(Bloomberg Opinion) -- It is late cycle in the era of unicorn madness. All that capital sloshing around looking for a home has made it easier for promising start-ups to get funded, but also made it too easy for many that never should have gotten off the ground. The process has driven valuations to unholy heights. QuicktakeUnicorns
It's not just the quantity of money that’s the issue, it's the concentration of all that capital. Nowhere is that more evident than at the $100 billion Japan-based Softbank Vision Fund (SoftBank is raising a second, even bigger fund, Vision Fund 2).
Rather than make lots of small bets, spreading risk across many early stage companies, the Vision Fund makes relatively fewer, larger bets, often on more established companies. Uber Technologies Inc. and WeWork parent We Co. are the poster children for this approach.(1) Uber has been a disappointment since it went public – its shares are down almost 30% since its May initial offering; We has postponed its planned IPO amid doubts about its valuation.
The Softbank approach looks like part of the problem: It has invested more than $80 billion during the past two years. Can any firm properly perform the due diligence needed when investing so much capital so fast?
For some context, U.S. venture capital funds invested $100 billion in 2018, an increase from $82 billion in 2017.
Eric Feng, a former partner at venture-capital firm Kleiner Perkins, notes that from 2003 to 2011, 157 new funds were raised each year on average. After 2012, that spiked some 40% to 223 per year. The number of funds and money raised have both grown: According to Statista, the media deal size of “later stage VC-backed investments has risen to $11.5 million in 2018 from less than half that size in 2010."
All this money chasing a limited universe of new ventures has inflated valuations. “A lot of capital does disrupt venture capital, which is the problem we’ve had as an industry,” says Benchmark Capital partner Sarah Tavel.
That was before SoftBank came onto the scene in 2017. Once the Vision Fund started pumping money into the eco-system, the imbalance became more acute, especially as it pertained to late-stage outfits that had already raised billions of dollars in venture capital.
The philosophy of Masayoshi Son, chairman and chief executive officer of the Vision Fund’s publicly traded Japanese parent company SoftBank, favors investing in dominant companies. "In our industry, winner takes all," he said. "By probability, the No. 2 company's chance of succeeding is very low."
As a result, Vision Fund is often the largest investor in each of its portfolio companies. This tends to drive valuations higher. Typically, the fund takes a 20% to 40% ownership stake (or more). Vision was Uber’s biggest investor before and after it went public in May; Vision’s $10.6 billion investment in We made it the biggest outside investor and second biggest shareholder after CEO/founder Adam Neumann.
The size and pace at which SoftBank made its investments raises issues of whether it paid close attention to the usual valuation metrics. Start-ups work off of future projections that are effectively fabricated numbers. To be fair, they have to be – founders are making projections for products and services that are novel or may not yet exist.
For early stage investments, “There are no bad ideas, only early ones,” says venture capitalist Marc Andreessen. That argument works less well with late stage investments like Uber and We. Perhaps the Vision Fund allowed the hype to get the best of its assumptions about future growth and singular domination by these companies in the commercial real-estate and local travel markets. The fund says that valuation declines in those two were more than made up for from gains in investments in Indian budget hotel-booking startup Oyo, workplace messaging provider Slack Technologies Inc. and food-delivery company DoorDash Inc.
The other issue with Softbank is how its prominence influences others. This is a pattern we have seen in other markets.(2) The firm’s rapid capital deployment created an auction-like atmosphere, pressuring other funds to race to invest.
When one huge fund waded into the fairly limited venture space, the result was that valuations ballooned. If lower valuations lie ahead, that will be good for future investment opportunities, but could mean big write downs for existing Vision Fund portfolio companies. And it will prove that even a fund as big as SoftBank's couldn't fight the skepticism of the public markets.
(1) Other SoftBank Investments include: Fungible $200 million; Oaknorth $390 million; Opendoor Estimated $500 million; Cambridge Mobile Telematics $500 million; Improbable; $502 million; Auto1 $561 million; ZhongAn $600 million; DoorDash $750 million; OSIsoft 800 million; Compass $850 million; Katerra $865 million; ParkJockey $900 million; Ola $800 million to $1 billion; Nuro $940 million; Flexport $1 billion; Rappi $1 billion; Fanatics $1.2 billion; SoFi $1.1 billion; Snapdeal $1.2 billion; Tokopedia $1.3 billion; Paytm $1.4 billion; Chehaoduo $1.5 billion; ByteDance $1.8 billion; Flipkart $2.5 billion; Cruise $2.5 billion: OneWeb $2.8 billion; Coupang $3 billion; Ele.me $3 billion; Nvidia $4 billion; Grab $5.5 billion; Uber $9.3 billion; We Company $10.5 billion; Didi Chuxing $13 billion; Sprint $21.7 billion.It also bought: Brightstar $2.2 billion; YMobile $2.3 billion; ARM $32 billionSources: Recode, Crunchbase, Business Insider, Softbank
(2) This is reminiscent of the mid-2000s housing bubble: Real estate appraisers rely on so-called comparables -- nearby houses that recently sold -- to set valuations for mortgages. Higher sale prices of similar homes fed a cycle of ever-increasing prices -- until the cash dried up, and the cycle went into high-speed reverse.
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Barry Ritholtz is a Bloomberg Opinion columnist. He is chairman and chief investment officer of Ritholtz Wealth Management, and was previously chief market strategist at Maxim Group. He is the author of “Bailout Nation.”
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