What Will a Recession Do to Venture Capital?
Featuring Josh Wolfe and Raoul Pal
Published on: July 24th, 2019 • Duration: 35 minutesJosh Wolfe, co-founder of Lux Capital, sits down with Raoul Pal to examine the indicators that are warning that the economic cycle is reaching an inflection point. Wolfe and Pal discuss the idea that inflated valuations in venture capital are being caused by the incremental buyer’s desperate search for growth. Wolfe warns that if the cycle indeed turns, a liquidity crisis could emerge. Filmed on July 9, 2019 in New York.
JOSH WOLFE: The last time that corporate buybacks eclipsed corporate CapEx was 2008,10 years ago. And that's happening again now. Whenever you see corporate venture activity, it's almost always a countercyclical indicator. All that BBB indebtedness, these are companies that are dinosaurs.
RAOUL PAL: Part of what I wanted to do in this Recession Watch Series was to get people who have true experience in an industry talking about their industry and what they see from their perspective. What's unique about Josh is not only is he a really great VC, he's also one of the smartest people in the world that I've ever come across. He's a bit of a polymath. And that makes him a great macro guy. So, he looks at the top down picture. He understands how public markets, private markets all fit together, and complex things like volatility, liquidity, and that's really unique for somebody in that space. And that gives us a really broad perspective. So, I can't wait to hear what Josh says about how he sees things playing out going forwards.
Josh, finally, we get together because it's always Mike Green who gets to see you. So, we get together because I have this hypothesis on testing out on a lot of people I respect to see whether the US or the world is potentially going to recession. I have a feeling that it is. I'm not 100% certain. I know it's getting weak. And I know that you see the world in a different way. And you're quite unique. Because you look at public markets, private markets, and you understand macro, because you hang around a lot of macro people. So, what's your take on where things are going? How things are in any of the flags that you're seeing?
JOSH WOLFE: So, I think about this as illiquidity, which is a word that I use often, which is the opposite of liquidity. You've got the yield curve. You've got $13 trillion of negative yielding interest rates, which I think is unprecedented and for millennia. You've got an enormous amount of people that in the US, I think 60% of buyers of government debt or retail, which is about double what it was a few years ago. And by the way, that $13 trillion of negative yielding debt was zero five years ago.
So, people are pushed out on the yield curve. You have a lot of people that are-
RAOUL PAL: And the aging population.
JOSH WOLFE: Aging population. And what do people historically do? The narrative is let me buy debt, typically, the percentage of my portfolio that should be allocated to fixed income should be roughly proportionate to my age. So, you're 60 year old, you got 60% plus in debt, fixed income, 40% maybe in equities and mutual funds. The portion that's in debt is at record low historic yields. So, you had $1 million or $2 million in savings as a retiree, and you were making $50,000 or $60,000 a year, now, you're making $10,000. So, what do you do? You go out on the yield curve.
So, maybe you're in fixed income instruments, or mutual funds or ETFs, that have some slightly higher yield than you think your principal protected. So, you were looking for your return on principal. The probability is grown that the return of principle is actually not there. Why? You might have stuff mixed in just like you did with subprime going back 10 years ago, that is not actually investment grade. Things might have been rated as investment grade, but they're not. And all of a sudden, you see a 10% decline. And you see this in Europe, that's this is happening now. H2O. Ironically named, completely illiquid.
I think the private portion of this was 9% of assets they had marked at nav, and then it dropped down to 2%, which means probably, it's really 50 basis points. And so, significant value impairment, and then you have the human behavioral reaction, which is to start pulling funds out of these funds. So, if you have that in the fixed income world where-
RAOUL PAL: Because there's illiquidity mismatch, because you can get money out for a while before it stops.
JOSH WOLFE: You have the illusion of liquidity, because you have daily trading and ETFs. And they're marked on a daily basis, but the underlines suddenly might be illiquid. And so, I think that there's a real risk of permanent impairment, which is the true measure of risk of principle. So, if that happens, and retirees start saying, wait a second, you know what, let me go to cash. Let me get out of these bond funds that I thought was safe, that creates a problem. Well, they also might need to sell out of equity funds.
Now, in both asset classes, you'd had a shift from active to passive. So, I actually think it's a great time probably for active managers who can actually do security selection and determine because the simple algorithm for all of these things was dollar in, buy and now, it's going to be dollar out, sell, which means some of the good stuff is going to be sold indiscriminately. So, people are pushed out on the yield curve, they're taking more and more illiquidity risk, and they don't realize it.
Now, you think about who the marginal buyer is. On the equity side, you've also had record amount of corporations that are buying that stock. The last time that corporate buybacks eclipsed corporate CapEx was 2008, 10 years ago, and it's happening again now. And that was right before crisis, and then hitting the March 2009 lows. Now, we didn't set up for history repeating if it doesn't rhyme, I don't know. But it certainly, peak valuations that you've seen over the past 10 years, and you could argue, well, relative to interest rates, you've got S&P yield at 4.6%, 10-Year at 2%, maybe the value's there, maybe it's not.
But then you look at the illiquid side, and not just on the bonds and not just on equities and people selling but my world, which is venture capital. And here, you have a marginal buyer on the public equities, who maybe was the corporation buying back its own stock. In my world, the marginal buyer is two kinds.
One, you've got SoftBank, which is setting irrational price. They have an enormous amount of money to put to work and have put to work pricing up their own stock. And we've talked on Real Vision before about this in the past with Mike. And so, I think that they have created irrational comps that other people have referenced to that have said artificially high prices that are almost equivalent to leveraged because a 10% or 20% down around wipes out everybody in that capital structure stack.
The second thing that I think you have is looking at some of the marginal buyers, which were foreigners. Now, if you take life sciences and biotech, a year ago, you had about 1,000,000,006, 1,000,000,007 of Chinese money that went into US biotech companies, out of a total of about $20 billion of life science money that went in. First six months of this year, you have about $700 million so about half. A billion dollars of capital that compared to last year is not there.
So, suddenly, VCs are looking around and saying, okay, who's going to be pricing out my Series B, C, D pre- IPO rounds? You have a handful of people who potentially are bag holders, maybe these are the Bailey Giffords or the Fidelitys that are doing these pre-IPO rounds. Why are they doing that? Because the returns were in the pre-IPO financings. But then you look at the pre-IPO companies that are now going IPO. So, Uber and Lyft. And potentially, We Work. These are the darling unicorns, and many of these have not held up well. Somehow, Zoom has done very well. Others have been disasters.
But you look again at SoftBank and you say, okay, they've got these illiquid stakes through the vision fund. And they try to do what? After these things went public, rather than just selling the stock, they tried to issue debt, have issued debt. $4 billion secured by the garden steak or the Uber steak to retail investors. And then the underlying, We Work originally were going to put $16 billion in, they put a few billion dollars in, they priced up their own paper, valuation, I've got my own tinfoil hat theory about why they're doing that to service collateral against mothership indebtedness. We Work now, going IPO, going to issue $4 billion of debt before they go public, because there's nothing more that people love than a more indebted company before they go public.
Now, the biggest counter is people will say, well, compare this moment to the 2000 bubble when you had all these phony valuations, at least companies now have revenue, which is true, because a lot of back then you just had eyeballs, you had no dollars, no revenue. But the problem is, in spite of all of this revenue, you still have no profits. So, if you have all of this revenue growth, but it's unprofitable, and it's really driven by the kindness of strangers, who are the providers of the capital, I think a lot of people are overestimating the potential profitability these companies.
So, one of the other very interesting things, of course, is you have this mismatch between CapEx and buybacks. But CapEx is a good measure of corporate investment activity. And so, buybacks now, eclipsing corporate CapEx. CapEx potentially declining at a time when interest rates are as low as they've been in many, many years. It doesn't bode well for the economy. And it comports with your view of recession. It also comports with your view, which I think is an excellent one of real volatility and risk amongst the European banks.
RAOUL PAL: I'm just looking at the situation we talked about on the corporate side, the amount of triple the debt. It's so enormous now. And it's basically five companies, that $800 billion is five companies, that's AT&T, Dell, GM, Ford, and GE.
JOSH WOLFE: And by the way, every one of those companies is not a company that a cutting edge, early stage entrepreneur engineer would ever want to go and work for. Now, the amount of indebtedness has served asset growth, and you could argue is fueling operations. But look at GE now in my world. GE, I predicted was going to divest of their corporate venture portfolio. Because whenever you see corporate venture activity, it's almost always a countercyclical indicator.
When P corporate VC starts happening, they feel like they're late to the game. They look at their brother, and they see that money is being made, at least in paper marks, CEO says, I think we should be doing corporate VC activity, the board says yay, then all of a sudden, they see one of their brother and say, wait a second. These guys haven't had any liquidity. They're divesting their portfolio. The secondary funds come in, they buy things at 70, 80 cents on the dollar.
The day that GE announced that they were going to divest their VC portfolio, we got contacted by a very large prominent buyout fund that said, hey, do you want a team and take a look at this? And I think that there's going to be portfolio after portfolio of corporate venture that starts getting divested so that they can free up cash for liquidity. But to your point, all that BBB indebtedness, these are companies that are dinosaurs, there's real structural risk that they're going to be disrupted by the next card, and it'll be dead.
RAOUL PAL: And my fear with this as well as it is anybody gets downgraded, which they will, in the next recession, they'll get downgraded. And the junk bonds here, there's two different owners. So, it's the pension system that owns the BBB because it's still investment grade. As soon as it goes out, it's not owned by them at all. It's owned by junk bond guys. So, there's no liquidity, there is the sellers, and there's basically no ability to buy that much downgrade stuff.
And I fear it knocks on into your world, because illiquid knocks on into illiquid. And we saw this in 2008, is hedge funds became the cash machine where they could be. So, they all had to gate. Then all the private equity guys were trading- I remember I was helping out a family office and they were selling out of stuff at 30 cents on the dollar, which was good stuff, but they're just desperate for liquidity.
JOSH WOLFE: Well, this was again, going back, just like 2008, was the time relative today when corporate buybacks and to the CapEx, 2008 was when BMP gated those three hedge funds. And that was the start of the catalyst.
RAOUL PAL: And that's what I saw with this H2O. And yeah, Neil Woodford is like, okay, this is interesting, because you're starting to see liquidity issues. And that's what it was. And that's why I thought it'd be a- I'm going to get George about this because there's a liquidity event going on. And people are saying they're isolated, and they were isolated with BMP. And then it was the money market funds. And it just started moving around. It tells you there's not enough dollars in the system and [inaudible] over time.
JOSH WOLFE: From a simple macro standpoint, even to the layman. If you're pushed out on the yield curve, and money's being printed, and money's available, and you go into this higher illiquid stuff, now, you've taken cash that was meant to help bail out the system, promote growth, you've put it into illiquid stuff. And now, it's trapped. And the question is, who is the incremental buyer in all of these things? So, in my world, who is the incremental buyer? Is it the crossover hedge fund? Is it the growth equity investor? Are the Tigers and CO2s and the Tiger Cubs that are doing private companies? Is it SoftBank?
When that capital starts to dry up, we have illiquidity crisis. So, massive illiquidity. In the case of the bond funds, you know that the illiquidity comes when you have these things that you think are investment grade that turn out not to be. In the case of the mutual funds, you have illiquidity when suddenly everybody starts selling, and people think that the underlying that they're able to get out of. So I agree with you, I think that this is a substantially underreported underrecognized risk.
RAOUL PAL: And I'm also interested in- because VC is very different to private equity, because private equity, they can have 100% ownership. So, then, yes, they have funding issues. So, debt rollovers, so that will become an issue. But in VC, you're at the mercy of other people's liquidity. So, you may have all the liquidity in the world. But if everybody needs out, or the underlying business needs to raise more capital and they can't raise capital, they're going to go bust.
JOSH WOLFE: So, there's two players here to the matter, the underlying LPs, and you have this denominator effect, in '07, '08, and then the GPs, the other funds that your co-investor within your syndicate, and you're constantly looking around and saying, where is this company that you're co-invested with them in this fund of theirs? Now, if they're in fund five, and they're going out and raising fund six, and that fund is tapped, they have no reserves to invest incremental dollars, you have real liquidity risk from that investor, ability to support their company on an ongoing basis.
If they're investing out of a fresh new fund, and it's a brand new company inside of that fund, because each fund is every two or three years, you raise your pool capital, it's a different story. But that's a dimension of risk, which is idiosyncratic, it is different from the underlying company. It's about who's in the cap table. Now, we've always said, because we do different styles of investing, we do special situations, can you invest in the late stage business at an early stage price? The only way to invest in the late stage business at early stage prices, because something is not impaired on the balance sheet or the income statement, but on the cap table.
So, I actually think that there's an opportunity for secondary players to come in and basically be liquidity providers. And so, if liquidity is scarce, that is how you get value, anything that's scarce tend to be valuable. And so, I think that there will be situations where funds will be at the end of their life, and not have the ability to invest in a company. But you also have situations where a fund might have a winner. And my winner might be somebody else's loser or vice versa.
And so, how I'm prioritizing in my fund versus how they are prioritizing in their fund and depending on what vintage the fund is, all that stuff starts to matter, because it becomes like a Mexican standoff. You're looking and saying, well, wait a second, who's got money to pony up here into the next financing, we need to bridge this company to an exit or sale? And that's when it's classic Carl Icahn, your price, my terms, because the valuations, which are in some cases set by these artificial SoftBank or others, what really matters are the preferences and the liquidation in the waterfall about who gets paid.
Somebody might put in a $5 million- a company could have raised $500 million. But somebody could put in a $5 million bridge loan with liquidation preferences on top and they can clear all the money that gets made in an ultimate sale. And so, a lot of this stuff is very illusory. And I think it