This Is How The Unicorn Bubble Will Burst

good stories to write about, talk about and dive into. Right, there's been no shortage of headlines, that's for sure. One of the big things that we've been writing about has, of course been the massive sell off that we saw in technology stocks. Yeah, that's exactly right. Like lots of things have happened in the last month and really all year,

with many global markets selling off. But I do think what's really striking and what felt different about this past month is how violent some of the selling has been in technology companies that heretofore have seemed really maybe bulletproof. And you know, I'm thinking of companies like Amazon, which was at one point of worth over a trillion dollars and then very quickly lost about a quarter of its market cap. Others like Netflix and Google and Facebook, which

had been struggling since the summer. Very much a different tone to the trading of these companies, And of course it might just be a blip, but maybe it's a sign that just sort of that pure optimism that people felt towards these companies have started to fade, right. And I think that's one reason why the month felt so stressful, because you saw these stalwarts not just of the technology sector, but really of the entire market, uh suffer during this downturn.

So you know, think about the major components in the SMP five hundred the thing stocks like Facebook and Amazon and Google really make up a big proportion of that. Yeah, exactly right. And and and you know, not to be labor this point, but these were also incredibly important stocks for hedge funds, and many of the successful long short managers were successful because they made big bets, concentrated bets on these companies. So when they fell apart, or when

the stocks fell apart, is really wreaked havoc. Now, the other thing that's interesting to me is we live in a time where there are a lot of really big tech companies that are not public or their tech ish companies. So whether it's Uber, Airbnb, we work a lot of these tech or tech adjacent companies that are gigantic, much bigger than many of the public companies out there, that have sort of feasted on, you know, incredible growth and

incredible access to private market money. And of course, one of the questions that rises in light of the tech sell off is if the public market is turning more negative on tech, then what does it mean for these companies that people are very obsessed with, but that you know, haven't really proven themselves to be durable businesses yet, right, because they've all been sort of lining up with the expectation that if they wanted to I p O there would be this huge amount of demand, and then suddenly

the recent market route kind of puts that into question. Although, well, I have a lot of thoughts about this, so I'm sure whatever we're about to discuss it'll be a good conversation. Joe Great, I think it will be too. So all that being said, I wanted to introduce our guest for this week's episode. We're going to be speaking with Bill Janeway, the legendary economist Himond Minsky characterized him as a theorist practitioner.

He spent thirty five years in venture capital affiliated with Warburg Pinkus, and he is affiliated member of faculty at Cambridge University. And I recently read his book Doing Capitalism in the Innovation Age, which really speaks to what I think is the sort of question of the moment about the relationship between entrepreneurship and financial markets and speculative activity. He's a rare voice that can sort of combine firsthand experience with how the investing world actually works with a

sort of economists academic perspective. So in light of that, and in light of his experience, I want to bring in Bill, Bill Janeway, thank you very much, Joe, it's great to be here. And Tracy, good to meet you. Yeah. The unicorn bubble is an extraordinary phenomenon, So let's let's first put it into a more general context. One part of that context, of course, is the maturation of the

digital revolution. The fact that, as Facebook and Google have demonstrated, it is possible to adjust markets numbered in the billions of users with extraordinarily little friction, little expense. So the notion that limitless growth may be available for other digital

service businesses is plausible. But second, there's also a more narrow context, and that is that for nine years from the global financial crisis until just within the last twelve months, the financial markets, the financial system, and investors but operating in an unprecedented environment, an environment in which the risk free real rate of interest has been effectively zero or

even less. That has pushed institutional investors principally mandated and chartered to invest in liquid public markets to behave in a way that my view is fundamentally unsustainable. They have been paying premium valuations relative to what's available in the public market to buy and this is the key to

buy illiquid secureties, securities they can't sell. Now. I'm not a great fan of business schools, but finance one on one at any business school in the world will tell you that there is a value to liquidity for an investor to be able to change her mind when she believes that circumstances have changed. But these investors from the public market world who have been piling into the new unicorn want to be digital giants, have been have been, as I say, paying premium values to buy illiquidity now

before we dive further into that. And I love that sort of framing of that in the central tension there, because you put it much better than I was. I just want to take a quick step back because I characterized you, or it wasn't actually me, but I you're characterized as a theorist practitioner, so you spent several decades

in tech venture capital. We're also an academic economists, and I think that's rare because you often hear, you know, sort of investors claim that economists don't really understand how their world works, and maybe that's true in many cases. Tell us a little bit about your academic background and how it has informed your view of the investing game.

Delighted to so, I I took a martial scholarship to Cambridge way way back back in the mid sixties, and I did a doctorate in economics under the students of John Maynard Keynes, and I I, how shall I say, I internalized a set of pretty fundamental lessons, one of which is that in the world of finance and of economics, we are all doomed to be making decisions under conditions

of uncertainty. We cannot know the full consequences of the decisions that we make that involve investing money, resources, time, energy, and therefore there is an in powerful incentive to construct hedges, ways to protect ourselves when what we hoped wouldn't happen does happen. This is where it links to my life as a practitioner. I learned in the trenches of venture capital investing in I t at the frontier from the late nineteen seventies right through the great tech book bubble

that peaked in two thousand. I learned two basic lessons. I call them the two fundamental theorems of venture capital. The first is corporate happiness is positive cash flow. A business that is generating more cash because it's customers give it more cash than it costs to deliver them, the product and service has achieved a kind of liberation from dependence on the problematic access to external capital when needed.

That's from the point of view, if you like, of the how shall I put it, the rational, practical, common sensical entrepreneur, which not all entrepreneurs are. The other the other lesson is from the point of view of the investor. It's what I call cash and control. The only joint hedge against the fundamental uncertainty of investing in early stage

companies at the frontier of technology. Cash means you have unequivocally access to enough cash to buy the time to find out what's going on when what is going on is bad, and control means you have enough control to shift the parameters of the problem. In my personal experience, that usually not always, usually began by firing the CEO. Okay,

let's switch back to the unicorn bubble. Here we have a set and there are many, I think globally now it's considered there's something like to hundred and fifty to three hundred unicorns who are characterized by burning billions of dollars of cash per year in pursuit of limitless growth. The notion of actually working to deliver positive cash flow from operations is seen as a kind of needless constraint

on the pursuit of that limitless growth. And on the other hand, the investors, motivated as we all know by that famous phrase fomo fear of missing out, have have not just been providing the cash on extraordinarily attractive financial terms. In many cases, they've been yielding control, governance ownership to the founders of the company, no matter how much money those founders raise from investors. So, Bill, I already have a bunch of questions, but I guess my main ones.

You were talking about liquidity earlier and this idea that investors maybe under paying for illiquid assets that they're assuming. Um, I guess that means you think that they might have difficulty exiting their tech investments. And then secondly you're talking about the value of cash flow in a company, and I guess my question is why are investors so comfortable continuously pouring more money into unprofitable unicorns uh such as uber.

You know you mentioned the fear of missing out, but I guess the question is, at what point does the fear of missing out transform into the fear of not making any money ever, So, just to be clear, Tracy, I was saying that these public market oriented investors have been overpaying for ill liquid securities and that consequently they don't have the opportunity to change their minds if they decide that maybe the future isn't quite as bright as it's supposed to be or as they hoped it would be.

I do think that it's not just the existence proof of the facts of this enormous potential for establishing global or near ex China global franchises, particularly in the consumer the digital consumer economy. As I said at the beginning, I also think the broader financial context really matters, with risk free real rates of interest essentially at zero and and even going out on the both the credit spread

and term spread in pursuit of greater returns. Having had since two thousand and eight very marginal opportunity to make any kind of positive real return, I think investors have

been reaching for risk. They've been able, they've been going further out onto the risk spectrum, which when it comes to the to the unicorns, has to be extreme uncertainty about what the outcome will be for whether it's it's it's Uber, which has challengers in many markets, which is facing regulatory frictions, which has the opportunity to see how the same social media that enables Uber to grow extraordinarily also enables the drivers to establish some countervailing market power

in terms of the the conditions under which they work. These are really big economic uncertainties which the investors have

chosen to ignore. If there's any catalyst for shifting that mindset, I expect it will be the same catalyst that has had such an impact on the broad public tech stocks, and that begins with the return of access to real positive rates of interest, as treasuries move up, as the tenure I think is now up around three point two percent, as we see credit spreads open up for liquid junk bonds,

and you know typically they sell in double digits. If you have ten twelve percent available in a liquid more or less liquid junk bond market, I think that's likely to dampen then perceived need to go way out on the risk spectrum and behave in the way they have been so Ultimately, just to clarify, now, if the if what we've seen in the month of October turns out to be just a blip and tech stocks continue to rally, then maybe this is all sort of an academic discussion.

But at some point, the divergence between what public markets are telling us and the kind of access to capital that private markets depend on, it can't last for too long. Eventually there has to be some convergence. Yeah, look, the definition of a bubble and this is some really great

academic work. This is where I love to move back and forth from the world of the practitioner to the academic, there's some great work to first world class economists Jose Shankman at Columbia un Shin at the Bank for International Settlements have have defined in a way a signature of a bubble. That's when the price rises, demand goes up.

When prices rise, demands supposed to fall. Right. But when in a financial bubble, when the price of the securities go up, demand increases, and we've certainly seen that in the world of the unicorns. What that means is that the price of the securities are being decoupled from any concern with cash flow past, present or future. Sooner or later, all bubbles burst sometime. They leave behind really productive assets like railroad railway lines, or electricity grids or internet fiber.

But they all bust. Now, the good news about this unicorn bubble is first, as it when it busts, there's no leverage. The economic consequences are going to be very limited. Second, no doubt out of these two hundred and fifty or three hundred wanna be fangs, there will be several that

established themselves as long term, sustainable, valuable businesses. You know, back at the in the tech bubble, Amazon raised five and sixty million bucks in the end of the first quarter of two thousand, about two weeks before the then old time peak of the nastac. If it hadn't raised that money under bubble conditions, it would have gone bankrupt

within six months. Jeff Bezos learned the lesson. He's got multiple levers for forcing gobs and gobs of positive cash flow whenever he wants to, whenever the market tells him he needs to. In the meantime, he can invest for maximum continued growth. Given that he has, he can generate

positive cash flow whenever he chooses. My view is that the Unicorn boards and their entrepreneurs are going to be challenged to demonstrate that, like Jeff bezas, they have plausible path to positive cash flow that are within their own control, that don't depend on limitless access to the kind of

capital that for a time has been available. So is there anything special about tech in particular that makes it more of a target for easy money or for capital just you know, trying to find anything to invest in. Because this easy money story, the search for yield, We've heard people talk about it across a variety of financial assets, right corporate bonds, being um. Probably the most prevalent example. People talked a lot about the shale oil story is

actually a capital market story. Is there something about tech here that makes it unique? Sure, it's growth, And the thing that makes it un in this environment is that when you're investing in growth, the rate at which you

discount the future really really matters. And when you can discount the future at rates that reflect the FED and for that matter, the Bank of England's the European central banks commitment to very very very very low to negative interest rates in the nine ten years after the global financial crisis, it means that that future value, however speculative, it may be just as much much larger. And you know, it's exponential. This is not a kind of linear exercise

and arithmetic. If the rate at which you're discounting the future rises by one percent ten years from now, the value of something of a buck ten years from now declines by a lot. And that's the biggest threat I think. I think there are two threats. Actually, One is this financial threat, this shift in the financial environment that differentially

penalizes high growth investment opportunities. The second is the growing recognition or the increasing inability to ignore the frictions that do affect even these extraordinary new companies with their potentially billion user markets. I mean the regulatory frictions, the political frictions which have been emerging around the world, not just in the United States, city by city, country by country

over the last year or two. Before we go too much further, I want to go back something I've been thinking about listening to when you talked about um your sort of academic history and having studied under the students of Canes, when you talk about the lessons you've internalized, I have to say, in a way they seem obvious. Okay, companies should have access to positive cash flo I mean I think that that would not surprise people. Control matters,

the future is uncertain. None of these things strike me as being particularly controversial. But how in your view do these insights differ from, say, what economists elsewhere may have thought.

Well here that that's a great question, Joe, because the fact is I went on my thirty five years sabbatical from the academy because in the early nineteen seventies it became clear that mainstream academic economics and mainstream academic finance had kind of drunk the kool aid, the kool aid of the where the building mathematical models that could be solved logically, and they were based on in both areas, both fields based on the concept the fantasy of what

has been called in the literature too much, the rational representative agent, the agent in the market who has an omniscient view of the future, not just of what's going to be the result of her actions, but of the model, a model which accurately explains how her and remember she's the representative agent. She represents all investors, all consumers, all firms, how those decisions will play out. This came to be

known as the rational expectations hypothesis. It was dominant, it has been dominant for generation, with the models in the central banks and the treasuries of the world, not just in academia, based on this view. Now, there are a couple of aspects of this that are pretty obvious when you stand back and assert that the power of that most rare resource common sense. First of all, if you have one rational agent, one represent of of agent, that means that she is her own creditor and debtor. You've

just excluded a financial system by construction. Nothing that happens in the stock market, the bond market, or the banking system can have any effect on the real economy. That is the central reason why all of the authorities were so caught by surprise in two thousand and eight. It does sound like common sense, as you say, to put it the way I put it, in terms of uncertainty about the future, need for ability to provide effective hedges

against that uncertainty. But as I say, for a generation, and not just from the University of Chicago, the doctrine the dogma that markets will be self correcting as rational agents exercise their omniscient knowledge in a world that they fully understand you. It was it was Alan Greenspan in the hero in the Hearings in two thousand and nine, after Lehman went bust in the World pros, who said

that he found a flaw in his thinking. The floor in his thinking was his belief that those rational, self interested bank bosses and private investors would all behave for their own best interests, as if they knew what their own best interests actually would be. And instead, of course, what we saw was everybody running for the exit to protect themselves, with a consequence that was catastrophic for the world.

The good news. The good news is that for those academic disciplines of economics and finance, two thousand and eight and the great recession that followed are the gifts that keep on giving. They have motivated a return to empirical study of markets, of economies of finance, a chuill systems with a much more realistic view, which is beginning to emerge in the literature. And you know, it took a generation for the economics that failed us so badly in

two thousand and eight to become dogma. It'll take a generation to undo it. It It won't happen overnight. But there is good news out there for the for the longer term and how we think about this world we're all trying to survive in So we're talking a lot about two thousand and eight. If we fast forward to now, as Joe and I were discussing in the intro, over the past month or so, we've seen a lot of

angst amid the tech stocks and amongst tech investors. Does the wobble in the public market in particular, does that suggest that the whole edifice of tech funding starts to fall down, that the vcs and the private markets aren't going to be able to depend on an exit through I p O s and that begins to sort of create a downward spiral invaluations. Do you see that happening? Well,

I certainly see exposure to it now. You know, as we all know, it's very hard to predict, especially the future, but I think we can see that there's a link from the movement towards quote normalizing interest rates to feedback and impact on the value of assets whose future returns dominate their current returns. And of course there's no set

of assets more of that category than the unicorns. Second, institutional investors will find that there are adequate returns available at much lower risk than buying into the digital wannabes at at super supervaluations with no guarantee of an exit path through a public market or any other way. So I think we have to expect that the world is going to look a lot more fragile over the next

period of months and years going forward. And as a final point, um, you know, my work is very definitely deeply involved at the interface between the financial and economic markets on the one hand and the political process on the other and the other lesson Another long lesson that goes way back in our history is that markets ultimately depend on the credibility and plausibility of the political underwriting

as and when bad things happen. We sure learned that in two thousand and eight, and I think we I think it's legitimate to have a concern going forward about the quality of political underwriting in the United States today. I'm glad you brought this up because I before we go, I want to hit on sort of another major theme of your writing, which we haven't talked about at all. And again I suspect it's another area where uh lot

of investors might bristle at this. But something you point out is that the areas where venture capitalists have been most successful have all been areas in which there has been an extraordinary amount of government spending to invest in basic research, the sort of expensive capital investment that often early stage private money isn't forthcoming for. And you point out examples throughout history. So I'm curious, like a can

you sort of clarify that point? But be these days we seem to have this sort of extreme dichotomy in which everybody wants to invest in VC, from soft bank to universities. I saw an ad on the subway this week saying invest in startups for as little as ten dollars like it's at the same time as government, particularly in developed economies, don't seem to be very good at

marshaling the resources for that core, core investment. So I'm curious if you can talk about this an incredible interest in investing in VC at the same time, according to you, a crucial component of VC's success, and not forthcoring. Let's let's bring this real down down to the real direct. My my personal experience was that in the course of the nineties, seventies, eighties, I realized that I had all my peers as investors, adventure guys, and the entrepreneurs we

were backing. We were all dancing on a platform that had been constructed by the United States Department of Defense, from silicon to software and onto the Internet. It was the not just funding research there was the d D was the first customer for the stuff that wasn't ready for commercial prime time, and for the biotech guys. The

National Institute's of Health was doing the same thing. When you got outside of those two sectors, there's been no record ever a venture capital success, investing in the products of material science for example, nanotechnology for example, for that matter, outside outside of silicon where the government was underwriting it to a the digital revolution doesn't need government subsidy and support.

On the contrary, it's matured to the stage where it's it's attacking the authority of the government, from from cryptocurrencies at the at the global level to uber at the at the city level. But the next revolution, the next needed technological revolution, the clean tech green tech response to

climate change US is nowhere. We haven't invested anything like the kind of resources that we did in computing or that we did in biotech in order to be able to convert this economy and shift the demand and supply curves for carbon. China's doing it, for sure, and this is the biggest open question in my mind as to whether and how China might succeed in this phenomenally difficult transition from being an effective follower to the frontier of

technology to become an innovative leader there. The U s did it in the twenty century. It did take two World wars and inspired political leadership, genuine political entrepreneurship, which we seem to have run out of over the last generation, Phil Janeway, fascinating stuff. Thank you very much for joining the Outlaws. I couldn't be happy to be here. Maybe even the return visit would be more than welcome on

my side, definitely, Tracy. I really enjoyed that conversation when I read Bill's book recently, Doing Capitalism in the Innovation Economy. That was prior to the volatility that we had seen in October. But in addition to, of course the volatility that we saw um, we also saw concerns around Saudi Arabia, which is of course a major funder of tech companies

and tech investors like soft Bank. So I really thought there was an incredibly timely conversation because it feels like a lot of these companies really are at a crossroads, right And if you want to think about an example of the importance I guess of of reliable financing when it comes to unicorns and various tech start of Saudi

Arabia is a really really good sort of microcosm of that. Because, of course, with all the drama and controversy surrounding the murder of the journalist Jamal Kashachi, people are talking about whether or not Saudi is still going to be spending money as freely on tech investments. And if the Saudi money goes, there are some crazy estimates out there saying that hundreds of startups could be affected. Yeah, I wouldn't

be surprised at all about that. And just in general, I do think that this link between what we see in public markets and the volatility that we see between public markets and private markets is probably not appreciated enough, and that at some level you can't just do business ignorant of what's going on in the markets that we see quoted every day. And I think that's a really

powerful point. And I suspect that a lot of these uh, you know, a lot of these unicorn c e O s will be surprised when they realize the degree to which, okay, maybe they're private, but they're not as insulated as they

might think, right. And it sort of gets back to that expectation point, right, like, what exactly are your original investors expecting from their original investment, And usually there are a lot of assumptions impeded in those expectations, many of which might not actually come to fruition, right, Exactly many of them won't because, as Bill pointed, out. We live in a permanent state of extreme uncertainty, and we might have a guess about something that's going to happen in

the future, but we really have no idea. And when uh, the future starts to deviate from any expectation which will happen one day, whether it's now or in the future, people are going to want actual cash to hold onto. Yeah, it's all about the cash, All about the cash, all right. This has been another edition of the Odd Lots Podcast. I'm Tracy Alloway. You could follow me on Twitter at Tracy Alloway, and I'm Joe Wisenthal. You can follow me on Twitter at the Stalwart. And you should follow Bill

on Twitter. He's at Bill Janeway and be sure to follow our producer on Twitter tofur Foreheads He's at foreheads t as well as the Bloomberg head of podcast, Francesco Levie at Francesca Today. Thanks for listening.