Thursday, March 13, 2014

The VC Bubble

Fred Wilson says that the current sky high valuations are because of the low interest rate environment:
Since the financial crisis of 2008, policy makers in the developed world have kept interest rates at or near zero. They have flooded the market with cheap money in an attempt to heal the wounds (losses) of the financial crisis and incent business owners to invest and grow their businesses. That has not worked particularly well but it has worked a bit. Though their words have changed in recent years, their actions have not changed very much. We still are in a policy framework where money is cheap and interest rates are near zero.
If you go back and apply the formula [yield = earnings/purchase price] and use zero for yield/interest rate, then one would pay an infinite amount for an earning stream. Of course that doesn’t make sense and it has not happened. But valuations are at extreme levels because you cannot get a decent return on your money doing anything else.
Fred is correct on the logic of both valuation calculations and what the Fed may think they are trying to do, but I don't think I agree and I don't think Fred's own data supports his argument.

He has a graph of Treasury yields which show a steady decline from the 80s to present day. Note that the internet bubble of the late 90s happened in a higher yeild environment, so I don't find the argument persuasive that valuations are increasing since the denominator in a DCF calculation is getting smaller. And let's face it, the big VC exits that give rise to bubble talk are not for companies generating much cash, or in industries that seem to have many moats.

I would also argue that there is a big difference between credit bubbles and asset bubbles, and the VC industry, being primarily asset funded, is insensitive to interest rates.

I do believe a story where historically, VC returns have been too high because that market was small and inefficiency. As more capital discovers it, it will drive returns down by funding more marginal companies. This additional supply could fuel an asset bubble if immature acquirers are willing to overpay in some high profile ways while they remain glamor stocks (in the case of Facebook) or have an excellent moat (in the case of Google). Note that the more seasoned companies -- Apple, Amazon -- do not make big acquisitions.

As VC as an asset class gets normalized, there may be a private market bubble as expectations readjust. But ultimately, I think the new equilibrium will have more companies, and more marginal companies, being funded which is good for us all.


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