This morning, the Wall Street Journal had an excellent article about the relatively sharp slowdown in venture investing and its impact on startup companies. Let’s just say it isn’t good. Deal flow is down. Cash is hard to find, and companies are closing their doors. If it seems like an echo of the dot.com bubble, it sort of is.
However, given the Fed’s aggressiveness in raising interest rates over the last 12+ months, it isn’t surprising. When cash was paying 0%, investors threw money at just about any good story they heard. Shoot, they even threw money at bad stories, and a lot of them.
Long years ago, as in just prior to the 2000 tech crash, I was attending a previous employer’s ‘capital management group’ meeting. It was a fancy title for trust department investment officers. We were in the midst of a debate over whether we should invest more money in tech stocks with no earnings but lots of sizzle, when one of our more senior portfolio managers spoke up.
This guy is plenty smart, and can spin a yarn with the best of them. While not verbatim, which would be impossible due to the passage of time, this is what he said:
“Gang, I drove down Government Street the other night. I saw some bums sitting outside one of the rundown hotels drinking hooch out of brown bags. They had two big barrels in front of them. In one was a great big fire, and this one guy was grilling a hot dog. On the top of the other was a television tuned into CNBC, and they were watching stock results. Guys, I am here to tell you, the money is ALL in, and it is time for us to get out.”
Of course, everyone howled, but not everyone took his advice. In fact, outside of his office, very few did. Not surprisingly, his team’s equity investment results crushed everyone else’s over the next several years. Me? I managed bond portfolios, and went long with Treasury and Agency debt.
I tell you that little story because of this: life tends to go in cycles. In the late 1990s, tech stocks were all the rage. If you had a line of credit from the bank and a business plan with the word internet in it, you could easily go public and be a millionaire without ever turning a dime. Seriously.
Over the last several years, a similar thing has happened with so-called private equity. Due to a finite amount of publicly traded stocks and a seemingly infinite amount of cash to invest, people threw money at all sorts of, shall we say, interesting projects.
I particularly liked the following passage from the WSJ article:
“California startup Zume, which was developing a robotic pizza maker and was once valued at $2.25 billion, recently entered a wind-down process handled by Sherwood Partners, a restructuring firm, according to Sherwood’s co-founder and co-president Martin Pichinson. Zume representatives couldn’t be reached.
Sherwood’s business increased by 50% through April 30 this year compared with the same period last year, Pichinson said. “And the storm hasn’t even started,” he added.
The venture-capital boom in 2021, as well as pandemic-era government funding to small businesses, likely kept businesses alive for longer than they would have otherwise, some observers believe. Now that those funding sources have dried up, the failures are coming in.
“Most of the companies we are handling now frankly deserved to have gone out of business a year or two ago,” said Barry Kallander, president of KallanderGroup, which provides corporate restructuring and dissolution services.”
New businesses are going to be harder to come by over the near term. The cost of money is simply too high. The numbers don’t make sense.
When interest rates are at 3-4%, relatively low margin projects like the next greatest coffee shop, yet another froufrou restaurant or upscale barber shop (it’s a thing) might be able to squeeze out a few pennies. However, when Prime is at 8.25% and you have to borrow at 9%, you don’t need a slide rule to do the math.
Let’s just say it takes a lot of cups of coffee and avocado toast to service the debt, a lot of them.
Perhaps not surprisingly, the NFIB Small Business Optimism Index is at its lowest level since the start of 2013, and has been trending downward.
It is going to be a tough row to hoe for a little while as private equity adjusts to the new price of cash in the financial system.
This isn’t a death knell scenario. There always has been, and always will be a place for private investments. As I have always said, there are very few truly bad investments, just bad prices for them.
I said the same thing back at the start of this century – that the internet was going to revolutionize how we conduct business and live our lives was without question. However, the valuation of some of the so-called ‘dot.com’ stocks were, to use Greenspan’s words, irrationally exuberant. Back then, just as it has been recently, investors would throw money at anything with some sizzle. Did you really want to buy your pet from an online puppy mill in 1999? Do you really want a robot to make your pizza in 2023?
- If you don’t care who or what makes your pie, consider this: Papa John’s International currently has a market cap of $2.36 billion and an OPM (operating profit margin) of 5.2%.
- Now, according to the WSJ, the robotic pizza making startup had a value of $2.25 billion before it went under. So, the machine making the pizza was worth as much as the entire company selling them?
Workers of the world unite! Or perhaps this is what makes people think AI is going to lead to the extinction of our species. But then again, there wouldn’t be any need for a pizza making robot if there aren’t any people. Just saying.
At the end of the day, hear this: investing goes in cycles. Good projects will end up making it, and bad ones will close shop. They always have and they always will.
It always comes down to the cost and availability of capital.
By the way, in case you were wondering, the sun will come up in the East tomorrow. Albeit it will be a little hazy on the Eastern Seaboard.
John Norris
Chief Economist
Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows on this any every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.
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