The death of the unicorns: How the interest rate bubble might cause a new tech crash
Avalon VenturesKevin Kinsella
Unicorns are supposed to be rare beasts. But in tech - where a "unicorn" is defined as a private startup company valued at more than $1 billion - at least 100 of them have been spotted so far.At Business Insider we have been discussing whether the unicorn glut is an indicator that the tech sector is in some sort of bubble.
Some people think there is no tech bubble because private equity has simply replaced the role of public stock IPOs, making it look like there is a bubble when in fact there is not.
But others - including at least one unicorn CEO - think there is a bubble.
Those folks believe that central banks - the US Federal Reserve, the European Central Bank and the Bank of England - have caused this bubble by keeping interest rates very low for a long time.
Those low rates - effectively zero percent across much of the West since 2009 - have made money incredibly cheap to borrow. That has allowed investors to pump money into projects that wouldn't get funding in any other environment.
Startups without revenue models - like Secret and Ello - are prime examples of this. But it has also affected companies that do have revenue, like Uber and Airbnb. At $40 billion, Uber is now valued privately at a sum greater than publicly traded companies like Kraft, Kellogg, CBS, Marks & Spencer or ITV. No one outside the company even knows whether it is profitable.
This cheap money has flooded into the tech venture capital and private equity markets. And it is sending valuations through the roof, insiders argue. (Moody's, for comparison, thinks a similar thing is happening in European housing - because the ECB is pumping money into the bond market that is ending up in property investment.)
Business Insider recently talked to Kevin Kinsella, the founder of Avalon Ventures, a venture capital company that has made investments in Zynga, Backupify, Good (acquired by Motorola), Nanigans, Neurocrine and Tapad. We wanted to know, what's going to happen when, inevitably, the central banks reverse course and start raising interest rates again?
There are signs that is about to happen because both the Fed and the BofE have said that the markets they regulate in the US and Europe are now so healthy that they expect to see some inflation, increasing the likelihood that they'll raise rates as a way of beating back that inflation.
We wanted to know how that might affect tech venture investing and valuations.
Kinsella told us that he believes higher interest rates will pop any bubble that has formed in tech. Investors will pull money from the public stock markets and rush to put it into the bond markets, where the new action will be.
"If you have money draining out of the public equity markets, that inevitably affects the private equity market. They cannot exist going in different directions because somehow that will rent the fabric of the universe. It's just not permitted that that happens. Obviously there can be anomalies for brief periods of time but it just can't happen forever," he says.
"In other words, you wouldn't see this unicorn phenomenon in the stock market if NASDAQ was in the tank and going lower, it just wouldn't happen. For a lot of reasons, not the least of which is if one of the avenues of liquidity is going public and your vehicle or your market for going public, NASDAQ for example, is going in the tank, well that's the problem."
The problem then, he says, is that private equity investors - the large, institutional investors who poured money in after the regular tech venture capital funds - will be stuck with big investments in tech startups that they cannot sell, or exit from via public IPOs, Kinsella says: "They're screwed, they're completely screwed."
"That's what I refer to as the liquidity crisis. Your private valuation has gotten way ahead of any potential notion of what a public valuation could be where you could exit."
Kinsella thinks the banks are now signalling that the tech bubble has peaked: "I think the interest rate, this is probably what's going to tip this over. It's like an early warning sign with a rumble in the distance, and pretty soon, the freight train is bearing down on you, or the earthquake is, buildings are shaking or whatever."
"We're in one of the biggest tech bubbles we've ever had."
Here's an edited transcript of our entire conversation with Kinsella. If you're interested in a how an interest rate bubble might shake out, it's crucial reading. We also discuss whether big tech unicorns like Uber and Airbnb are over-valued in the long run.
Kevin Kinsella: Basically my point of view on unicorns is that private companies which have sky high valuations, it doesn't really mean anything in the real world until it's marked to market. And there's only two ways things get marked to market in venture capital: Either a company is acquired by another company for cash or marketable security, or it goes public, and then it has reporting requirements and then the market will determine the value.
The problem in my view, at the present time, is with the continued flood of money, now. Venture capital has peaked in terms of its appetite, in terms of how much money it wants to put in. So now private equity funds are piling in. Primarily because interest rates are virtually zero so there's no fixed income play and they're not moving around. A good trader loves an active market, you don't make money when the market is static.
The stock market has gone up and if you are stock picking, that's fine, you may do a bit better than the market. But if you want to play in another game where you can get rapid increases of value and so on and so forth, this apparently has become the new parlour game, to invest in these companies and many their cases, the private equity that has been piling in onto of the venture capital is creating the unicorn, in other words the company with the $1 billion valuation.
My metaphor for that is it's like a rich man's game of saying 'okay i'll trade my two, half-a-million-dollar, Siamese cats, who have beautiful blue eyes, for your beautiful, gorgeous, $1-million golden retriever and we'll call it square.' And you can play that game all day long but if you really want to know what a Siamese cat is worth or a golden retriever is worth, you go on eBay or you go down the pet store, and it's certainly not those values, that I cited by way of example.
BI: I was interested in what you said about the interest rates being zero, so there's no fixed income opportunity, so private equity is looking elsewhere. Clearly it sees value in tech, so that's where to go if you want to see values rising. Is the link that direct?
KK: I mean we live in a global market and money's fungible and hedge fund private equity is looking for momentum plays, and there ain't no momentum plays in bonds, right? When the interest rates were spiking up or down, well they never really spike down they do spike up though. Something's got to happen, there's got to be motion, the dice has to be rolling on the board, and if it's not then they're not going to play because they're not going to get the adrenaline rush from looking at… you know, money markets fund interest rates or bond interests or whatever. It's got to be sexy. It's got to be things like either going long or short on Greek bonds.
BI: So when interest rates start to go up again, what happens to the flow of private equity money then?
So when that starts to happen … it's like everyone running over to the other side of the ship - so when futures on interest rates become attractive, a lot of money is going to slosh from equities, where they've had a great run for quite a few years, over to that 'cause they're looking for the next play and they want to anticipate it.
So if you have money draining out of the public equity markets, that inevitably affects the private equity market. They cannot exist going in different directions because somehow that will rent the fabric of the universe. It's just not permitted that that happens. Obviously there can be anomalies for brief periods of time but it just can't happen forever. In other words, you wouldn't see this unicorn phenomenon in the stock market if NASDAQ was in the tank and going lower, it just wouldn't happen. For a lot of reasons, not the least of which is if one of the avenues of liquidity is going public and your vehicle or your market for going public, NASDAQ for example, is going in the tank, well that's the problem.
I think the interest rate this is probably what's going to tip this over. It's like an early warning sign with a rumble in the distance, and pretty soon, the freight train is bearing down on you or the earthquake is, buildings are shaking or whatever.
BI: So currently, right now you've got more than 100 unicorns and my understanding that one of the reasons these unicorns exist is because they have not gone public. Instead they've stayed private with new, bigger private equity valuations. The original early VCs, instead of staging IPOs, have resold the equity privately. So you have this situation: interest rates go up, the money starts sloshing to the other side of the boat, what happens to all the private holders who are holding equity at what used to be valued at a unicorn level? How do they cash out?
You have to look at the fundamental raison d'être of the business - what is it doing? What's the nature of the business and what are its prospects for success? What are its prospects to break even and then return the sustained profit? Because a lot of the philosophies of the businesses are just 'we're interested in getting customers now and if we're losing money with each customer now that's okay because we have this huge hoard of venture capital that we can subsidise the operation with and once we have the required number of tens of millions of customers and we drive our competitors out of business, then we can start to raise prices and become a proper business.'
Well there's several problems with that. The first one is that, if you notice, is that how many of the unicorn companies are really prosaic businesses - like limousine services or renting rooms in your house? The original VC firms from the '70's made their money and established the reputation of their respective brands by leveraging big cleverness with small capital, not small cleverness with big capital, and that's what's going on with these unicorns. That has never worked and it won't work this time. It doesn't produce venture quality returns, and it never will.
BI: If I look at things like Airbnb and Uber, they are prosaic, old fashioned businesses, renting rooms and renting cars. But they don't own any of the inventory, they don't have any of the asset risk, no operational expenses. All they do is take a percentage of transactions, and there are millions of transactions, and that is a great business to be in. All you have to do is maintain the app and that's pretty much it. The consumers and employees take the risks and spend the money.
KK: Okay so it's not that simple. First thing is - and this gets back to the whole unicorn thing - these companies have to return money to their investors and they're not going to do that per transaction, they're not going to do that by the revenue that they're getting because they're losing money. Therefore at the end of the day, the investor who piles onto the completely ridiculous multi-billion dollar valuation, finally someone's going to say 'you know what, stock markets in the tank, you've got this valuation, we've been really grinding your numbers and we just don't see how A, you're going to break even, and B, how you're ultimately going to make money on a sustained basis doing this.
BI: You really think Uber can't break even?
KK: Not if they're subsidising drivers. The rumour is they're subsidising drivers in San Francisco to the tune of $10 million a week.
So obviously they raised a boatload of venture capital at huge market caps, and they're just subsidising this and my view is that if there's not path to profitability, just trying to dominate a market and then hope that they can raise prices later, they could be woefully disappointed because I think the price inelasticity for demand for delivery services is pretty significant.
BI: So let's say the recession comes along but the underlying business is actually viable. The business is profitable. It may not meet the valuation they hoped, but it's a real business. My worry is, if I'm the last set of investors in and we've now ploughed in some astronomical sum of money, like $1 billion dollars, at a valuation of $10 billion, and it's all still private equity, then when the market goes down, I can't sell this. The market is completely illiquid. At least if it had IPO'd, I could bail out of my shares and get some cents on the dollar. But what if you're Fidelity or Calpers, one of these large institutional investors that comes in at a late stage - how are they going to cash that out?
KK: They're screwed, they're completely screwed.
BI: So you have a highly valued asset stuck in an illiquid non-transparent market?
KK: Yeah and that's what I refer to as the liquidity crisis. Your private valuation has gotten way ahead of any potential notion of what a public valuation could be where you could exit. And therefore the problem is that you're stuck with the investment.
BI: Let me play devil's advocate - Airbnb, Uber … they have one good thing going for them: they don't really have employees and all they do is take a cut from transactions and the market for these transactions is massive. If Uber can get 50% of all taxi rides and take whatever the cut is, just for making an app, at the end of the day, that's like printing money. Why is that not a good idea?
I heard a pitch from some Stanford Business School grads in a café in Palo Alto. So they were smart guys - late 20's, early 30's. They had great academic credentials, Stanford Business School, knew a lot about entrepreneurship and all that sort of stuff, but what they were proposing to do was, taking the metaphor you're talking about which is 'you don't have any inventory, you don't have any employees, you just take a cut of these transactions.' So they had this great idea that they were going to solve the on-time, on-demand delivery for pharmaceuticals.
So I said let's analyse that a minute. First of all, for venture capital, one of the original principles is people you want to invest in are people who've done it before with someone else's money. Not people who've just came out of business school.
So I said, "do any of you know anything about the pharmaceutical business or drugs or drug pricing? Or do you know anything about actually delivering bottles of pills to people? Either of you come out of a business related to that?"
"No, we just think that mobile enabled web service is so great that it will conquer the world."
So I said, I don't think so. We like domain expertise. We like to find people who say "I've been working for this company and they deliver pills and I had this great idea and I went to my boss and he said 'we're not going to do it your way we're going to do it my way. But I want to leave and do it my way because X, Y, Z, this is how we're going to kick ass."
And then I'd say "yeah that sounds great, let's go. Let's see you kick some ass. But you know something about that business - it's not just another mobile web enabled delivery of something."
There are things that have done well. If you get out of Uber and Airbnb or WeWork at the right time, Oh man! I mean high-five! You have made a ton of money, and don't look back! Head to the Bahamas and don't look back! Because the company you exited may not be as robust and healthy in three years from now.
BI: Okay, are we in a bubble?
KK: We're in one of the biggest tech bubbles we've ever had.
BI: You're not even going to qualify that?
KK: Everyone who is inside of an expanding bubble can't imagine another world where the bubble collapses on them. It's unimaginable because they haven't lived through it. And one of the problems of course is with millennials.
Let's say you're 30, right? Fifteen years ago in 2000 when that market blew up, you were only a sophomore in high school, you were 15. So you have no institutional memory of what went on there. Of course you've read about it and talked about it and then you have a rationale that's been pre-digested for you by someone else. This time it's not a bubble, this time, these tulip bulbs, they're really worth $200. Think of all the beautiful colours! More people are planting gardens every year in Holland and all over the world. It's 200 now but it'll be 300 soon!