Coming bust in venture capital: S'pore may be worst hit

Irrational exuberance explains the boom in venture capital financing and may also explain its bust.

On the surface, global venture capital (VC) is doing great.

VC financings in China, the United States, Singapore and the world reached record levels last year, with Singapore’s VC investments 30 times higher in that year than in 2012.

Under the surface, however, large losses by highly valued start-ups, falling profitability at initial public offering (IPO) time even with longer times to IPOs, and declining VC investments in China threaten the future of global VC, including VC financings in Singapore.

The biggest loss-making start-ups are in ride-sharing. They are losing money in Singapore, the US, China and India, with total losses of about US$5 billion(S$6.8 billion) last year for Grab, Uber, Lyft, Didi and Ola.

Most bicycle-and scooter-sharing, food delivery and peer-to-peer (P2P) lending start-ups are also losing money (America’s GrubHub and Green Skyare exceptions), with more than5,400 P2P start-ups collapsed or close to collapse in China. Other highly valued American start-ups with large losses include SpaceX, WeWork and Palantir.

Empirical evidence also suggests the profitability of start-ups is low.

One study of US start-ups found that only 18 per cent of those going public last year were profitable versus 78 per cent of start-ups in 1980. And the per cent profitable has fallen even as the median time to IPO rose from 2.8 years in 1998 to 7.7 years in 2016.

The increasing time to IPO in the US has meant that the number of IPOs has not kept pace with the rising VC investments.

Although investments by US venture capitalists last year surpassed the previous record high in 2000, the number of IPOs has never returned to the peak years of 1993 to 2000; only about 250 were carried out between 2015 and 2017, versus about 1,200 between 1995 and 1997.

Instead, US start-ups have depended more on private than public funding, going through many more private funding rounds than in the past. This has caused the number of “unicorns” – private start-ups valued at more than US$1 billion – to explode between 2014 and 2016, before the US number was exceeded by China’s last year. At the end of last year, there were about 140 in the US with an aggregate valuation of about US$700 billion, or slightly less than the US$736 billion of Chinese ones.

VC SCENE IN CHINA

In China, low profitability has already reduced the amounts of VC investments. Its VC investments in the second half of last year were 40 per cent less than those in the first half – those for biotech and artificial intelligence (AI) also fell – the first time Chinese VC investments have fallen. And this fall occurred even as American VCs increased their investments by 125 per cent in China over 2017.

The fall in Chinese VC investments follows a huge increase over the last decade, with the amount invested in the second quarter last year more than twice the amount invested for all of 2014.

 
 
 

Ninety-seven unicorns were created in China last year for a total of 186 at the end of the year. Many of these unicorns are said to be losing vast amounts of money, putting pressure on VCs for more funds, a situation that also exists in the US and India.

This is a classic case of what Nobel laureate Robert Shiller calls “irrational exuberance” in a book by the same name. His model describes how price increases in the stock, bond, or housing market lead to more price increases as each increase provides more evidence that the market will continue to rise. The media’s role is to create a “narrative” that justifies the price increases, thus encouraging further increases.

In the current speculative bubble, it is increases in both VC funding and the valuations of unicorns that are driving expansions.

Both types of increases make it appear to investors, entrepreneurs, policymakers and the media that we are entering a new era of productivity improvements, driven by algorithms, big data, AI, robotics, smartphones, the Internet of Things, blockchain and driverless vehicles, even as productivity improvements aren’t emerging, nor are the profits of highly valued start-ups.

How might this global VC bubble burst? The Chinese bubble is already over, and the only question is how big the fall will be. VC investments fell by 31.7 per cent in January from the previous month, and 67.5 per cent from a year earlier. The number of IPOs, which has been growing rapidly for much of the last 10 years, w>as also 65 per cent lower in January than a year earlier, meaning there are fewer choices for overvalued Chinese unicorns, and suggesting further declines in both IPOs and VC investments in the future. Many start-ups such as Didi, Xiaomi and Meituan Dianping are laying off staff and slashing bonuses on the expectation of falling profitability.

VC SCENE IN THE US

In the US, although declines in VC funding have not yet begun to appear, the increasing amount of funds needed to support America’s unicorns has already impacted so-called seed funding for early start-ups. The amounts rose from US$600 million in 2008 to US$19.2 billion last year, with the latter figure representing 25 per cent of total VC funding >last year.

The heavy investments by existing VCs in money-losing start-ups continue to exist even though new money continues to flow into the VC system from corporate venture units, reaching a record high of US$53 billion last year.

For example, SoftBank has invested US$60 billion of its US$100 billion Vision Fund since mid-2017, mostly on money-losing start-ups such as Uber and WeWork on the expectation that profits will soon emerge.

Although the growing risk enabled SoftBank’s Vision Fund to apparently receive better deals than earlier investors, many of its investors are now saying they have paid too much for these investments, a sentiment that will strengthen as losses continue.

The only remaining solution for America’s VCs is to push their money-losing start-ups on the public so that someone else will incur the losses, notably public investors.

 
 

Many sources report that this year will be the biggest for unicorn IPOs. One source estimates US$200 billion in “expected” market capitalisations from IPOs for start-ups such as Lyft last month, Uber this month, and Palantir and Pinterest later in the year.

But will the US stock market value these start-ups to the “expected” levels, those necessary for America’s VCs to remain vibrant providers of capital to start-ups?

And how might lower-than-expected levels impact the rest of the world? Might they reduce expectations for start-ups globally, thus reducing VC investments in Singapore, Europe and the rest of the world?

The quick turnaround in fortunes of ride-sharing platform Lyft, which went for a public listing just last week and was quickly slapped with a “sell” rating by some analysts days after its IPO, is a case in point that investors may not be prepared to accept excessive valuations. Already, some are predicting a rough ride for other unicorns preparing to list on the public market.

With the VC industry now a global one, with significant fractions of VC investments moving between countries, falling expectations for VC investments in big countries such as the US and China can impact other countries, thus causing an optimistic “narrative” to quickly become a pessimistic one.

Coupled with the impact from declining VC financings in China, Singapore may feel the worst pain.

Singapore’s short VC experience may not be long enough to withstand the rapidly declining optimism for start-ups that would likely accompany a decline in VC financing in the US and China. Just as its VC financings grew by 30 times between 2012 and last year, they can drop equally fast if optimism for start-ups falls.

The last time optimism for start-ups fell after the bursting of the Internet bubble 15 years ago, it took more than 10 years for the US VC industry to recover. Let’s hope for the best but prepare for the worst.

• Jeffrey Funk, a former technology consultant who went into academia, retired from the Faculty of Engineering at the National University of Singapore in 2016.