Months ago (in April), as the rise in the CPI was starting to get underway, the InnovationAus editor asked me; “Why is any sign of wage or consumer price inflation stamped on immediately by governments, while asset price inflation is considered virtuous?”
He noted that “twenty-somethings and thirty-somethings are gathering up their pitchforks because they not only can’t afford to buy a property, but they are now getting gouged for rent.”
His interest wasn’t just in housing but also in startup valuations in the tech sector, saying; “Isn’t the VC market being flooded with $$ as the super funds go in search of yield? That the established VCs raising record-sized funds has less to do with the Australian ecosystem becoming ‘more innovative’ or in any way more attractive and more to do with zero/near-zero interest rates and the fact that the place is awash with money”.
I’ve had several stabs at trying to write this. The terribly short answer is that it is all about letting politics dominate policy. The longer answer delves into the theory of value, but it ultimately hinges on the insufficiently accounted-for role of expectations in determining value.
A really good place to start though is with the tales of two “titans” that have been playing out in front of us for days. Of course, I am talking about Sam Bankman-Fried and Elon Musk.
As Bankman-Fried’s FTX has gone spectacularly bust over recent days, aside from the racy headlines of the ‘polycule’ (a term that Musk, among others, has used), the stories repeatedly tell us the company was “once valued at $32 billion”. (All dollar amounts are USD unless otherwise specified)
I am a great fan of John Quiggin and enjoy every time he tweets about bitcoin heading towards its true value, which is zero. That is, I’m a cryptocurrency sceptic.
Fiat money issued by nation-states is no longer backed by gold, but it is backed by the coercive power of the state, including the taxation power and the need to maintain the nation’s investment standing.
Crypto has no such backing.
Even if you aren’t a crypto-sceptic, the details of how FTX operated make the idea that anyone could ascribe that value is stunning. A little digging reveals that the valuation arose from a Series C financing round.
For the niceties of the description of funding rounds, I am relying on Investopedia. To put it simply for the uninitiated, the rounds after initial seed funding (where so-called “angel investors” come in) are as follows:
- Series A – the venture has moved from being a great idea to an actual plan for developing a business model that will generate long-term profit. Investors are looking for companies with great ideas and a strong strategy for turning those ideas into a successful, money-making business. Funding typically comes from established venture capital firms like IDG Capital and Google Ventures. Firms undergoing Series A funding rounds may be valued at up to $24 million
- Series B – the business has moved past the development stage, and new investment is required to expand market reach. Series B is led by mostly the same characters as Series A, with a new wave of other venture capital firms specialising in later-stage investing. Most Series B companies have valuations between $30 million and $60 million
- Series C – businesses that raise Series C funding are already quite successful. The funding focuses on scaling the company, growing as quickly and successfully as possible. Series C is when hedge funds, investment banks, private equity firms, and large secondary market groups accompany the types of investors already named. Mostly a company will end its funding at Series C and use the valuation to “boost valuations in anticipation of an IPO”
So, let’s get back to FTX and its Series C financing. Exactly the kinds of firms we would expect to find have been listed as investing in the Series C round. Those we know include Singaporean state investor Temasek, SoftBank’s Vision Fund 2 and Tiger Global, and Canada’s Ontario Teachers’ Pension Plan. There were twelve investors, most of whom had participated in previous rounds.
FTX had two rounds of Series B financing. First, over 60 investors participated in a funding round of $800M in July that valued the crypto exchange at $18 billion. Then, in November, 69 investors poured in another $420 million in Series B-1, valuing the company at $25 billion.
Let’s for a moment see what all this looks like from the point of view of those investors. At the Series B-1 valuation, investors in Series B were looking at a return rate of 117% per annum. At the Series C valuation, Series B-1 investors were now looking at a 133% annualised return, while Series B-1 investors were looking at 112%. The guys inside those funds who recommended the investment were looking like heroes.
Let’s look at one of these funds, the Ontario Teachers’ Pension Plan, which has already written off its $95 million investment in FTX. So should teachers be wondering about their retirement savings, as one columnist pondered? The short answer is no; the fund in August had net assets of 242.5 billion Canadian dollars (about US$182 billion). That is, the FTX write-off represents only 0.05% of their wealth.
The fundamental question that needs to be asked is who did the valuing on which each of these rounds was based.
However, the real valuation isn’t always what matters. Just as in a housing boom, buyers flood the market for fear of missing out (FOMO), so investors will put away their concerns and accept a valuation because someone else is already investing at that value.
So the roundabout keeps spinning if investor A accepts the valuation because they understand investor B will invest and therefore accepts the valuation. In reality, investor B only accepts the valuation because they think investor A will accept and therefore accept the valuation.
Nowhere was this suspension of belief more dramatic than the over-investment in long-distance fibre capacity in the first tech bubble. The investment was based on the supposed fact that the internet’s capacity was doubling every hundred days. Even telecommunications company executives who had access to their own data not only repeated the claim, they and banks financing them invested based on that claim. (A little note about this is included at the end of this article).
Meanwhile, elsewhere in the finance wonderland, Elon Musk has spent $44 billion buying Twitter (well, $46.5 including closing costs) and currently seems intent on burning it to the ground.
While Musk raised much of the finance by selling down his stake in Tesla, large investors and major banks have provided $13 billion in equity (not debt) financing.
It may be that those external investors have priority equity and face less risk than Musk if the company only has a near-death experience but remains salvageable under new ownership. It is not a good week for Sequoia, which has an $800 million exposure on Twitter, nearly four times the amount it has just written off with FTX.
What these two stories have in common is the nature of the company in question. Both FTX and Twitter are essentially “platform” companies, just like five of the top ten companies by market capitalisation in the world.
These companies derive their value from the number of users they have and the fact that their product is more valuable to each of their users in proportion to the number of users.
Economically this looks like the network effect familiar in telecommunications but is more technically a “demand side economy of scale”, as beautifully outlined over two decades ago by Carl Shapiro and Hal R. Varian in Information rules: a strategic guide to the network economy. These companies typify the third age of capitalism.
What we know of as capitalism – really a market economy – started when first the “owners of the means of production” were individuals (capitalists) who, either on their own or in small partnerships, built mines, factories and railroads.
It was only in the middle of the nineteenth century that the common-stock company became anything other than a bespoke vehicle authorised by specific legislation on a company-by-company basis. This marks the second stage of capitalism, typified by being listed on a stock exchange and largely in one country.
This phase of “managerial capitalism” represented a high point of corporate transparency and a facility for government oversight. However, it came with its own challenges, first detailed by Berle and Means in The modern corporation and private property. The development into a multinational corporation often involved listed subsidiaries in new markets as ways to provide the capital for growth.
More recently, the third phase of capitalism consists of very large, truly transnational enterprises with highly complex internal structures. Some of these remain listed on stock exchanges, but increasingly they are not. Some are conglomerates ultimately held by State-owned corporations (including many owned by democratic governments), while some are controlled by “private equity funds” that access personal wealth and superannuation funds.
The development of this third phase has been facilitated by the development of platform companies. The move from ownership capitalism to managerial capitalism was necessitated by the ever-larger amounts of capital that needed to be invested in productive enterprises. The nature of competitive markets meant that the cash flows these businesses could generate were closely related to the money invested in them.
The basic theory of finance is that investors value a company based on the future cash flows from the business. As a result, market-to-book ratios relating market capitalisation to historic capital investments were usually close to one.
Certainly, there were some ‘intangible assets’. Brand value was one of these; examples such as Richard Branson’s Virgin brand show how an intangible asset can be leveraged.
But some assets can be valued by how much they can be sold for rather than how much they cost to buy or what the cash-flows are worth (in net present value). This resulted in the move to “mark-to-market” these assets in company accounts.
This marking-to-market was a major contributor to what in Australia we call the Global Financial Crisis, and it is only in the world of marking-to-market that investors in FTX were doing well.
A consequence of this world, in which market capitalisation can far exceed capital invested, has been the growth in funds available in venture capital funds and all the various other versions of “private equity”.
There is no better example of this than Musk, whose ability to indulge in Tesla, and then SpaceX, was courtesy of his payoff from Pay-Pal.
At the moment, these investors face prospects that are a little like playing a distorted game of roulette where the payoff from getting a number right is 40 times. By covering the board, you have a lot of losses, but the wins make up for all the losses.
That makes investing a game of scale, and the people who get bigger fastest are already big. But ultimately, the whole game only pays off when IPOs occur. And here is the crunch; these investors are ultimately paying the biggest differential between the market value and the capital initially employed.
We already saw what happens when sentiment turns at the start of the millennium, and investors start looking more for cash flow than future asset sale returns. We called it the “dot.bomb”. In Australia, we had our own cast of lively characters (the best surely being “two bags” Tyler) covered in Kate Askew’s excellent Dot.Bomb Australia.
Governments don’t act to stop these bubbles from occurring for several reasons. The first is that they have very limited tools to deal with them, especially now that so much financing is by knowledgeable investors who can thoroughly investigate the businesses.
Second, most policymakers only know neoclassical or orthodox economics, which teaches them that the market always determines the right price, especially when the purchaser is informed and rational.
Finally, any action to stop a bubble bursts a bubble; while bursting it later might be messy, having it happen on your successor’s watch is much better.
However, underlying some of the worst excesses are some other characteristics of the third age of capitalism. Managerial capitalism has been replaced with ‘financial capitalism’.
Ownership capitalism focused on production, and owners were interested in building enterprises and intergenerational wealth. Managerial capitalism’s focus moved to increasingly shorter-term returns. Financial capitalism focuses almost more on the returns available from restructuring, refinancing and tax avoidance.
Creating value by financial machinations alone cannot be sustained forever; it will end on its own accord. However, while the economy is dominated by platform companies, where value is far more than the capital invested, there is a steady flow of new excess cash to be fed into financial machinations.
These same large equity funds come hunting businesses in the ‘old economy’. Brookfield, which has made an $18.4 billion Australian dollar bid for Origin energy, also invested $250 million in Musk’s acquisition of Twitter (but don’t worry about the cost to them if they write off the Twitter investment, they have $690 billion under management).
The arrogance of these funds can be seen in Brookfield’s Origin bid, arguing “the benefits of accelerated investment to smooth the way towards the government’s 2030 emissions targets should outweigh any regulatory concerns from the firm’s parallel ownership of transmission company AusNet or foreign investment concerns about a North American takeover of sensitive gas production and power plants.”
It escapes all understanding that paying a significant premium to buy existing assets that need to be retired can accelerate the new investment required to fund the transition.
Complex structures and strange accounting dominate the third age of capitalism, both of which rely on the arbitrage of national regulatory institutions (meaning the rules and the bodies that make and enforce the rules). Unfortunately, there is currently little prospect of any effective action to close this down.
One of Winston Churchill’s famous wartime quotes from a 10 November 1942 speech at the Lord Mayor’s Day Luncheon in London is apt here. Before the usual quote, I provide an additional part of the speech for context:
“I have never promised anything but blood, tears, toil and sweat. Now, however, we have a new experience. We have victory-a remarkable and definite victory. The bright gleam has caught the helmets of our soldiers and warmed and cheered all our hearts…
Now, this is not the end. It is not even the beginning to the end. But it is, perhaps, the end of the beginning.”
We have had another victory, as another weakness in the third age of capitalism has been exposed. We are, however, at best in the position where policymakers will start to turn their minds to the way market economies are now working, rather than the models they have that are still based on economists’ observations at the end of the 19th century.
The story of ‘the capacity of the Internet is doubling every hundred days’.
The 1990s was the era of the ‘tech boom’. By the mid-1990s, telecommunications infrastructure was at the centre of the world’s attention.
The list of the ten largest companies in the world in 1999 included Cisco, Intel, NTT, Lucent Technologies and Nokia. Investors poured some US$2 trillion into the telecommunications industry. Like many booms, this one was triggered by legislative reform, the US Telecommunications Act of 1996.
One of the new age carriers was a company originally called WorldCom, which largely grew by acquisition, becoming MCI WorldCom when it acquired the company that started life as Microwave Communications Inc. MCI started the whole industry of competitive telecommunications carriage in 1969.
Growth by acquisition is always a hard strategy to properly execute. The cultural and technical integration is never as easy as it seems in the planning phase, making the realisation of savings hard. It is much harder if, like WorldCom, you use “a liberal interpretation of accounting rules”.
For example, suppose you book the integration costs (or in WorldCom’s case a write-down of the acquired assets) in the first quarter after the acquisition. In that case, you make the growth rate after the purchase look better than it really is.
Like a Ponzi scheme, this works for as long as you can keep it going, but eventually, you run out of acquisition targets. Other tweaks, like not accurately reflecting the level of doubtful debts in the provisions, can also help sell the growth story.
But nothing sells the growth story more than the idea of growing demand. Here, WorldCom had a great story to tell: the internet’s capacity was doubling every hundred days.
The basis of this claim was one spreadsheet developed by Tom Stluka, a capacity planner at WorldCom. In one telling, this spreadsheet just modelled “the amount of traffic WorldCom could expect in a best-case scenario of Internet growth.” In another, it was based on the capacity of new connections rather than the actual traffic on those connections.
A quote attributed to Stluka says he had built a best-case scenario: “I had built a model in an Excel spreadsheet that translated what our sales forecast was into how much traffic we would expect to see. And so I just assigned variables for those various parameters and then said we can set those variables to whatever we think is appropriate”.
A writer who has described the impact of the digital spreadsheet on modern society as “a techno-epistemological tool that creates meaning and cognitive trajectories of analysis and action notes that “the doubling meme started to become popular in the telecommunications industry to the point where it began to drive investment”.
Throughout this period, one analyst, Andrew Odlyzko, reported that the doubling claim was simply inaccurate. In a reflective piece following the telco crash of 2002, he summarised both the actual data and where the claims had been made. He concluded:
“There are several lessons to be drawn from the myth of astronomical Internet traffic growth. One is that almost all people are innumerate, lacking the ability to handle even simple quantitative reasoning, and in particular to appreciate the power of compound interest.
“Another one is that people are extremely credulous, especially when the message they hear confirms their personal or business dreams (as the Internet growth myth did, by offering the prospects of huge growth in telecom and effortless riches for participants in the game). They are not willing to examine contrary evidence, and overlook glaring implausibilities and inconsistencies in what they hear.
“Finally, myths are very persistent, since respectable financial analysts and reporters were still writing about ‘Internet traffic doubling every 100 days’ as late as 2002.”
The moral of this story (and the reason it is covered in so much detail) is that bad ideas are often remarkably difficult to discredit, even when there is extensive evidence against them.
David Havyatt is a former telco executive, former adviser to Federal Labor ministers and former advocate on behalf of energy consumers. He is a long term observer of Australian innovation policy.
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