Buffeted By Risk
Over the last nine months we have seen escalating and increasingly dramatic asset re-pricings in public markets. Risk assets have seen their prices surge on strong earnings, relief rallies and central bank interventions. The mirror image of these positive pricing episodes has unfolded on earnings misses, political risks and fears of the end of extremely supportive monetary policy. Lately, we have seen new asset price records on the S&P and Dow. The tech heavy NASDAQ has clawed its way back to record levels. Leading private firms have shattered records, sometimes their own records, of valuation and funding round dollars raised. The last year has been a tale of epic feasts and hallowing famines.
We have spent, and will continue to spend, much time trying to deduce patterns, forecast currents and understand this ride along the saw tooth of chart after chart. Below follows a brief and introductory sketch of what we think we are learning in this risk on, risk off market environment. What we know for sure is that the private names we follow benefit greatly from the risk-on excitement and seem to come through the risk-off fear better the bigger and more well-known they are.
Markets have established a pattern of selling off aggressively on major earnings misses from leading firms. Thus, if a firm that is seen as representative or indicative, encounters difficulty the entire space is aggressively sold off and then drifts back toward old highs. Here, public names effect our private names through media coverage and write-ups and write-downs in mutual fund portfolios that hold unicorns on their books. Clearly, this pattern is not completely new and earnings always matter greatly. What seems different? The moves are more rapid and dramatic. This suggests virility of fear and a lack of faith that markets are setting prices correctly. This deserves regular attention.
The real downswings come as political risk, which is underpriced, aggressively asserts itself. Election antics, terror attacks, coup attempts and corruption inquiries are rising and riling all over the world. This makes sense and is not new. However, the severity is enhanced as is the speed. This too, suggests a lack of markets’ confidence in their own price ability as regards risk. The other novelty is that we de-price each of these emerging political risks. We stare into the abyss, run and then, stride back with amnesiac risk assessment. The best examples are Brexit and looming sovereign credit risks in Italy and beyond. Brexit was furiously priced and seen as shocking despite massive knowledge of its impending possibility. Shortly after the global and dramatic sell off, we had a re-pricing upward based on no new information or analysis. The selloffs and buy backs were rapid, global, based on nothing new and occurred in close chronological order.
Similar patterns, although far less dramatic, have occurred with regard to business-hostile political candidates, coups, mass protests and terror attacks.
Massive upward re-pricing occurs as soon as one or more money center, central banks postpones interest rate normalization or hints at great easing or stimulus. Most recently, global markets rallied on the Japan travel plans of former Fed Governor Bernanke. Weak jobs report? Great news. We are less likely to see a .25% Fed rate increase. Chinese GDP growth is reported at under 7%, a multi-decade low growth rate. Great! We are less likely to see rate increases and likely to get stimulus, monetary and fiscal. Japan flirting with more aggressive easing? Wonderful news. This suggests that markets believe that rates set the tone and the market dances to the rate beat. This too strongly suggests a lack of confidence in price setting of assets and interest rates. Greed and fear have moved into bi-polar co-working space in many decisions maker’s minds. Fast and large price swings occur and are rapidly undone.
What do we make of all this? Markets have lost confidence in their own price setting abilities. We quickly are similarly struggling for a deep rationale to follow market pricing signals. The pattern they are displaying suggests that we too should be skeptical and cautious regarding the accuracy of short term price signal. Now more than ever, long term guidelines and greater diversification will be essential. It is an age to watch closely, do deep research into what is influencing the crazy price action in the assets you own. Might be time to commit to a cogent understanding, ignore the short term signal and stay a rational course.
Unicorns Find Religion in Debt Financing
We have been seeing a spate of debt deals recently by technology unicorns. Uber raised $1.15 billion from its first high yield loan in July. Didi Chuxing, the Chinese car hailing company, took on a $2.5 billion syndicated loan following a $1 billion infusion from Apple. Airbnb raised $1 billion in debt in June, Nutanix took on $75 million and Spotify issued a $1 billion convertible debt in March. Nothing wrong in tapping the debt market, many companies do. But private technology companies? That is rare given their poor cash flow profile.
Which begs the question: are companies being opportunistic in the face of a low-interest environment or is it a sign of a slowdown in venture capital funding, forcing the company’s hand to debt markets? For the record, venture capitalists deployed $15.3 billion into 961 deals during the second quarter of 2016, which is off 12% and 22%, respectively, from the year-earlier period, according to the latest data from MoneyTree. In other words, the deal sizes are actually climbing as the number of deals shrinks.
We don’t see any megative implications from these debt deals. We believe instead that the companies are being opportunistic. The private markets are in the midst of a new normal. Companies are staying private longer than in the past and new, non-traditional, investors (banks, mainline mutual funds) with deep pockets have stepped in to fund and take strategic positions in the late-stage companies. As a result, companies are developing much more than in the past and valuations are getting rich, leaving less-than compelling upside for new late-stage investors.
In the end, it comes down to issues of dilution and control. Early investors don’t like their investments getting diluted. Debt financing provides some breathing room while the companies explore ways to access new markets and improve their competitive positioning. More important, debtors don’t demand board seats, giving managements the discretion over strategic and business decisions that may prove unpopular with all potential investors.
Furthermore, private companies need the freedom to deploy cash opportunistically or for strategic/legal reasons. For instance, Uber, Didi, Airbnb and others are gearing up for long, and costly battles to maintain their competitive positions. Spending $100M to satisfy private-car drivers or defeat the hotel lobby may not be the catalyst an equity stakeholder would like to see their cash used toward.
Similarly, Palantir, Uber, and others have all been spending heavily in funding liquidity events for their employees. Palantir has noted its plans to buy back over $200M in stock while Uber spent over $400M in 2015 alone. This use of cash is in some ways simply the cost of doing business in the Valley, both as part of the battle for talent and retaining employees as well as a time-buying tactic to further cushion against the need for an IPO.