Venture Capital and Rational Bubbles

This post continues my journey to explain the seemingly over priced, high risk and difficult to value venture capital market. It is well known that the empirical security market line is too flat compared to theory. This means higher risk-higher beta stocks have lower than predicted returns. Conversely, lower risk-lower beta stocks (just like the ones Warren Buffett favors) have higher than expected returns. This phenomenon is called betting against beta (BAB). Two possible reasons exist for its existence.

The first is based on leverage constraints facing institutional investors like pension and endowment funds. These investors are forced to reach for asset risk to satisfy their higher risk appetites. Furthermore, leverage constraints may impede margin and short sales ordinarily used to correct over pricing. Leverage constraints and aversion probably tightened following the great recession given the failures and near failures on many undercapitalized institutions like Lehman.

A second complementary explanation is provided by behavioral economics. The argument is as follows:

1)     Investors over weight low probability high payoff events-even those with negative expected values. A simple example is the lotto. The number of players spikes as the grand prize increases even though the winning odds fall even lower. The large unlikely payoff dominates the negative expected value. A technical explanation is players (investors?) prefer positive skew. This is especially true when the wager (investment?) is relatively small compared to investor’s overall wealth. Thus, as investor wealth tends to be pro-cyclical-so is the demand for lottery type investments like venture capital (IPOs and Private Equity as well).

2)     Two additional behavioral effects reinforce the above.

a)     Representativeness-investors focus on winners like Uber and hope their investments will be winners. They are ignoring the higher base rate failure of such investments.

b)     Overconfidence-even if investors realize “home runs” like Uber are rare they believe they possess special skill enabling them to spot “Ubers”.

Add to the above the difficult to value nature of venture investment and it is easy to see how investors can get carried away in a rational bubble.

A third more traditional factor underlying the current market is low interest rates. The Federal Reserve has keep rates artificially low following the great recessions hoping to stimulate the economy. This means projected cash flows are discounted at lower rates leading to higher values. Additionally, on the demand side, low rates forcec investors to search for higher nominal (non risk adjusted) yields by going further out on the risk curve.

Thus, the venture capital market may be experiencing a rational, albeit still dangerous, bubble.

J

First Mover Advantages and Disadvantages

In Joe's last post The Price is Right he questioned the pricing of Uber, noting:

"Uber’s price is being justified on a winner- take- all, first mover, basis. I wonder, however, about the economic validity of this agreement. The industry entry barriers seem porous, switching costs for both users and drivers are low and international competition exists. "

Indeed, in a paper two colleagues and I published in the Review of Financial Studies, we do  find that the first acquiring firm in an industry after a long dormant period without acquisition activity earns abnormally positive returns.  We are quite skeptical of the first mover - or low hanging fruit argument, however, noting:

"Cottrell and Sick (2001), and Schnaars (1994) examine first-mover advantages and disadvantages, noting numerous cases in which the imitator ultimately gains the advantage over the first mover. Examples from the software industry include the success of the VHS tape format over Betamax, IBM following Apple, and Excel following VisiCalc. Cottrell and Sick (2001) also note the phenomena in the motorcycle industry with Yamaha, Kawasaki, and Suzuki successfully following Harley Davidson, and the Indian and European models."

The question is whether Uber can maintain a sustainable comparative advantage.  It's an open question, but my instincts align with Joes.  

All the best,

Ralph


References

Cottrell, T., and G. Sick. 2001. First-Mover (Dis)advantage and Real Options. Journal of Applied Corporate Finance 14: 41-51.
Schnaars, S. 1994. Managing Imitation Strategies: How Later Entrants Seize Markets From Pioneers. The Free Press, New York.

The Price is Right or Is It?

The latest financing round values Uber at more than $40B. Uber’s transaction volume is around $2B of which their take is 20% or $500MM. Yes its revenues are doubling each year over its short existence. Still this seems richly priced. How long and fast can they grow, and when do they start earning a return? Keep in mind Uber’s value exceeds that of Aetna, CBS and KKR among others. Uber’s price is being justified on a winner- take- all, first mover, basis. I wonder, however, about the economic validity of this agreement. The industry entry barriers seem porous, switching costs for both users and drivers are low and international competition exists. Furthermore, as the Wall Street Journal notes, some smaller tech firm valuations have recently fallen prior to their planned IPOs. So, is Uber immune to such a reversal?

Some VC observers like Play Bigger Advisors have tried to explain away a possible bubble by inventing a new metric- Time to Market Cap (TTMC). They believe special firms like Uber represent mythical Unicorns endowed with unique market characteristic justifying what at first glance appear to be nose-bleed valuations. Past Unicorns included Apple, Microsoft and Google who capture a disproportionate share of their market categories. They cite the TTMC of $1B for Unicorns has fallen from 8.5 years in 2000/2003 to now just under 3 years. VC are focusing on a few winner Unicorns with big investments and driving up their values. Conversely, they are pulling back from losers referred to in the Wall Street Journal article just as quickly. Therefore, they conclude there is no bubble.

This sounds like another version of the “This Time Is Different” justification. How do you operationalize the invest in winners (Unicorn) strategy? Is it like buy low and sell high? Can TTMC slow down and mean revert? The problem with these types of relative value approaches is they lack an intrinsic value anchor. They can quickly degenerate into a herding or momentum investment strategy. Over optimistic investors ignoring the base case who have excess liquidity and are eager to invest will keep pushing prices higher until there is no one left who believes and the process corrects. The price is right, but which one-the price going up or the price coming down? Finding mythical Unicorns may be more difficult than thought. Even if you do, at what price does investing in Unicorns cease making sense?

j