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Dec 20, 2015

Naked Unicorns in Subprime Valley

The signs of a tech bubble are plain to see. But Silicon Valley doesn’t want to admit it—and average investors are at risk.

Shortly after the late 1990s technology bubble burst, many cars in Northern California sported a bumper sticker pleading, “Please, God, just one more bubble!”

Those prayers have been answered. The signs of a new tech bubble are everywhere: Easy money, widespread exuberance, hidden leverage and mass participation by amateur investors. Many believe it’s different this time, insisting that valuations are reasonable and that Tech 2.0 companies have real business plans that will generate real profits.

How did we get here? Broader economic forces are one reason. With interest rates at unprecedented lows even after the Fed’s recent hike, many investors have been forced to take extra risk to generate returns. Fast-growing tech companies offer the prospect of tremendous rewards. “It only takes one,” the venture capital guys say. The collective valuation of the 142 unicorns is around $500 billion.

Another phenomenon, the involvement of large mutual funds in private investments, is a contributor. T. Rowe Price, Blackrock, Fidelity, and Wellington–four firms that offer open-ended investment products with daily liquidity–have pumped significant amounts of capital into late-stage private tech firms. Two thirds of unicorns—companies valued at $1 billion or more—have a mutual fund, hedge fund or bank as a major investor. 

But as the music stops, retail mutual fund investors may find hard-to-value illiquid assets getting rapidly marked down, possibly forcing indiscriminate selling of allegedly “safe” assets.  As Warren Buffett put it, “It’s only when the tide goes out that you can see who’s been swimming naked.” Recent reluctance to go public and valuation markdowns suggest we’ve reached high tide—and we’re about to discover who’s most exposed.

For investors frustrated with the challenge of generating returns in today’s climate, the hopes offered by opaque private markets are more appealing than the reality presented by transparent public ones. Just consider two firms that operate in cloud storage: Box and Dropbox. Dropbox is private; Box is listed on the New York Stock Exchange. For no obvious reason, Dropbox garners a significant premium compared to its public peer. T. Rowe Price and BlackRock invested in Dropbox at a $10 billion valuation. But if it traded at the same revenue multiple as Box, the company would be worth $3 billion. What’s the difference? When reality isn’t sexy, investors throw money at potential.

Over the summer, BlackRock marked down its valuation of Dropbox by 24 percent. Then, this fall, Fidelity marked it down as well, along with its stake in Snapchat by 25 percent and its stake in Zenefits, a maker of online human resources software, by 48 percent. More recently, Fidelity marked up its stake in these three companies, but not enough to recover the losses of recent months, highlighting the radical uncertainty surrounding such valuations. Moreover, following its IPO, Square was trading around $12 per share, well below the $15.46 investors paid in the last private round in October. Gilt Groupe, once valued at over $1 billion, is now trying to sell itself for about a quarter of that. Valuation volatility is rightly leading many to question how many unicorns are overvalued. 

And consider the over-the-top confidence of the Valley’s employees. They’re commanding ever increasing wages, with reports of $500,000 annual pay packages offered to recent college graduates. Interns are making $7,000+ per month. Expectations for such sky-high pay have become both inevitable and unsustainable; they’re reminiscent of the $1 million pay packages promised Wall Street associates in 1999. By 2000, once the party had ended, annual bonuses were being replaced by pink slips.

Financiers are so convinced that the good times are here to stay that they’ve begun lending money against overpriced and illiquid private stock or employee options.

Paper-rich but cash-poor employees are borrowing money they can’t repay without a company sale, from specialist funds that have arisen for just this purpose—and even from banks. In effect, the “cash buyer” of a multi-million dollar property in San Francisco may actually be using 100% borrowed money.

So, let’s get this straight: Higher valuations drive higher incomes that drive higher housing prices using lots of leverage. Seems fair to assume that lower valuations will drive lower incomes and lower housing prices…with, uh-oh, under-collateralized loans. The dominoes are lining up.

One of the telltale signs the end of a bubble is near is popular obsession with get-rich-quick investing opportunities. Back in 1999, taxicab drivers were doling out stock tips. And because that was a bubble in publicly-traded stocks, and online brokerages made investing accessible to all, E*Trade and Schwab were opening accounts at dizzying rates. Today’s equivalents are the crowdfunding campaigns allowing companies to raise equity from Joe and Jane Sixpack, which were made possible by the 2012 JOBS Act. Since September 2013, investors have used crowdfunding platforms to pump more than $700 million into over 1,700 private companies.

As with any proper bubble, there are rationalizations galore. Of course, it’s different this time—it always is. Uber is attempting to disrupt the entire global transportation system. Airbnb is permanently changing the way people procure temporary housing. And both companies are unlocking the productive potential of otherwise stranded capital in depreciating assets. Why have your car sit idle or your apartment empty when either (or both) can generate a return?

All of that may be true. But what happens when competitors enter the market and, say, do away with surge pricing? Or taxis respond with apps of their own, as they have in New York? Or states and countries start regulating Uber and Airbnb? Or the notoriously fickle millenials get bored of the platform and move on to the new new thing?

There’s no doubt that today’s resurgence of tech start-ups will generate world-changing companies. But with all the unicorns roaming in subprime valley, the fantasy grows more obvious by the day. As with all good fantasies, it’s easy to lose yourself in the story. But the story’s almost over.

Vikram Mansharamani, PhD, is a Lecturer at Yale University in the Program on Ethics, Politics, & Economics and the author of Boombustology: Spotting Financial Bubbles Before They Burst (Wiley, 2011). Follow him on twitter @mansharamani.

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