The Bubble Question

One interesting thing about the high valuations of tech startups now is where the money is coming from. It's not stock markets.

At or near the bottom (or is it top?) of this "bubble" funnel a lot of high valuation investments from "private" money acquisitions & other supposedly smart money, like the recent AirBnB investment. Were $10bn valuations possible without public markets before recently? Does that make us daffier if this is a bubble? IE, is this proper risk capital that is less fragile and sensitive to death spirals?

Facebook has been aggressively scaling up (in my opinion successfully) their ad business since the IPO. Facebook has/had 2 big make-or-break risks: (1) losing popularity/users (2) failing to turn users/visits into into ad revenue. There was also some risk that in trying to fix #2, #1 would break.

Risk, reward, uncertainty. Nothing unusual here. Risk #1 is constant ambient risk. Risk #2 is/was more of a "what's under that rock" risk. The rock is being turned as we speak and so far the news has been good. FB value has roughly doubled in the last 9 months and IMO, that's the product of "information" about the viability of facebook as an advertising platform.

Here is the subtle point.^ They could have turned that rock just as eerily before IPO. They could have worked on the ad platform sooner or they could have delayed the IPO. I think that move was deliberate. Facebook chose to make that unavoidable, but timeable risky step after the IPO.

As an analogy, imagine a widget company. They get investment design & manufacture a warehouse full of widgets. Then they pause, take some more investment, don't spend it and go public before finding out if their widgets sell.

What role does this pre-IPO money play? FB didn't seem to need it to operate.

^I'm not sure about this. It's a speculation and I don't know or understand enough to be confident at all about it.

While it is certainly true that valuing a business with an ongoing (and somewhat predictable) revenue stream, the typical yield approach is earnings / purchase price, this is not as applicable in situations where there is either no revenue (such as in the case of Oculus Rift) or little predictable revenue (WhatsApp). What exactly is the yield rate on the Oculus Rift acquisition when earnings are near zero?

Much of the acquisition activity that is driving exits, which is in turn driving VC activity (exits motivate investment), is coming from land grabs in expectation of FUTURE potential significant markets. Facebook grabs OR because it believes that the $2B purchase price now will be far outweighed by the potential for VR in the future, same for WhatsApp.

It would be simplistic to say that valuations that drive acquisition activity comes simply from comparing yield levels.

That being said, where does Facebook get the money to make the acquisitions they do? From the public market. The public market is mostly driven not by individual investors, but by major market movers, which are few in number compared to the "retail" investor market, but significant in influence. And Goldman Sachs and the like might be motivated to keep pushing money into Facebook because the alternatives are weak, given the current low yield environment.

If yields improve, then GS and the other market movers might shift from equities to other asset classes (fixed income, equities, maybe even CDOs again), and then as the money stream starts to taper for folks like Facebook, their acquisition activity will slow, and then valuations will start to decrease, and then Venture Capital activities in those sectors will also dampen, because the exits will be seen as less lucrative.

It would seem to me that exit activity drives valuation more so than current yields, but current yields might impact the money flow that drives those acquisitions.

One of the later episodes of the a16z podcast featured Marc Andreessen and Benedict Evans. They were discussing technology valuations and made some good points. Though I disagreed with their "no bubble" consensus, they were right in mentioning the classic "Russian oil money" and "new players" argument. Previously, most tech investing was done by U.S. venture capitalists. (One of the reasons why non-U.S. start-ups find it hard to fund themselves.)

However with multi-billion dollar technology floats like Facebook taking place - many, many people are taking notice and bringing lots of money with them. This, obviously, increases demand which in-turn increases prices. That's all. If, or indeed when, the bubble pops and people realise that these businesses aren't worth the price paid, I suspect it won't lead to the type of crisis that occurred in 00/08 - just lots of rich people with less money.

I don't know about SF, but it certainly didn't stick in London (UK) post the dotcom bubble. Many people ended up either with no work in tech or taking voluntary pay cuts, and the hourly rates for contractors dropped dramatically only to get back to previous levels in GBP terms 10 years later. Many tech workers left London because they couldn't afford to live there any more. New properly developments around certain parts of London didn't find tenants, rents dropped making it more attractive to buy a few years later.

I generally agree with fred that monetary policy is driving valuations. However, I think it's not quite as simple as he describes (although he may be intentionally simplifying for his audience).

It's true that financial assets compete with each other for investors. So when the Fed reduces the yield on Treasurys or MBS, the marginal investor will rotate to a riskier asset. This will create a chain reaction that eventually raises equity prices. However, it's not the case that earnings yield (Earnings/price or the inverse of P/E) is going to be equivalent to the interest rate on Treasurys (T-bills). Typically the way that investors think about it is earnings yield = Treasury rate + equity risk premium. So at an equity risk premium of 5%, even a Treasury rate of 0% would result in an earnings yield of 5% or P/E of 20, not infinity. This isn't too far from the market multiple of the S&P 500 right now. (The historical average ERP over the past century has been 4.2%.) So the market multiple implies that the overall market is not in a bubble, but that doesn't eliminate the possibility that some sectors are in a bubble.

The Fed's influence on the market goes beyond their impact on interest rates. One reason for the sharp rise in markets is that investors are fearful of inflation. Although CPI inflation has remained low, investors would rather hold scarce assets such as equities and real estate than a rapidly diminishing percentage of the money supply (i.e., cash) that results from money "printing". While money creation is nothing new, and in a sense, unconventional money creation is not that different than conventional easing, the sheer scale of our current monetary policy is unprecedented. This lack of precedent creates a high degree of uncertainty in the ultimate outcome.

The final reason for the strength of the markets is a widespread belief that the "Fed put" is back. It is almost universally believed that the Fed has taken on a third, unstated mandate of stable and rising equity markets, by easing and talking the market up when it declines. I don’t know to what extent this is true, but the mere notion has created a hidden source of instability in the market by giving investors unusual confidence. While there is no reason to believe that markets will crash, it's also not out of the question.

The Fed has announced that it will "taper" QE purchases from $75 billion / month to $55 billion / month. At the current rate of taper, QE purchases could reach zero by the end of the year. One key question for investors is whether this may reverse any of the three dynamics listed above.