From Private Equity to Zombie – The ABC of capitalism
We have long been critics of the profitless prosperity doctrine that pervaded financial markets while money was free. The doctrine permitted companies with no profit, and no prospect of making any, to invest private equity and family office money in the pursuit of gaining market share. Often this was achieved by crushing old-world incumbents into submission, if not oblivion.
Without regard for damage to the social fabric of a city or the jobs lost, the shiny new business was funded by altruistic private equity investors who simply needed the business to grow large enough to IPO at a premium. Unshackled by the need to make a profit as a going concern, these businesses could adopt unprofitable pricing models and operate with impunity by blinding regulators and cities officials with the promise of making the world a better place.
Back in September 2019, in an article entitled How Soon until we see the collapse of profitless prosperity?, I asked; Is it just me? Or have investors in loss-making U.S. technology companies, like Uber, gone completely insane? I went on; “I just reread my articles about the space-letting company WeWork. In 2018, WeWork lost its owners US$1.7 billion. Billion! Then I looked at my notes on Uber. Uber recorded a US$3 billion operating loss in 2018.
“In normal circumstances, if a company announced that kind of loss, with no immediate prospect of stemming it, its shares would plummet.
“But today, the two companies still have an estimated market capitalisation of US$80 billion to US$90 billion. That’s roughly the same market capitalisation as the Commonwealth Bank which generated US$6.7 billion in profits in 2018 or Volkswagen (US$14 billion in profits), Morgan Stanley (US$8.5 billion), Christian Dior (US$3 billion), Lockheed Martin ($US5 billion) or Caterpillar (US$6.1 billion).”
That was late 2019.
Today, Uber’s market capitalisation, after a 62 per cent share price fall from its high, sits at US$45 billion. WeWork’s market cap is just US$5 billion.
Multiply WeWork and Uber’s travails across the spectrum of profitless, artificially-propped-up hopefuls, and the destruction of wealth, the opportunity cost, and the missed productivity improvements to nations is immense.
This is what happens when money ‘gets free’; misallocations of capital are common and the subsequent losses even more so.
Money however is no longer free
The spigot of ultra-cheap capital is being slowly turned off and central banks are winding back the accommodative settings that once dominated monetary policy. The consequent share price falls from all-time highs of those early 2019 Tech superstars is blood curdling; Beyond Meat is down 89 per cent from its high, while Zoom Video (-81 per cent), PagerDuty (-57 per cent), CrowdStrike (-44 per cent), Pinterest (-77 per cent), Chewy (-79 per cent), Fiverr (-87 per cent), Fastly (-87 per cent) and Lyft (-77 per cent) have all cratered.
Many of these companies had been funded by private equity investors to hire massive numbers of employees to work collectively to build revenue and demonstrate strong growth rates. For many companies the funding was free and lasted decades, staff options were exercised, and subsequent funding rounds were at ever higher valuations because the company in question could show rapid revenue growth.
With enough money anyone can ‘buy’ revenue growth. Simply charge less for the product or service and masses of customers will flow your way. Making a profit however is much harder.
None of that concerned the altruistic private equity supporters. They would be out, via an IPO, long before the challenges of making a profit dawned on unsuspecting mum and dad share market investors.
Zombies rising again
In the absence of profit, and without continuous funding supplied by generous shareholders or junk bond investors many of the market’s former darlings will go broke. Thousands of jobs will be lost and damage to the economy will be complete.
Zombies are companies unable to cover their interest expense from operating income. Of the 3000 U.S. companies in the Russell 3000 small cap index, 620 or 21 per cent meet the Zombie criteria. And that is a significantly higher number than the 440 companies that existed before the pandemic.
It’s an even more serious problem now because the previous enthusiasm for funding such companies has dried up.
In May Junk Bond issuance of US$2.2 billion was a fraction of the near US$50 billion in the same month a year ago. May’s issuance was the slowest in 20 years. And according to Bloomberg, raising cash in the leveraged loan market has been equally depressed with new loan starts of under US$6 billion in May compare with more than $80 billion in January.
Rolling over their debt obligations to keep everyone employed may soon be a thing of the past. And for those that can, rates will be much higher, ensuring any and all dreams of a profit to shareholders vaporize.
And when that happens, a ‘soft landing’ becomes less likely, and economists will inch the probability of recession just a little higher.