Tech Bubbles, FOMO & Revenge Effects
What are we missing in all the chatter about fear of missing out (FOMO), scarcity, and the current technology bubble among late-stage private companies? I’ll posit a few things, some obvious, some less so, and a couple deranged and hypothetical:
- Lots of people took this 2001 bumper sticker very seriously: Knowing that most of the money is made by being early to prominent tech IPOs, they did the rational thing: They bought earlier. In this case, not just early, but pre-IPO – in late-stage, private markets. One reason we are seeing this incredible rush to buy overpriced companies in private markets is fear of missing out on the appreciation when the companies come public. As a result, the post-IPO price appreciation is happening pre-IPO, making private companies back-door public – except, as Bill Gurley has written, in the ways that matter most, like liquidity, quality of financials, oversight, etc. You know, little things.
- A bubble in equities is generally less destructive than a bubble in debt – there are fewer claims on real assets, and thus less collateral to be sold – but a bubble in private equity markets is also very different from a bubble in public equity markets. There is less liquidity, so price declines tend to be sharper, more surprising, and less continuous. We should not confuse the new ability to sometimes buy and sell private company shares with the existence of a liquid and well-functioning market in those shares. Liquidity disappears from even the most liquid markets when it’s most needed. What happens when liquidity was never really there in the first place?
- The related distortions make it difficult to anticipate knock-on effects. For example, consider the growth in securities lending, especially in so-called specialty names with high scarcity. Markit says there are now $15.3 trillion of securities available for lending globally, with more than $2.0 trillion on loan on a typical day. Low interest rates in developed economies has an increasing number of institutions trying to cover shortfalls on the fixed income side of their portfolio by building large securities lending businesses, especially in securities with high scarcity premiums. That, in part, explains why some funds have used early positions in pre-IPO companies to drive a highly profitable post-IPO securities lending business. They use the companies’ small floats to earn high rebates for lending “specialty” equities out again – look at the 100% negative rebates out there – and then reinvest the proceeds. But how well are the proceeds invested? What are the default risks at the borrower in event of a jump change in price? There are some very strange things going on in securities lending, with negative rebates abounding. Who knows what defaults might look like in future, or whether lending proceeds have been reinvested intelligently?
- Revenge effects in technology markets can be very strong, as Edward Tenner has written, but revenge effects also exist in technology capital markets. The interplay between capital markets and technology creates myriad new opportunities for risk creation and risk obfuscation, much of which is justified, at least in part, by the wondrousness of technologies and the jobs created. This breeds a species of hucksterism, like the oft-repeated claim that “We overestimate technology’s short-run effects, but under-estimate its long-run effects”. This is, of course, just true enough to be dangerous, as ever.
- Will this end badly? It doesn’t need to, and it may not, but it would be surprising if it didn’t. Like prior bubbles, the catalyst will be something largely anodyne, perhaps a modest public market repricing causing collateral issues as illiquidity drives a sharper late-stage private market repricing. There are some superficial similarities here with what happened in the late 2000s in illiquid collateralized credit instruments (even if this is equity, not debt), where the repricings rippled through primary and then second markets, causing collateral sales, thus forcing more securities sales at sharply lower levels, and so on.
- Another problem with these pre-IPO, post-IPO (PPIPO) companies is the inevitable accumulation and calcification of preferences & related terms in their capitalization table. Each round has its own preferences, sitting on top of the round before it, generally with terms uniquely tied to that round’s participants. The ordinary way to unwind this mess is to, in the process of going public, collapse all the preferred shares into a single class of common shares, wiping out the preferences. In the absence of doing that, it’s a mess, one that encourages predatory types, like private equity firms, to show up and offer silly & unnecessary methods by which they can
screw people over &solve the problem. This would, of course, in most cases lead to much lower prices, if you could make it happen at all given the absence of cash flow at most pre-IPO, post-IPO tech companies.
- 8 o'clock, 8:30 in Newfoundland.