Inflated Capitalism & The Tunes of a Recession

“I’ve become more pessimistic about the opportunity of stabilizing inflation at an acceptable level without a recession”

- JPMorgan Chase chief economist, Bruce Kasman

I was in the United States a week ago. The city of New York had about ~40% lesser foot traffic compared to my last visit (roughly a year & a half ago), intuitively. Fine-dine restaurants readily allowed walk-ins instead of the ever pricey “we are full until 3 weeks” jab. And unlike the perpetually addictive, surplus draining slot machine party, gambling floors in Las Vegas were ghost-town basements with little customer action.

Much akin to the?Greater Fool Theory?where people who thought could consistently beat the house off overcoming nearly impossible odds only to realize a complete wipe out at sunrise, venture capital investors in the bull-run thought they could continue buying overvalued assets and sell them for a pro?t later, because it will always be possible to ?nd someone who is willing to pay a higher price. Alas!

Never has my learning curve about an economic cycle been steeper. We live in irrationally interesting times.

So why has the bottomless money spinning party suddenly switched gears to a moment of brutal fiscal truth ? What are we really looking at ? One of my favorite finance writers, Marc Rubenstein said in a recent newsletter —

One model of a market is simple as a “mechanical equilibrium” system. In this model there are two groups of investors: optimists who think the security is going up and pessimists who think it’s going down.

In effect, the market price represents a consensus view of all the expectations and information in the market.?

In many situations that model works but it falls short in a number of ways. First, it doesn’t explain why there’s so much trading.?Saturday Night Live?once aired a sketch where the news anchor announces, “And today on the New York Stock Exchange, no shares changed hands. Everyone finally has what they want.” Not only does that never happen, it is seen as a sign of dysfunction when it does.

In other words, what you want — keeps changing, making a perfect imperfection.

Let’s start with the macro. Yields on?10-year US Treasuries?(safe government debt issued by the United States Department of the Treasury to finance central spending as an alternative to taxation)?touched 3.28% earlier this week, surpassing a peak in 2018 to trade at the highest since 2011.

Now although the US Federal Reserve?(the central bank of the United States)?has increased interest rates by 0.75%, biggest rate hike since 1994, it is still far behind the record levels of inflation. However, what is beyond comprehension is — global tension, supply chains and war were blamed often, but there was?no mention of 0% rates for years together, $5 trillion in bond purchases and $7 trillion in national debt.

The longer inflation in an economy stays elevated, the greater the chance it becomes entrenched for subsequent years. Stock markets (even experts) have failed to successfully price that in, and those who tried the?art of timing?have more so.

On average,?bear markets?have taken?13 months to go from peak to trough and 27 months to get back to breakeven since WW2. The S&P 500 index has fallen an average of 33% during bear markets in that time. Breathe deep!?We are only two-thirds of the way in.

It seems we are now in a period of what is known as?stagflation?— lower growth plus higher inflation. Which has a dangerous cascading effect. This is the moment people begin to believe inflation will touch 9%, leading a whole lot of other people to believe it will go to 10% and next thing you know — we are in the middle of a hard-hitting recession. It is then that the most vulnerable segments of the fiscal system get hit hard — the middle class on the retail end & fledgling startups & SMEs on the institutional end.

Let’s talk about our industry — the world of “institutional investing”. Guess we now know where this is going…

…to the elephant in the room. Why ??Because when a forest fire occurs, elephants are the slowest to retreat. Come in?Tiger Global, a large hedge-fund which raised a $12 billion fund in late 2021 and deployed 60% of it by April 2022 itself! Their mindset was to create a pre-IPO fund standard after supposedly seeing an arbitrage between public and private comparables. Guess what ? The?Vanguard 2.0?strategy seems to have back-fired, and how. Tiger is down 60% already & looking at some more correction, with little dry powder left for new deals at scale. The idea of funding 100x of annual recurring revenue just got thrown under the bus. Rewind a little & imagine those high-flying dealmaker funds flaunting in your face the “rare to get into” models you felt FOMO’ed on.

Well guess what ? The joke’s on them.

40% of these funds’ capital (those that raised after March 2020) was invested to “support their founders” through down rounds, bridge rounds & syndicates, which in turn brought losses to as high as 50 cents on the dollar, simply implying returns will be captured by hungry new value investors (read Buffett, Gurley) swooping in for a cheap buck, not those beset with a loser mindset.

Let’s drift a little & look at public markets —?Unity, the flagship SaaS company for the modern-day gaming economy is down 35% from it’s peak. Extrapolating that to the larger lot of companies — the median SaaS (Software as a Service)?Price-to-Sales?multiple?(calculated by taking a company's market capitalization (the number of outstanding shares multiplied by the share price and divide it by the company's total sales or revenue over the past 12 months)?during the boom was 15x, now humbled down to a modest 5.6x

Greed is a fat demon with a small mouth. Whatever you feed is not enough.

With a few millions of venture dollars on the cap-table, a SaaS company claiming the coveted $1 billion valuation will have to, if listed, do a staggering $178 million in Annual Recurring Revenue (ARR) at current public comps! In other words, if you’re only still growing at 15% Y-o-Y, it will take a decade to get back to your?last private round valuation.

Robinhood, the stock-market trading app, is now hovering around $6 billion on the bourses after raising $7.5 billion in private funding rounds. About a third of public?Bio-tech?stocks are trading below cash.?Of the total universe, 40% have less than 20 months of cash, leaving?secondary capital?as the only source of saving face.

Valuations around the globe & across sectors have collapsed like a pack of cards —?Buy Now Pay Later?(a type of short-term financing that allows consumers to make purchases and pay for them at a future date) player?Affirm?now trades at a $5.3 billion market cap v/s a $30 billion peak market cap – a 75% change over a year – whereas in Australia, 15 BNPL?stocks have eroded over $28 billion in market cap from peak levels. None of the major companies in the segment —?Klarna, Affirm, Afterpay and Zip, is currently profitable.

Klarna, the biggest player of the lot with 145+ million active consumers across more than 400,000 merchants in 45 countries faced a 67% drop in its valuation, letting go of 10% of its workforce.

Pain leaves only after teaching a lesson.

That said, a downturn to the magnitude of the GFC in 2008 is unlikely in 2022, but recession in 2023 will be tough to avoid. Venture capital deployment will inevitably revert back to once in 3 years instead of once in 1 year. Therefore, availability of cheap, back-to-back capital to mark-up rounds every 12 months will wash out.

Everyone is saying the “freeze” in private venture funding is limited to?Series A?and beyond. I think it’s about time the industry is accountable and transparent with founders on what is really happening. To be honest — all stages are frozen, with most waiting to time the bottom. If a company is found investible & ticks off most buckets, there’s still the price issue.?“Should it be a 25% discount to previous year vals, maybe 50% ? Let’s probably sit this out.

2021 saw founders drawing down $1 million cheques from angels, who are now busy checking their brokerage balances or worrying about their own jobs. Institutions are facing redemptions left, right & center. For those who missed a company’s previous round, this might seem like an attractive opportunity to get into companies sane enough to anchor away from aggressive expectations. But no one is admitting it. The party statement for most VCs is —?we’re still investing. It’s important for founders to know they aren’t.

Late stage, defined as the final private round before the company goes for an initial public offering (IPO) has little to no visibility of sane capital acceptance. Crossover funds’ public books are down 50-60% at the least. These funds will have to further sell down their public book to meet redemption asks, taking the private (venture capital) stock weight up even further to ~40-45%, well outside of their mandate. This in turn might cast a dirty spell of secondary transactions. Only the most conservative & value adding start-ups will IPO and expect to be fully subscribed. This will be messy as down rounds bring into focus the tussle between funds not wanting to mark down and companies needing the money. Preferred shares will erode cap tables & subsequent term sheets. Late stage companies will have to pivot towards profitability while the reality is that all business models will not be able to make this transition in 6-12 months. Many founders have never had to worry about profits or cash flows, only growth. That environment is gone. For good.

Let’s take another example at the top of the value chain —

Elon Musk’s rumored cost of capital for acquiring Twitter was 14% (Morgan Stanley issued convertible debt instead of what was supposed to be a margin loan initially). Fourteen percent, yes! That’s the rate for the “greatest entrepreneur of our generation.”?

The confidence of a high-growth decade is finally waning. Take a second to digest this — the economic bust of 2008 destroyed 19% of global market capitalisation.?Fast forward to 2022, we’re at 14% erosion already.

An entire generation of founders became better at selling to VCs than their customers because fundraising became easier round after round.?Passing the parcel?became real. The result ? Brutal reversion of long-term means. The music must stop eventually.

Take another breathtaking stat — about 1,300 funds (Venture, Private Equity & Crossover) have commanded the coveted $1 billion AUM size in the history of private funding.?Only 22 have returned 2.3x or higher, cash-to-cash. Most have underperformed public market indices or in other words, sought refuge in marked-up IRRs.

India against the World

As a consequence of Western tightening & an expectedly larger oil import bill, most economists now expect India's?repo-rate?(rate at which the central bank, the?Reserve Bank of India?in case of India, lends money to commercial banks) to move closer to 6%. Some are even building in 6.5% by end of FY23. Things are moving too fast too soon.

If the repo rate goes to 6%, there is fair chance our 10 year G-Sec yield?(loan or capital issued by the government in lieu of a coupon payment to the holder of the underlying security)?can surpass 8%, thus leading to?severe de-rating for equities?should this play out.

As a consequence, one must logically?expect the bond P/E?(the dollar amount an investor can expect to invest in a company in order to receive a dollar of that company's earnings back)?to collapse to 11.5-12x. Today the Nifty is still trading at 18.5x on 1-year forward estimates. How can one justify equity P/E at such premiums when the 10-15 year average premium of equity P/E over Bond P/E is only 300-350 basis points?(1/100th of 1 percent).?

A rational conclusion is to expect Nifty50 Forward P/E to revert to it’s 10 Year average of ~17x, which may lead to a painful de-rating in many mid and small cap stocks which are already trading above their large cap peers owing to the multi-year bull run.

All in all, Indian markets will remain choppy with substantial correction trends for the most of FY23. FIIs will continue to exit as the global money tap dries. FDs won’t attract retail investors after the taper tantrum settles. Given steep upward moves in?cost of capital,?real estate prices will at best remain flat for years to come.

Bonds will continue to fall with banks taking significant mark-to-market losses on a balance sheet level. Safer companies will outperform as usual with equities violently falling back to profitability over growth-at-all-costs. In these times,?history ought to be indexed over more than the future.

Across many seas,?The Swiss National Bank,?the quintessential safe-haven of HNIs, politicians & institutions alike, raised its policy interest rate for the first time in 15 years in a surprise move earlier this week and said it was ready to hike further, joining other central banks in tightening monetary policy to fight resurgent inflation.

A logical investor will want to never over-index on one event. The main argument for a recession is that one usually occurs after the Fed starts hiking interest rates. That is true, but only part of the story. Just because recession occurs after the tightening cycle has started does not mean that the tightening caused the recession. Recessions occur because of untimely shocks in the economy. Think of it as running a marathon without any practice.

Recent recessions have in fact not been associated directly with Fed-rate tightening. The 2001 recession followed the bursting of the stock market bubble, while the 2008 followed the asset-market crash. The?start?of most recent recession was the result of a global pandemic and had no connection to monetary policy.

Quoting Morgan Housel —?The future is always endlessly unpredictable. What changes isn’t the level of uncertainty, but the level of people’s complacency.

All in all, winter has come. The smell of free money is temporary & comfortable. But in investing, what is comfortable — is rarely profitable