Unicorns: Why This Bubble Is Different

Bubbles are banal; bubbles are necessary. Bubbles are banal: wherever markets in assets exist, there will be found the persistent recurrence of momentum investing, herding behavior, and prices decoupled from any concern with past, present or prospective cash flows. Bubbles are necessary: they mobilize capital to fund the deployment of transformational technologies and the exploration of their use on a scale far beyond what would be generated if investment were strictly a function of observable financial returns and economic value.

Over the past year or so, a phenomenon has emerged at the frontier of the digital economy: a wave of ventures delivering “disruptive” web services: Uber, Airbnb and their kin, generically known as “unicorns,” that share the double distinction of being valued at more than $1 billion while remaining private companies. How can we know whether these unprecedented valuations, some 107 of them at latest count, represent a bubble…and, if so, why this bubble is different?

Financial bubbles can be distinguished and categorized along two dimensions. The first dimension is the object of speculation. Charles Kindleberger, in his masterful work Manias, Panics and Crashes, laid out the extraordinary spectrum of assets that have been the foci of bubbles:

Investors have speculated in commodity exports, commodity imports, agricultural land at home and abroad, urban building sites, railroads, new banks, discount houses, stocks, bonds (both foreign and domestic), glamour stocks, conglomerates, condominiums, shopping centers and office buildings.

Occasionally, as in the case of railroads and some glamour stocks – for example, those representing the companies that commercialized electricity, radio, aviation, computing, the internet – the economic assets on which financial speculators focus have the potential to deliver step-function changes in productivity and, indeed, in the very scope of economic possibilities. Today’s unicorns appear to embody precisely that promise.

The second dimension is the locus of speculation: is the bubble expressed in the prices of traded securities in the liquid capital markets or is it driving the valuation of assets held (or serving as collateral for assets held) by the institutions of the credit system? The distinction has enormous consequences when, inevitably, the bubble bursts. The markets of the real economy can shrug off a collapse in prices in the relatively unleveraged financial markets for equites and junk bonds. But a collapse in the value of the assets held by highly leveraged banks freezes the provision of working capital across the entire economic system. The contrast between the economic consequences of the implosion of the dotcom/telecom/internet bubble of 1998-2000 versus the Global Financial Crisis of 2008-9 is definitive.

Wherever they arise, bubbles share a common signature. Whether speculation is limited to the liquid capital markets or whether it infects the core credit system, the signature of a bubble is this: as prices rise, demand increases. Against the conventional pattern of “negative feedback” that associates higher prices with lower demand (and greater supply) – a response that is essential to the establishment and maintenance of market equilibrium – the demand curve inverts in a bubble.

Bubbles in stock prices “are associated with increases in trading volumes…a well- established stylized fact.” Bubbles in the credit system have a similar profile: higher prices of the assets held by leveraged financial institutions feed through to increase the value of their equity with a multiplier effect on their lending capacity: “When the price of a risky assets rises, the leveraged financial institution purchases more of the risky asset….But then, the additional purchases of risky assets…fuel the asset price boom further.

It is along this second dimension that speculation on the future economic value of the unicorns is different. For its venue is neither the credit system nor the public, liquid capital market. The venue of this bubble is the market for private placement of equity securities with institutional investors – hedge funds, mutual funds, even sovereign wealth funds – whose portfolios overwhelmingly consist of public, freely tradeable shares.

Private placements of equities with institutional investors have a long history: more than 35 years ago, I myself was a pioneer in this market segment. But pricing of such placements was always at a substantial discount to the valuation of comparable public companies, as much as 40%. For the first time in the relevant record, institutional investors are choosing to pay premium prices to purchase securities without liquidity and in increasing volume.

Let’s unpack that sentence:

First, “premium prices”: valuation metrics for the most recent financing rounds of unicorns – calculated as enterprise value divided by annual revenues, given the lack of profits reported by the vast majority of these fast-growing ventures – are currently running on the order of twice that metric for comparable public companies.

Second, by purchasing unregistered securities in the absence of a liquid trading market, the new investors have chosen to forego the most valuable option an investor in a speculative venture can possess: the ability to “sell too soon;” the right to get out before having to find out if the speculation has been validated by economic reality; the opportunity to make money even if the venture fails.

Finally, the signature of a bubble can be discerned in the increasing volume of such purchases of securities even as the disparity in valuation between private placements and public markets has grown.

Between 2013 and 2014, Goldman Sachs’ count of the aggregate dollar value of private placements of tech company equity of more than $100 million quadrupled from $3.3 billion to $12.2 billion as the number of such transactions tripled from 15 to 49. And by Morgan Stanley’s more inclusive reckoning, technology private placements have risen from $9 billion and $10 billion during the twelve months ended March 31, 2013 and 2014, respectively, to $33 billion during the twelve months ended March 31, 2015.

What’s going on here? Let’s begin with the supply side of this new and different market. As the complex of technologies that enable the development and delivery of disruptive services on the web have matured, the frictions that inhibit the growth of new companies have declined enormously. At start-up, the cost of introducing a new service is radically less than just 10 years thanks to open source (that is, “free”) software tools and the availability of computing resources for rent as needed from Amazon and the other cloud suppliers. Marketing begins with social media and advances through search engine optimization (i.e., gaming Google for better placement). And the service is delivered over the web as, from the point of view of the user, the underlying IT disappears.

So the number of Darwinian “hopeful monsters” grows while the potential scale of any one of them grows even more. It is radically less costly in time and money to reach users and for users to take advantage of the service. Before profits or even revenues are recorded, an exponential increase in the number of users serves to imply a boundless market for the emergent unicorn even before a model for revenue generation and a path to profitability has been demonstrated.

This especially appears to be the case for the web-based, two-sided market platforms represented by Uber and Airbnb. Both the suppliers and customers enjoy virtually friction-free access to services – including endogenous measures of service quality – that have historically been provided through far less efficient means characterized by substantial information asymmetries.

But a word of warning: these services are delivered physically and locally, unlike the virtual services delivered by Google and Facebook. Consequently, as each has been learning city by city, they are subject to local ecosystems that have evolved around the provision of such services: regulatory, political, cultural. The London taxi industry is not the same as that of New York nor San Francisco. The unbounded growth rates implicit in their valuations are subject to exogenous impediments that may induce step- function revaluations of growth prospects.

On the demand side, institutional investors have now been living with real interest rates close to zero for more than five years. Stock market returns have been attractive since recovery from the Global Financial Crisis was established and have averaged about 12% annually over the past five years. But the flow of new companies to the public markets, with the potential to deliver extraordinary growth and returns, has been highly constrained.

For half a generation, since the last stock market bubble burst in 2000, the number of initial public offerings (“IPOs”) for technology companies has been far below the quarterly average of the previous twenty years, 10-15 per quarter versus more than 30. One factor has been the extreme consolidation of the investment banking industry since that time, with access to the market dominated by a small number of dealers whose own economics dictate their interest only in large offerings, more than $100 million.

IPOs even at that scale limit the amount available to the major investing institutions, who can only accumulate meaningful positions by buying into a thin after- market, driving up the price against themselves. Under such circumstances, it appears rational for investors of this sort to make substantial commitments – many tens of millions of dollars – to offerings marketed as “pre-IPO” at valuations which are advertised as taking into account the post-IPO price increases.

Here, at length, is the crux of the matter. Sooner or later the unicorns will either go public or not. If they go public, their valuation will be subject to the two-way trading activity of the more or less liquid stock market. So far, the indications are mixed, at best. For every IPO that has validated the last private round in recent months, another has recorded a substantial markdown.

The alternative to an IPO, of course, is sale to a strategic, corporate acquirer. But at the $1 billion-plus private market valuations for companies not generating profits or in some cases even revenue, the list of potential acquirers able to pay the price and absorb the dilution is very short indeed, limited to “FAGA”: Facebook, Amazon, Google and Apple, with perhaps Microsoft thrown in.

The very existence of the FAGA set of players, of course, is what motivates the underlying force of the Unicorn Bubble, expressed as another acronym, “FOMO”- fear of missing out. For the digital revolution has just now crossed the threshold from the complex build-out of infrastructure to the enormous commercial potential available from exploiting this new economic space. Think mail order retail – Montgomery Ward and Sears Roebuck – the “killer apps” of the railroad age.

Institutional latency guarantees that the Unicorn Bubble will persist yet awhile. The establishment of dedicated funds by major investment managers, as well as allocations by several sovereign wealth funds, will not be reversed overnight, whatever the results of the IPO market test. Yet, there will be consolation for society at large, if not for those motivated by FOMO to sacrifice liquidity in pursuit of the next FAGA.

Indeed, the vast majority of the horde of hopeful monsters will fail to meet the speculators’ dreams and the failure of many will take the ultimate form of bankruptcy. But there will be a few amazing winners to demonstrate yet again the occasional role of productive bubbles in funding economic development at the frontier of technological innovation.