October 31, 2019


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My fascination with financial markets has recently peaked to a level I last experienced around the late 1990s “dot-com” craze.

Warren Buhai

Senior Portfolio Manager
BCompt(Hons), CA(SA), CFA

Warren has 19 years’ industry experience, with a strong focus on research and portfolio management of multi-asset funds. Most recently he has transitioned to a senior portfolio management role in STANLIB Absolute Return team.

The Global Financial Crisis (“GFC”) in 2008 resulted in Central Banks printing money (better known as quantitative easing or “QE”) and reducing interest rates down to zero without fear of any long-term consequences provided asset classes kept producing positive returns.

Then around five years ago, certain government bonds began trading with negative yields, implying a guaranteed loss for an investor if held to maturity. As global recession fears have risen, so this level of negative-yielding debt has increased to a hard-to-fathom $16 trillion, about 30% of the world’s investable bond universe. Some Danish banks now even offer negative interest rate mortgage bonds meaning they pay you interest every month on your home loan.

So where do the unicorns fit in?

The unintended consequence of “free” or rather “ultra-cheap” money has been to incentivise the wrong behaviour in both corporates and investors. For large listed corporates, it has become beneficial to borrow “cheap” and use debt funding to buy back shares at ever-higher prices. Instead of investing in growing their businesses and/or improving productivity, these companies are opting for a more “guaranteed” and less risky way to generate improved short-term earnings per share growth in an uncertain environment. Unsurprisingly US corporate debt is at its highest-ever level as a percentage of GDP.

From an investor’s perspective, there are various consequences. Let’s focus on the impact on the unlisted or private asset markets, home to the elusive unicorns.

“‘Unicorn’ is a term coined in 2013 to describe an unlisted company that has a valuation of at least $1 billion.”

As you can imagine, initially they were a fairly rare breed in the unlisted space (less than 50 in 2013), hence the name, but as a result of significant amounts of ultra-cheap money to finance their growth, there are now 404 unicorns globally with a total valuation of $1.3 trillion1.

Through interest rate reductions, Central Banks in developed markets have intentionally incentivised investors to take risk to generate real wealth, in the hope that this in turn will spur more consumer spending. Many investors take the bait simply because money sitting in the bank or in government bonds would give them a return below the inflation rate.

Over the past five years, we have seen a significant increase in investment money (about $4.4 trillion) flowing into unlisted assets, such as venture capital and private equity, where illiquidity and opaque corporate governance risks are many times higher than in the listed environment.

The flight of investors’ cash to these riskier assets has allowed start-up unicorns to create business models that can make seemingly endless losses, provided they grow revenue aggressively. A good example of this phenomenon is Uber, recently listed and previously the most highly valued unicorn. Uber has been generating very high revenue growth through large spend on advertising, driver incentives and passenger discounts and has attracted investors due to the sheer amount of capital looking for a home in the venture capital space. The ultimate question is, when do we think this endless support of zombie-like companies will end? Looking at prior cycles can provide a clue to when we may expect the bubble to burst. An initial indicator is the percentage of new companies listing in the US with negative earnings (see chart on the left). The latest level matches the peak last seen at the height of the dot-com bubble in 2000.This would not be a concern if these unprofitable companies had successful listings. A second warning sign is the performance of these new listings. For example, Uber’s share value is down over 25% since listing in May this year. It now has a market capitalisation of about $50 billion.

“The flight of investors’ cash to these riskier assets has allowed start-up unicorns to create business models that can make seemingly endless losses, provided they grow revenue aggressively.”

While some unicorn listings were successful, generally we’ve seen a similar pattern over the past two years, where aggregate US IPOs are underperforming in the S&P500 index, as well as their private market counterparts. This is similar to market behaviour ahead of the peaks of the previous two equity bull markets in 2000 and 2007. In China, the second biggest unicorn market after the US, IPO performance is even worse and venture capital funding has collapsed 77% year-on-year.

Valuation multiples for unlisted companies are potentially a third indicator, since they have reached levels not seen since the late 1990s dot-com bubble. Some of the recent successful unicorn listings currently trade at price to sales multiples of over 30 times. Scott McNeely, CEO of dot-com darling Sun Microsystems, in response to assumptions made by investors to justify the 10 times price to sales multiple when the share price peaked at $64, famously said, “Do you realise how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”

His share price was $5 three years after that peak. Today, there are 36 S&P500 companies that have price to sales multiples of over 10 times compared with 29 such companies at the peak of the dot-com bubble!

While no two cycles are the same, investors’ behaviour often follows a similar path the longer a cycle continues. There are currently many warning signs like the ones seen in prior periods of irrational exuberance. What makes this current cycle unique is the sheer amount of capital clamouring for ever more expensive, ever more leveraged private market investments, which by their very nature are illiquid and opaque. Ironically, when this cycle of seemingly endless ultracheap money inevitably ends, the pain may first be felt within public markets because investors who need to raise capital quickly to repay debt will inevitably sell the most liquid assets first, regardless of relative valuation levels.

However, there’s never before been this amount of money sitting complacently in the private market space. How will it all end? It’s a difficult call to make, given this cycle’s unique features. It’s clear though that investors who have flocked to private markets on the assumption that these have uncorrelated and low volatility exposure relative to public asset markets may be in for a rude awakening when this cycle comes to an end.

Top Points

  • Negative-yielding debt has increased to a hard-to-fathom $16 trillion. This amounts to about 30% of the world’s investable bond universe!
  • The unintended consequence of “ultra-cheap” money has been to incentivise the wrong behaviour by both corporates and investors.

 

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