Rising Interest Rates & Fried Unicorn Meat

Jim Edwards at Business Insider has published an excellent interview with venture investor Kevin Kinsella which busts a lot of the public relations tales told by some of his competitors.

The Federal Reserve system can’t raise interest rates by that much, but it needs to later this year in order to preserve its institutional credibility. When that happens, even though it’ll be a small hike, it could have the effect of doubling, tripling, or quadrupling yields on high rated bonds — even a slight rise in rates, because they’re so low, could have that effect. Just going back to pre-crisis 2007, rates like the Federal Funds rate were more than 20 times what they are now.

So from the perspective of investors and financial institutions looking for assets that’ll yield a return, the entire environment changes quite quickly, as it becomes more attractive to be a creditor than a debtor.

Just a slight hike creates a lot of competition in the financial markets that’s currently being occupied by high risk stocks, of which tech companies are just a small category.

The ‘unicorn’ thesis is that America is leading the world in creating technologically advanced companies which will catapult the rest of the economy into a golden age.

BI: So let’s say the recession comes along but the underlying business is actually viable. The business is profitable. It may not meet the valuation they hoped, but it’s a real business. My worry is, if I’m the last set of investors in and we’ve now ploughed in some astronomical sum of money, like $1 billion dollars, at a valuation of $10 billion, and it’s all still private equity, then when the market goes down, I can’t sell this. The market is completely illiquid. At least if it had IPO’d, I could bail out of my shares and get some cents on the dollar. But what if you’re Fidelity or Calpers, one of these large institutional investors that comes in at a late stage — how are they going to cash that out?

KK: They’re screwed, they’re completely screwed.

BI: So you have a highly valued asset stuck in an illiquid non-transparent market?

KK: Yeah and that’s what I refer to as the liquidity crisis. Your private valuation has gotten way ahead of any potential notion of what a public valuation could be where you could exit. And therefore the problem is that you’re stuck with the investment.

This is essentially what has happened to high profile companies like Groupon, Zynga, and Twitter (particularly the last in recent days) — private valuation galloped out in front of any sane public market valuation. When the companies went public, they were unable to maintain their private market valuations, despite a lot of gibberish about non-financial metrics. The problems in those companies had less to do with the essentials of the businesses and more to do with impossible prices on the stocks themselves.

The reason why, contrary to protests that this malinvestment is somehow ‘insulated’ from the public markets, is that all of the limited partners investing in these funds have major exposure to the public markets. Illiquid parts of their portfolio have to be covered by liquidations elsewhere. And pension funds in particular which have major exposure to venture investments will often go looking for bailouts from the government.

Attitudes within the venture community tend to be very short sighted because it’s been beneficial — especially since 2007 — to be blind to the broader risks, and to be able to tell convincing happy tales about why all these massive valuations are justified by unconventional measures, buffeted by saying one thing to the general public, while concealing financial problems until the moment the public offering happens or the company gets acquired by a larger one.

The error in thinking being made is similar to the one made by Chinese planners — namely, that the profit and loss system can be ignored, that economic fundamentals don’t matter, and that falsified prices can result in a more efficient allocation of resources than real prices.