investors, all consumers, all firms, how those decisions will play out. This came to be known as the rational expectations hypothesis. It was dominant. It has been dominant for a generation with the models in the central banks and the treasuries of the world, not just in academia, based on this view. Now, there are a couple of aspects of this that are pretty obvious when you stand back and assert that the power of that most rare resource, common sense. First of all, if you have one rational agent, one representative agent, that means that she is her own creditor and debtor.

You've just excluded a financial system by construction. Nothing that happens in the stock market, the bond market, or the banking system can have any effect on the real economy. That is the central reason why all of the, authorities were so caught by surprise in 2008. It does sound like common sense, as you say, to put it the way I put it in terms of uncertainty about the future, need for ability to provide effective hedges against that uncertainty. But as I say, for a generation, and not just from the University of Chicago, the doctrine, the dogma, that markets will be self-corrhizant,

as rational agents exercised their omniscient knowledge in a world that they fully understand. You know, it was Alan Greenspan in the hearings in 2009 after Lehman went bust and the world froze, who said that he found a flaw in his thinking. The flaw in his thinking was his belief that those rational self-interested bank bosses and private investors would all, behave for their own best interests as if they knew what their own best interest actually would be. And instead, of course, what we saw was everybody running for the exit to protect themselves with a consequence that was catastrophic for the world. The good news?

The good news is that for those academic disciplines of economics and finance, 2008 and the great recession that followed are the gifts that keep giving. They have motivated a return to empirical study of markets, of economies, of financial systems with a much more realistic view, which is beginning to emerge in the literature. And, you know, it took a generation for the economics that failed us so badly in 2008 to become dogma. It'll take a generation to undo it. It won't happen overnight. But there is good news out there for the, for the longer term, in how we think about this world we're all trying to survive in. So we're talking a lot about 2008. If we fast forward to now, as Joe and I were discussing in the intro over the past month or so, we've seen a lot of angst amid the tech stocks and amongst

tech investors. Does the wobble in the public market in particular, does that suggest that the whole edifice of tech funding starts to fall down, that the VCs and the private markets aren't going to be able to depend on an exit through IPOs, and that begins to sort of create a downward spiral in valuations. Do you see that happening? Well, I certainly see exposure to it. Now, you know, as we all know, it's very hard to predict, especially the future. But I think we can see that there's a link from the movement towards, quote, normalizing interest rates to feedback and impact on the value of assets whose future returns dominate their current returns. And of course, there's no set of assets more of that category than the unicorns. Second, institutional investors

will find that there are adequate returns available at much lower risk than buying into the digital wannabes at super-valuations with no guarantee of an exit path through a public market or any other way. So I think we have to expect that the world is going to look a lot more fragile over the next period of months and years going forward. And as a final point, you know, So my work is very definitely deeply involved at the interface between the financial and economic markets on the one hand and the political process on the other. And the other lesson, another long lesson that goes way back in our history, is that markets ultimately depend on the credibility and plausibility of the political underwriting

as and when bad things happen. We sure learned that in 2008. And I think it's legitimate to have a concern going forward about the quality of political underwriting in the United States today. I'm glad you brought this up because before we go, I want to hit on sort of another major theme of your writing, which we haven't talked about at all. And again, I suspect it's another area where a lot of investors might bristle at this. But something you point out is that the areas where venture capitalists have been most successful. have all been areas in which there's been an extraordinary amount of government spending to invest in basic research, the sort of expensive capital investment that often early stage private money isn't forthcoming for.

And you point out examples throughout history. So I'm curious like, A, can you sort of clarify that point? But B, these days, we seem to have this sort of extreme dichotomy in which everybody wants to invest in VC from soft bank, to universities. I saw an ad on the subway this week saying invest in startups for as little as $10. At the same time, as government, particularly in developed economies, don't seem to be very good at marshalling the resources for that core investment. So I'm curious if you can talk about this, an incredible interest in investing in VC. At the same time, according to you, a crucial component of VC's success is not forthcoming. Well, let's, I'll bring this real

down to the real direct. My personal experience was that in the course of the 1970s, 80s, I realized that I and all my peers as investors, as venture guys, and the entrepreneurs we were backing, we were all dancing on a platform that had been constructed by the United States Department of Defense, from silicon to software and on to the internet. It was the not just funding research. The DOD was the first customer for the stuff that wasn't ready for commercial prime time. and for the biotech guys, the National Institute of Health was doing the same thing. When you got outside of those two sectors, there's been no record ever of venture capital success investing in the products of material science.

For example, nanotechnology. For example, for that matter, outside of silicon where the government was underwriting it. Today, the digital revolution doesn't need government subsidy and support. On the contrary, it's matured to the stage where it's attacking the authority of the government, from cryptocurrencies at the global level to Uber at the city level. But the next revolution, the next needed technological revolution, the clean tech, green tech response to climate change, U.S. is nowhere. We haven't invested anything like the kind of resources that we did in computing or that we did in biotech

in order to be able to convert this economy. and shift the demand and supply curves for carbon. China's doing it, for sure. And this is the biggest open question in my mind as to whether and how China might succeed in this phenomenally difficult transition from being an effective follower to the frontier of technology

to become an innovative leader there. The U.S. did it in the 20th century. It did take two world wars and inspired political leadership. genuine political entrepreneurship, which we seem to have run out of over the last generation. Bill Janeway, fascinating stuff. Thank you very much for joining the outlaws. I couldn't be happy to be here and maybe even a return visit would be more than welcome on my side. Definitely. Tracy, I really enjoyed that conversation. When I read Bill's book recently doing

capitalism in the innovation economy, that was prior to the volatility that we had seen in October. But in addition to, of course, the volatility that we saw, we also saw concerns around Saudi Arabia, which is, of course, a major funder of tech companies and tech investors like SoftBank. So I really thought that was an incredibly timely conversation because it feels like a lot of these companies really are at a crossroads. Right. And if you want to think about an example of the importance, I guess, of reliable financing when it comes to unicorns, and various tech startups. Saudi Arabia is a really, really good sort of microcosm of that.

Because, of course, with all the drama and controversy surrounding the murder of the journalist Jamal Khashokchi, people are talking about whether or not Saudi is still going to be spending money as freely on tech investments. And if the Saudi money goes, there are some crazy estimates out there saying that hundreds of startups could be affected. Yeah, I wouldn't be surprised at all about that. just in general, I do think that this link between what we see in public markets and the volatility that we see between public markets and private markets is probably not appreciated enough.

And that at some level, you can't just do business ignorant of what's going on in the markets that we see quoted every day. And I think that's a really powerful point. And I suspect that a lot of these, you know, a lot of these unicorn CEOs will be surprised when they realize the degree to which, okay, maybe they're private, but they're not as insulated as they might think. Right. And it sort of gets back to that expectation point, right? Like, what exactly are your original investors expecting from their original investment? And usually there are a lot of assumptions embedded in those expectations, many of which might not actually come to fruition. Right. Exactly. Many of them won't because, as Bill pointed out, we live in a permanent state of

extreme uncertainty and we might have a guess about something that's going to happen in the future, but we really have no idea. And when the future starts to deviate from any expectation, which will happen one day, whether it's now or in the future, people are going to want actual cash to hold on to. Yep. It's all about the cash. All about the cash. All right. This has been another edition of the Odd Lots podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Allaway. And I'm Jill Wisenthall. You can follow me on Twitter at the stalwart. And you should follow Bill on Twitter. He's at Bill Janeway. And be sure to follow our producer on Twitter, Tofor Forges. He's at Forges T. As well as the Bloomberg head of podcast, Francesca Levy, at Francesca today.

Thanks for listening. You can get the news whenever you want it with Bloomberg News now. I'm Amy Morris. And I'm Karen Moscow here to tell you. about our new on-demand news report delivered right to your podcast feed. Bloomberg News Now is a short five-minute audio report on the day's top stories. Episodes are published throughout the day with the latest information and data to keep you informed. Yes, there are other products like this from a variety of news organizations, but they usually rerun their radio newscasts throughout the day. That's not what we do. We create customized episodes that can only be heard on Bloomberg News Now.

And we don't wait an hour to publish breaking news. When news breaks, we'll have an episode up in your podcast feed within minutes. So you're always getting the latest stories and developments. Get the reporting and the context from Bloomberg's 3,000 journalists and analysts. We're all over the world. Listen to the latest from Bloomberg News Now on Apple, Spotify, or anywhere you listen.