On Bubbles in Venture Capital
We’ve been thinking about bubbles for a long time here at Amasia and recently Amasia Fellow Daniel Tan and I had the chance to get a bit more structured and precise, spurred by the piece we wrote recently on the cleantech debacle. There is a reading list at the end.
Firstly, bubbles aren’t completely irrational
Efficient market theory states that prices reflect all available information because of the actions of rational actors. After you’ve stopped laughing hysterically, you can join me in playing along by asking the obvious question: how can bubbles even exist? The answer is that for large swathes of time, participating in a bubble can be economically rational.
Essentially this equates to the Greater Fool Theory (which appears again below): “the idea that, during a market bubble, one can make money by buying overvalued assets and selling them for a profit later, because it will always be possible to find someone who is willing to pay a higher price.”
For investors who are not betting on momentum for a living, watching a bubble from the sidelines while you’re playing Cassandra can be rather dispiriting. And if you are in the bubble, FOMO (more on that below) causes a complete warping of reality.
The causes of bubbles are really well understood
Quite a bit of behavioral economics is focused on bubbles as these are entirely a function of human psychology. I’ve written elsewhere about my admiration for Daniel Kahneman and even simplistic algorithms being better than much-vaunted intuition. But Kahneman and his main collaborator Amos Tversky noted that while heuristics or rules of thumb are usually helpful, they can “sometimes lead to severe and systematic errors” (quoted in Mansharamani’s Boombustology):
There are five primary (and interrelated) heuristics that bias our decision-making:
Quantitative Anchors: People usually believe that higher previous prices justify higher future prices and are therefore reluctant to make drastic, contrarian bets. This encourages harmful recursive thinking: investors believe current prices are reasonable because they are similar to yesterday’s prices, which were similar to prices the day before, and so forth.
Gambler’s Fallacy. This refers to “the erroneous thinking that a certain event is more or less likely, given a previous series of events.” There are obviously many cases in real life where past outcomes do influence future outcomes (for example, there is some correlation between past and future prices), but even accounting for this, we often place excessive emphasis on the immediately preceding series of events.
The Endowment Effect: This posits that people attach greater value to things they own (Mansharamani p. 76). A landmark study by Kahneman, Knetsch, and Thaler showed that a) people are loss averse because it requires more to convince people to part with items they own; and b) People are biased toward the status quo because it is difficult to ask people to relinquish ownership.
Overconfidence: We tend to overestimate our ability to pick investments and estimate future performance, and overrate our performance relative to that of others. We are prone to overprecision, or being excessively certain about the accuracy of our predictions and instincts.
FOMO (Fear of Missing Out): This is the big one. Rational theorists assume that we value items for their intrinsic and absolute value; the psychological reality is that humans are more likely to assess value relatively. DeMarzo et al found that people care more about how their wealth measures up to their peers than the independent value of their wealth. As the economic historian Charles Kinderberger put it: “There is nothing as disturbing to one’s well-being and judgment as to see a friend get rich.” It takes a rather evolved human being to ignore FOMO.
Putting all these together, we get to a “herd mentality”.
But VC bubbles are more bubbly, for specific reasons...
Venture capital has certain characteristics that make the asset class even more prone to bubble formation. Here are four that matter:
Lack of short-selling mechanisms: In public markets, if investors think a stock is undervalued, they can buy it; if they think a stock is overvalued, they can short it. Importantly, both generate profits. On the other hand, in private markets, investors can only profit if they believe a company has growth potential or is undervalued. This absence of a way to profit through short-selling in VC creates an inevitable bias towards optimism because positive thinking is the only way to potentially make money. And when the movie ends, it ends in an ugly fashion as Professors Fried and Gordon write: “A market that makes it difficult and costly to express negative sentiments is prone to a bubble and thus an abrupt collapse when negative fundamentals finally become too pervasive to ignore.”
Capital glut: Investors hunting for something, anything, to drive “alpha” in our low interest rate environment have poured money into venture capital as an asset class. The horror that is Softbank’s Vision Fund is exhibit A. For VCs, having too much money incentivizes them to be less picky with their investments; for entrepreneurs, it distracts from capital efficient product development, bankrolls lavish and unnecessary advertising campaigns, and shields startups from competitive market forces that instill resourcefulness and discipline. As a result, start-ups raise too much money at too high valuations. (This is a pervasive issue for startups and I’ve written a simple guide on what to do if you’ve raised too much money.)
Greater fool theory: The VC-founder-tech industrial complex leads to start-ups often prioritizing achieving higher valuations over truly developing their business. An article in Barrons puts it well: startups often “focus on ‘positioning’ their companies for the next funding round—effectively playing branding and marketing roles in order to court the next group of investors or to get bought by a bigger firm, instead of properly managing their revenues, costs, and operations.” As a result, we start to see Ponzi-like situations (there, I used the word) where companies are, in effect, relying on the “kindness of tomorrow’s capital markets” to provide existing investors with returns.
Silicon Valley “success” definitions: When you are being pitched and importuned 24/7, it might, it just might, lead you to see the world through rose-tinted glasses and yourself as larger than life. The very title of Forbes’ annual ranking of top VCs exemplifies this — it is the ‘Midas List,’ We forget that the original King Midas story didn’t end well… But more seriously, a hankering to be on the Midas list fuels “swinging for the fences” behavior that affects everything from portfolio construction to behavior as a board member and investor.
What does Amasia do that is different?
I wish I could write here that we are some kind of magical dream beast that operates orthogonally to everyone else. Sadly we have fallen victim to virtually every “attribute” listed above. Repeatedly. But we try learning and persevering…
A few things help us stay within guardrails (= protect us from ourselves):
We manage small core funds and have concentration limits, so we can’t do really stupid things
We take the full vintage period to invest at a slow pace, so we rarely suffer from extended “deal fever”
We are probably more disciplined about valuations than most
We are material investors in our own funds, so we’re not just gambling with other people’s money
We try our best to get our founders to prioritize good business building over future valuations — our view is always that if we do the former, the latter will come. This can often be difficult and can lead to tensions — it is no fun being the VC who is less focused on future valuations and “get big fast” than the founder!
The desired risk-reward profile of our funds, therefore, is quite different from most early stage VC firms. This is deliberate. A good thought experiment is: in a choice between a 1% chance of a 100x investment, or an 80% shot at a 4x investment — we’d take the latter. This is not received wisdom in our industry. We’re fine with that.
The Best of What We Read
Bubbles in general
1. What’s That You’re Calling a Bubble?: This Harvard Business Review article offers a thoughtful overview of what the term ‘bubble’ really means.
2. Irrational Exuberance by Robert Schiller: In his seminal book, the Nobel-Prize winning economist dissects the psychology behind asset bubbles.
3. The Greater Fool Theory: What Is It?: In this short memo, a Cornell professor examines the ‘strategy’ of buying overpriced stocks.
VC bubbles in particular
1. Squaring Venture Capital Valuations with Reality: In a study of 135 unicorns, researchers at UBC and Stanford offer empirical evidence to show that they are indeed relatively overvalued (the average unicorn is reportedly overvalued by 48%).
2. The Valuation and Governance Bubbles of Silicon Valley: Law professors at Harvard and Columbia examine the specific features that exacerbate VC bubbles.
3. Why Tech Startups Can’t Seem to Stop Flushing Cash Down the Toilet: This article examines the factors underlying today’s capital glut in VC.