Beware the fallout when the cheap money tap turns off
Today, there’s a plethora of companies that would not exist but for the altruism of a tidal wave of high net worth investors running from low interest rates into the arms of private equity funds. Companies like Uber, Tesla and Lyft. But as night follows day, this too shall end.
As the old aphorism warns, Wall Street will sell what Wall Street can sell. If frustrated high net worth investors want to escape low interest rates by speculating on start-ups with no prospect of making a profit, except from selling that start-up to a bigger fool, then that is the service private equity funds will provide.
And providing it, they are in droves. A new record number of private equity firms around the world, are now holding a record US$1.9 trillion of uncalled capital to invest in a record number of deals at record high multiples so that they can IPO a record number of unprofitable Unicorns.
It’s plainly absurd.
Falling, nay plunging, short-term interest rates is stimulating debate at the Montgomery office about whether assets are universally supported when rates decline.
In theory, lower rates are a little like turning the Earth’s gravity off. But instead of floating humans, financial markets witness floating asset prices. When rates fall, the process of discounting future earnings back to today results in the present value of future earnings rising. And the further out in the distant future those possible earnings are, the more impact declining rates have on valuations.
But how high can asset prices rise when they are divorced from reality?
History shows that investment analysts have a bad habit of being too optimistic about the magnitude of a company’s future earnings, the speed with which those earnings will be delivered and the length of time the growth will last. By looking at an individual company in isolation, analysts are collectively convicted of projecting stronger earnings growth than is possible. All that one needs to do to prove this, is to aggregate all those projections and realise the sum total is not possible. In other words, they cannot all be right, they cannot all be profitable and they cannot all grow for that long.
And sometimes even individual examples appear plainly absurd. You might recall I previously compared the claim in Uber’s prospectus that its TAM (Total Addressable Market) was US$17 trillion. But given global total GDP is $75 trillion and Uber cannot operate in China, which is 15 per cent of the global economy, Uber’s claimed TAM is equivalent to 27 per cent of global GDP. I can safely say that Uber does not have a total addressable market that is more than a quarter of the global economy. Ridiculous.
WeWork is the latest Unicorn looking to list on the stock market and offer its loyal founders an opportunity to exit. According to NYU Professor Scott Galloway its claims are even more absurd than I thought Uber’s were.
Galloway summarises the period in financial market history we find ourselves now in as “Consensual Hallucination”. It’s apt. When one hallucinates, a very different reality is created and in an article entitled WeWTF, Galloway reckons WeWork’s investors, its staff and even its founder are all on a giant acid trip. Indeed, he suggests that any analyst who believes WeWork is worth more than US$10 billion is “lying, stupid or both” and points out that the bankers who are facilitating the IPO “stand to register $US122 million in fees flinging faeces at retail investors.”
There’s an important point to make here with a rhetorical question. If all the world’s high net worth and ultra-high net worth have piled into these companies through Private Equity Funds, before they IPO, who will be left to buy the companies from them when they do list? It tells me that faeces may indeed hit the fan.
Of course, keep in mind we are distinguishing here those companies that make massive claims but no money from those companies on more reasonable multiples and making billions in revenues and profits. We aren’t talking about Google, Facebook or Apple, or even Amazon.
Galloways talks of a cult at WeWork, a cult that believes its own ‘bs’ and points to the prospectuses ‘dedication’. “We dedicate this to the power of We – greater than any one of us, but inside each of us”.
Another side note is useful here. According to one report, WeWork paid its founder US$5.9 million for the rights to use the name ‘We’.
Also noted is the average 25 number of mentions of a founder or CEO in a Unicorn’s prospectus. This compares favourably to the 169 mentions of WeWork’s founder.
In a particularly brilliant bit of prose Galloway observes; “So, We isn’t a real estate firm renting desks, it’s a Space as a Service (SAAS) firm. I know, use the word “technology” over and over, despite having little R&D and computers and stuff, and voilà … we’re Salesforce. Today I froze water and used this technology to reconfigure the environment encapsulating my Zacapa and Coke. So, I’m Bill Gates…”
But perhaps more concerning is the sort of reinvented accounting I recall in 1999 before the tech bubble burst. At WeWork the prospectus notes the use of “Community-based EBITDA”. Galloway is right to point at this as profitability before the BITDA, but it also removes other expenses, including real estate, which “comprise the bulk of cost required to deliver the service”.
Galloway is not overstating it when he suggests that a more honest description of WeWork’s invented earnings metric would be “EBEE, Earnings Before Everything Else.” But I would be more concerned about the $US700 million of stock the founder has sold and the fact that WeWork is not a tech company at all but merely a rent arbitrageur, leasing properties at one price, then fractionalising them to rent out at much higher prices.
If WeWork has hyped the market by simply charging sky-high rents to start-ups that want a hipster environment, then the gig will be over when the spigot of cheap capital funding start-ups ends.
Which brings us back to the debate at our office. How long will low rates continue to support prices and behaviour that is tantamount to a misallocation of capital amid a suspension of reality? Only time will tell but I don’t expect we should have to wait too long.