My colleague Jim Edwards reports that a growing number of VC investors are beginning to fret that low interest rates are causing another bubble in technology.
On the surface, it’s not hard to see why people are telling this story.
Startups are increasingly commanding valuations of several billion dollars without much profit to show for it. The most famous of these right now is WhatsApp, which just got Facebook to cough up $US19 billion for it, despite the business side being negligible.
AirBNB (the site where you can rent out your house to travellers), meanwhile, is reportedly raising money at a $US10 billion valuation, which would make it more valuable than Hyatt Hotels. Examples of breathtaking valuations abound.
On the flipside, nominal interest rates are famously quite low. Also, the Fed for years has been buying up bonds in an attempt to decrease interest rates even further and make the system more liquid. One way this Fed activity theoretically works is through the substitution effect. If the Fed is removing Treasuries from the system, then would-be Treasury holders have to put their money somewhere else if they want a return. So maybe they go invest in riskier areas, like mortgage lending or car loans.
The story being told by the people screaming bubble is essentially that the substitution effect is spilling dramatically into startups, that the Fed is pumping all this money into the system, and it doesn’t have many places to go, so it’s driving up the valuations of your Pinterests, Snapchats, AirBNBs, and so forth.
But the data doesn’t back up this story. And the easiest way to see this is to look outside tech. It stands to reason that if the tech boom were about a tidal wave of cash looking for risky companies to invest in, then the boom wouldn’t be limited to just tech. All manners of industries would be seeing the rush of cash.
So let’s take a look.
PriceWaterHouse Coopers MoneyTree Report has a great website tracking total VC investment by sectors historically.
Here’s a quarterly look at software industry dealflow. You can see that over the past 10 years there’s been a pretty steady increase in investment amounts (excluding, of course, the 2008-2009 crash). The dollar number represents total amount invested in that quarter. The second number represents what that represents as a % of total VC investment that quarter. And the third column represents total deals.
Ok, so here’s VC investment in software …
But now let’s look at healthcare… there’s really no trend at all. While Q4 2013 was pretty huge, it was actually down for Q4 2012.
Here’s biotech (which is a hot sector in the stock market). Again, nothing unusual in terms of growth.
Here’s financial services. Nothing special going on.
You can play around with the data more here, but it seems pretty clear that the only industry that’s seeing a huge rush of investment cash is tech (specifically software).
This alone is pretty devastating to the argument that the Fed is causing a new tech bubble because the Fed argument relies on the idea that cash is being pushed into the market and creating a insane appetite for risk. But if that were the big story, we’d be seeing that cash pop up in all sectors, not just tech.
The above data forces us to look for an alternative explanation of what’s going on. Why is software seeing this gigantic boom while other VC sectors are not? I’d argue that the answer lies in the ridiculous speed at which companies with minimal cash needs can become world-changing behemoths or cash faucets.
Say what you will about WhatsApp, but you can’t not be astounded that a company founded only in 2009 with just a handful of employees has surpassed in volume the entire size of the text messaging industry. That’s a story that’s got nothing to do with the Fed.
Or take Candy Crush. Look how quickly the company has gone from virtually zero in revenue to a run rate of over $US2 billion.
Again, that’s not the Fed’s doing.
This week it was reported that Apax, the one company that invested in Candy Crush, is poised to see a 10,000% return on their investment.
Why does this matter?
The VC game has always been having a few number of big winners cancel out the majority of losers. In tech right now, we’re seeing those big winners reach dizzying heights extraordinarily quickly. The dynamics aren’t really the same in other industries. Healthcare and biotech, as exciting as they are, don’t have the same winner-take-all effects that help a company like WhatsApp become such a big thing. Financial services is an area that’s ripe for “disruption” but it’s hard to imagine a path from zero to billions in an industry so filled with regulation.
So tech is unique in that winners (which are always rare) can become gargantuan in a short period.
Of course, none of this means that current levels of investment spending in tech is sustainable. A lot of it will end in tears. There will be inevitably too much copy-cat investment trying to repeat Candy Crush that will end up being money flushed down the toilet. And of course there are and will be companies in the red-hot “messaging” space that offer perfectly fine services that go nowhere just because they didn’t catch the network effects just right.
The point though is that there are way more compelling and interesting dynamics than the Fed.
The Fed argument just fails on so many levels. It fails to explain why cash isn’t flying into non-tech speculative areas. And it’s not consistent with how people invest. Sorry, but if you’re looking at trying to get the next Candy Crush, and you know that the last investor made 10,000% on their money, do you care whether interest rates are 0%, 2%, or even 10%? No, you don’t. That’s not to say the Fed can’t change investor behaviour, but it makes much more sense that it would change the calculus of an investor looking at whether a mortgage bond yielding 6% is compelling or not. At these levels a tiny change in rates might make a big difference. For tech? Not so much.
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