The date was October 2018, my friend and I were on a trip in New York City – still in our senior year of college. We booked a weekend trip last minute because there was a restaurant my friend wanted to try out, and because we haven’t seen each other in a couple of months. When booking our accommodation, we saw an intriguing place located in the financial district; situated at 110 Wall Street was one of the two WeLives that existed before it was shut down. If it isn’t clear to you now, WeLive is the long-term rental/hotel venture of WeWork – the vision of this venture was to change the way people lived, in contrast to how WeWork was supposed to change the way how people worked. The concept: a sleek dormitory for working professionals with free booze, arcade games located in the laundry room, and catered Sunday dinners. It was supposed to be an idea that would spread across the world like wildfire.
Once we checked in, we were notified that later in the night there would be a party happening in the basement club, the Mailroom, which doubles as both where residents pick up their mail, and an underground bar decorated with velvet couches and walnut paneling. Heading into our room, we were greeted with the “hippest” hotel layout I’ve ever seen: the first bed embedded within the wall with curtains for privacy and the second being a sofa bed, pots and pans hanging on the wall above the stove with knives seemingly floating in midair in-front of a metallic strip right below it, the final touch of this millennial paradise of course being a fridge filled with boxed water.
We were ready to head out of the hotel for dinner later that night, and while walking down the bare concrete walls of the hallway we noticed a big monitor displaying the weather on the wall, at that moment my friend – an econ major – stared at the screen, shook his head, and said, “this is what happens when there is too much QE.” At that point in time, I was still a 4th year engineering student with zero knowledge of the financial markets, but close to four years later, it all made sense.
What is QE?
QE stands for Quantitative Easing, a monetary policy tool in which central banks globally use to increase economic activity when interest rates are just barely hovering above zero. During QE, central banks purchase treasury/government bonds and other financial instruments such as mortgage-backed securities from the open market. This creates new bank reserves, providing banks that sold the treasury bonds with more liquidity, which should encourage additional lending and investments through times of economic trouble.
As more government bonds are being bought, through the laws of supply and demand, the prices of these bonds then go up. These government bonds pay a fixed coupon amount, so as the prices of these bonds go up, the yield (return) you get from these securities goes down – making them less attractive for investors looking for a safe haven for their cash and encouraging them to invest their money back into the economy.
Okay, thanks for the econ lesson, but what does this have to do with VC?
When there is fear of a looming recession, investors pile their money into government bonds because it is usually the safest form of investment, as there is a much lower chance that the government will default on its debt obligations as opposed to private enterprises. When investors see the decreasing yield these treasuries provide, it incentivizes them to invest in the private sector instead and seek higher yields through riskier investments.
Though it is hard to effectively measure the impact of QE, one thing to note is that many of the tech giants that we see today were founded around or a little after 2008 such as Uber and Airbnb. As the financial system is flushed with money from central banks, investor risk appetite steadily increases, ushering in the era of growth at all costs. From this point onward, companies would stay private longer and raise giant private fundraising rounds never seen before outside of IPOs.
The steady influx of capital into VC
There is no doubt that the money being poured into venture capital after 2008 has been steadily increasing overall, the amount of money injected into venture capital financing in ‘21 stood at a staggering $620.8B with a deal count of 34,647 deals according to Venture Monitor. This figure was more than twice the figure of the year before which equated to $297.3B with a total deal count of 26,500.
When the ecosystem is pumped full of money and has the attention of once outside spectators, one must raise the question: are investors taking a careful look at the companies they’re investing in, and carrying out the appropriate due diligence? The two names that come to mind when thinking about the paradigm shift in venture capital strategies are SoftBank and Tiger Global.
Suddenly, startups were getting hundreds of millions of dollars with the strategy that it would supercharge their growth – this is because Masayoshi Son believes that technological singularity will occur – where machines would end up surpassing human intelligence by 2047.
The force behind supercharged valuations: FOMO
At the peak of the fundraising bonanza, investors of all stripes were willing to invest at almost any price due to the fear of missing out (FOMO) according to the Financial Times. Naturally, as funding rounds were being wrapped up and near closing, last minute investors would tend to side-step comprehensive due diligence – not fully understanding their monetization strategy and pathway to profitability.
The constant economic growth in combination with lax financial conditions following the great financial crisis of ’08 made investors approach venture capital investments as bets that only move in one direction – up. As a result, the incentives for both the founders and investors were to keep companies private for longer and raise increasingly massive sums for their subsequent funding rounds. By keeping the company private for longer, founders were able to keep their valuations artificially high and investors were able to hide their exposure in the private market and mark higher returns for their investments. It was a system that worked well for both parties involved and it looked like a train that would never stop to a halt, and because of this, the venture capital industry became bloated.
The inevitable devaluation and resetting of expectations
The global economy has been experiencing unprecedented economic growth for over a decade since 2008 (excluding the small blip that is covid 19), however, all that has changed with the present macroeconomic and geopolitical troubles that are brewing. Inflation, which was initially touted by central banks as transitory, proved to be anything but. Global shipping & manufacturing bottlenecks caused by covid still lingers, driving up prices for goods and services, record high energy prices caused by the war in Ukraine – and finally, subsequent rounds of QE carried out by central banks globally (which was sped up during covid in an attempt to stave off a global recession) were some of the factors that have brought us to where we are right now.
Unlike the stock market which is continually tracked and public to any spectator, the private holdings and valuations of startups remain behind closed doors as only the investors and founders themselves have that information. When the condition for the perfect storm is right, market forces converge onto all asset types; public indices that are broadcasted are the first to feel the pain as everything is updated in real time. Venture capital, like any asset class, is also affected by the macroeconomic forces and market sentiment – devaluations just don’t happen unless a funding round has been concluded. Founders can look the other way and pretend that it won’t happen until their company runs out of money and is forced to fundraise during the precipice of an economic downturn.
As inflation starts to bite, and consumers are slowly feeling the pain, the natural instinct is to be more conscious of what they’re spending their money on. The first wave of large devaluations has started, impacting the fintech industry, more specifically buy-now-pay-later (BNPL) players as consumers are reeling back from conspicuous consumption – after all, how many OLED 4K HDTVs does one really need? Klarna, the Sweden-based BNPL player is a notable case as they have suffered an 87% markdown in valuation from their latest funding round earlier in July – the company is now valued at $5.9B.
Unsurprisingly, the fund behind Klarna’s sky-high valuation was SoftBank. After they led their venture round of $639M back in July ‘21, the round had doubled Klarna’s valuation to around $45B amid the boom in ecommerce during the covid 19 pandemic. Within recent years, the VC investment strategy has shifted from backing bold founders that have spotted a great market opportunity to spreading out their bets globally while increasing their ticket size. The strategy hasn’t worked well so far for both SoftBank and Tiger Global, with the former disclosing a one-year loss of $27B and the latter disclosing a loss of $17B within the same time period in May of ‘22.
What’s next for VC?
Venture capital is no longer the goose that lays the golden eggs, as investors, both sophisticated and unsophisticated, have entered the arena and pushed up valuations for everyone involved. Although more capital could equate to more opportunity to back riskier technological bets that could change the way we live for the better, this romanticization of a technological utopia evaporates once one pours over fundraising data and sees where the capital is being allocated. Instead of fixing immediate problems such as the agricultural supply chain, VCs pour money into businesses such as instant grocery delivery, a business model which not only has lackluster unit economics but is also detrimental to the environment; perfectly illustrating that we have reached the peak of the VC bubble.
Once all the hype and FOMO have subsided, the investors that will remain are the ones with strong investment discipline and ones that have been active since the beginning of the modern VC industry, the likes of Greylock Partners and Kleiner Perkins. These investors don’t follow the hype since they have been through many boom-and-bust cycles as opposed to the newer investors that have joined the industry: the longevity and successes of their investments and exits can speak for themselves. As to what will happen to all the investors that have been overpaying and artificially inflating startup valuations, this can be perfectly summed up by a quote from the Oracle of Omaha, Warren Buffett: “only when the tide goes out do you discover who has been swimming naked.”
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