Checking Vital Signs: Do You Want to Buy Tech, or Short It? What Impact on Office Markets?

Tech has clearly been the driving demand factor in office markets around the country. Where would Bay Area office markets be without tech?! And the main driver – the blood supply behind tech demand? Hint: It’s not corporate profits. It’s venture capital. So, where are we in the cycle considering the flow of capital? If the flow of VC slows, crawls or evaporates, will the office markets collapse --- and if such a scenario is even likely in the foreseeable future, WHEN might this occur? Do you want to be “long” tech, or “short” it? We put this question to a local brainbox – a venture capitalist whose tenured company has more than $1B invested in public and private tech. We agreed not to disclose the VC’s name, but here’s a direct quote:

“I think VCs are beginning to get more cautious. This was a good article from the LA Times: ‘The Silicon Valley Investment Bubble Starts to Deflate’.

The late stage venture market has gotten ridiculous in my opinion. While there are real companies creating real value that could sustain their valuation in the public markets (Uber), there are countless companies with inflated valuations, dubious unit economics and questionable long term models (Dropbox). There are also many companies that I believe will be very cyclical and will not survive a downturn (many of the on-demand “Uber for X industry” companies like dry cleaning/ wash and fold, food delivery, etc). I think these late stage VC-backed companies will begin to be hurt soon. Their employees and investors need liquidity and the valuations will not work in the public markets. The private money spigot is beginning to slow.

There is still value to be had earlier stage, and I think that is driving many traditionally late stage investors to push earlier and earlier. At some point the same dilemma will flow to the early rounds as well though, likely sooner rather than later (1-2 years).

I think public tech is quite reasonable. The Russell Growth index is trading at 27x 2016 earnings for 30% earnings growth, and the S&P Tech index is trading at 15x. Not stretched by historical standards. I think the valuation issues are primarily limited to the private markets, companies like Salesforce should be OK in my view (Salesforce has much better cash flow than earnings given the biz model, so the company is not as expensive as it optically appears on earnings. Certainly could correct downwards but I do not think there is a disastrous scenario in the cards there).    

So, back to what ends the late stage VC party?

• Pre- IPO valuations get too high, and late stage companies face inability to continue to raise money privately or publicly. As a whole public market tech will be OK in this scenario, and maybe benefit as money comes back to old tech. VC LPs lose money in this scenario, but I do not think Main Street gets hurt too badly. This is a mini-cycle/rotation, not necessarily a blowup. Worrisome for late stage VC firms, less worrisome from my seat. This will happen at some point, guaranteed. I think you get scared once tech IPOs stop working and start to rotate to old tech. This could be happening now. Bad for the Bay Area and CRE, not sure there is more widespread systemic risk though.

• Rates come up and money rotates from growth to value.
  • Lots of traditionally public money has gone to the venture markets given a paucity of growth in the public markets and a low rate environment that allows investors to wait to get paid.
  • I have been considering the case that rates do not ever go back up, at least not to where they were. I think it at least deserves some consideration.
  • The biggest driver to rates is GDP growth. The biggest driver to GDP growth is workforce growth.
    • The point here I am still considering is that perhaps tech will eventually cause GDP growth to become uncoupled from workforce growth. I think this thought is likely wrong, as too much of global production is tied 1:1 to population growth.
  • Globally, the population, and thus workforce is peaking. It is getting harder to grow global GDP.
  • While the US population is still growing, rates will not go up here if global GDP does not accelerate and rates do not go up globally.
  • Therefore, we could be in a prolonged (100 years+ - it takes a long time to reverse demographic trends) period of slow global GDP growth and thus low rates.
    • Moreover, as the growth cycle faces deflationary pressure due to demographics - monetary policy loses its efficacy and Keynesian economics become less relevant (I think this is already happening).
  • This will cause investors to continue to favor the increasingly rare growth opportunities.
  • We could have mini cycles within this environment, but I am beginning to believe this will be the long term trend.
  • I know this is a “this time is different” argument, which I hate. This is the main thing keeping me from subscribing to this argument.

• A broader geopolitical/macro related event that broadly hurts financial markets - in this case we are all screwed anyways. This will happen at some point. The risk of the “black swan” event is always there.

• I do not think the IPO data holds true for tech. From my data the 2013, 2014, and 2015 tech IPO classes all have positive average returns. The returns have gotten worse though, and the IPO pipeline has definitely slowed or stopped.

Also worrisome is that it is hard to make money in these IPOs unless you get a large allocation on the deal, which is difficult. While the companies are trading well from their IPO price, the returns from the first day of trading on are much worse (returns all made in the first day of trading). This is pushing more public money private (to try to secure larger positions for upcoming deals), which is having the unintended consequence of allowing the companies to stay private longer. This is slowing now that late stage valuations have gotten so stretched.”

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