Venture Capital: The Next Big Short?

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Includes: CHAT, FB, HUBS, LN, QQQ, SKYY, TWLO
by: Ian Bezek

Summary

Gary Vaynerchuk argues an "Armageddon" is coming for the venture capital space.

If he's right, would the economic damage be limited to tech communities or spill out to the broader economy?

My thoughts on trying to trade the situation.

Yesterday, I asked if Treasury bonds were the next big short. You can make a good case for an imminent top and reversal in the US bond market, but plenty of people have lost a great deal of money trying to catch the reversal in that market prematurely. Bonds may fall, but it's been a tough trade to execute so far.

Today, let's look at another potential "big short" - venture capital. Are the tech unicorns in danger of facing a mass extinction? On the affirmative side, we have a powerful argument from an industry insider.

Wine magnate, superstar VC investor and bestselling author Gary Vaynerchuk just appeared in a startling interview with Recode Media. Vaynerchuk is obviously an enthusiast in the social media and advertising space and talks ebulliently about some of his investments, such as Snapchat (Private:CHAT). However, he's showing serious concern that things have gotten out of hand. He asks the podcast's host (I've lightly edited to clarify, and remove profanity):

Do you know how many start-ups are going to go out of business in the next couple years? [...] Everybody is just building arbitrage machines. There's nobody building a start-up business anymore.

Everybody's creating a start-up financial machine. You don't have a start-up business, my friend, you have a start-up financial machine because from the day you raise your seed round, everything you do is to [get your Series A financing]. I cannot wait for the Armageddon that's going to put out 97% of these fake entrepreneurs [...] This is the greatest era of fake businesses, ever.

He elaborates on this idea, suggesting that start-up entrepreneurs are no longer focusing on the user. Instead of building a product that will be sticky and serve an actual customer need, the new entrepreneur looks purely at the metrics needed to get funding.

If 80,000 users is the number where VCs are currently assigning a significant valuation, then the entrepreneur will do whatever is necessary to hit that number and get cash, rather than building the business organically and letting the chips fall where they may. This numbers-based approach that aims to hit targets rather than meet consumer desire works in the short run, but is unlikely to create lasting success.

Discussing problems in the Internet space, such as advertising fraud and bots, Vaynerchuk says that everyone seems content to ignore serious issues. As long as arbitrary metrics are achieved and funding rounds continue to close as scheduled, he suggests that simply no one cares whether or not the so-called businesses being created will ever make economic sense.

He admits to a personal lack of oversight, getting caught up in the enthusiasm. Speaking about VCs:

We made money by actually building a business, and then we all thought we were so smart writing checks [...] I'm going to lose so much money [...] because I wasn't able to diagnose early enough that we were creating a culture where every student on earth decided:

"Wait a minute, I'm not going to get a job coming out of school, I have an idea."

His losses won't be singular; he forecasts widespread losses for the whole VC/tech start-up industry. Specifically, he says that this is more like the tech bubble; that valuations are far out of line, and that the suffering will be far worse than 2008 for VC since valuations are so detached from reality:

Most of the companies we all look up to and write about and think about and think are doing well do not make profits. [...] With these inflated values and money in the bank, these entrepreneurs have way too much burn; they're fancy. This is way more 1999, 2000, 2001 than 2008.

At one point, he suggests the next "Big Short" (his choice of words) will be in the VC space, as these 97% of "fake" entrepreneurs get forced out of business. The host of the podcast is quick to suggest that the damage will be limited to the VC space, but Vaynerchuk disagrees, saying the ripples will be huge.

He suggests, for example, that if and when Facebook (NASDAQ:FB) loses half its value, the repercussions will be felt in the broader economy. And he's right on that; much of the upturn in housing and incomes in recent years has come from a few innovation clusters in the US in booming regions such as Silicon Valley, Austin, or Seattle.

Redfin had an interesting report on this a couple years ago, charting market cap of a local areas' leading public firms against housing prices. Here's Mountain View, CA, for example:

Click to enlarge

If you lag the median sale price by a quarter or two, there's a pretty solid correlation. So, it should perhaps come as no surprise that as the tech start-up area has seen a little bit of a slowdown since late 2015, housing prices are starting to stagnate, as Bloomberg notes in an article describing how properties are starting to linger on the market. The author notes the correlation:

Venture-capital investments in Silicon Valley fell almost 20 percent in the first quarter from a year earlier to $4.9 billion, according to an April report from PricewaterhouseCoopers LLP [...]

"Given that a larger proportion of the $3 million-plus category is purchased with cash, or folks use some of their other assets to make those kinds of purchases, I think they're more susceptible to stock-market volatility than your entry-level buyer would be," Levine said. "That's one of the big drivers of the current slowdown."

While it's true that there is great regional variation in the US economy and the housing market is more local than national, if the gusher of funds from the tech industry stops flowing into the economy, you have to imagine the hit to the economy would be quite sizable indeed.

If the future indeed comes to pass as Vaynerchuk suggests, it's somewhat difficult to play on the public markets. Most of the VC-funded firms he's discussing will never make it public, nor are there many VC firms we can directly short. You can short things created to capitalize on the froth, such as the cloud competing ETF SKYY, but it has exposure to a lot of mega-cap tech companies that are unlikely to implode.

You can short particular flimsy public tech companies; HubSpot (NYSE:HUBS) comes to mind due to this hilarious and scathing book attacking the company as essentially a gigantic exercise in creating and marketing vaporware.

A general short of the NASDAQ QQQ, while unlikely to produce huge returns, would almost certainly be meaningfully profitable.

Finally, you can look to short the areas that have made large profits off the VC boom; shorting REITs with heavy exposure to Silicon Valley office space or residential properties being one such idea. In any case, if Vaynerchuk is even partly right, it should be a couple of interesting years in the tech unicorn arena.

It should be noted that Vaynerchuk's view isn't universal. Peter Thiel, for example, was quoted by Bloomberg as saying:

Startup tech stocks may be overvalued, but so are public equities, so are houses, so are government bonds.

And the National Venture Capital Association reminds us that while this year is down from last year so far, it was still the second-biggest first quarter for the VC industry since 2001. You can look at the sizable decline from last year as a top. But you can also see it as a still robust level that has merely taken a breather from last year's euphoric conditions.

In any case, it will be worth watching how new tech IPOs fare in the back half of 2016. The IPO market for tech firms had been pretty much closed until recently, but the recent arrival of firms such as Line (NASDAQ:LN) and Twilio (NYSE:TWLO) represent returning interest. How these stocks trade going forward should play a meaningful role in determining if venture capital has merely seen a slowdown, or if a big bust is coming.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.