Earlier I wrote about early stage valuations being de-risked through schemes similar to how mortgage backed securities were derisked and how that was creating a bubble. The reason derisking creates a bubble is that by artificially de-risking a high-risk investment, the amount of money that can be invested increases significantly.
To speak in math: if the total amount of money to invest is MONEY, and only 10% of MONEY can be invested in high risk investments, then only 0.1*MONEY is available to invest. Now suppose I can take an investment vehicle, like an early stage start-up, and de-risk the investment, then instead of only 10% of MONEY being available to invest, 30% or 40% of MONEY is available to invest. The net effect is to increase the total amount of money entering the market creating an asset bubble.
If the total amount of MONEY is also increasing (thank you QE), then you have two accelerators – the derisking making more money available and more money coming online…
As for how to derisk an investment …
There are two ways to derisk an investment. The first it create a hedge. The second is to foist more risk on some people and less risk on others. So for example, in the mortgage backed securities market we had both. We had credit default swaps as a hedge, and senior debt as a way to derisk the investment for some. In the early start-up game, the hedge is to invest in many different start-ups in the same space, and the derisk strategy is to have warrants on any early liquidity the company may get.
Essentially the investor is pushing more risk on the employees and founders by being first in line to any money the company makes.
But there is another way to derisk …
The other way to derisk is to believe that something is less risky. Essentially we take leave of our senses, and believe the hype that surrounds us. This second form of derisking is far more dangerous and far more explosive.
After I wrote my little note, this made the rounds: https://www.linkedin.com/pulse/investors-beware-todays-100m-late-stage-private-rounds-bill-gurley where he seems to be arguing that traditional risk analysis is being ignored in favor of a devil-may-care must-invest-at-all-mentality…
And it all leads to this:
The author, Bill Gurley, had this money quote:
All of this suggests that we are not in a valuation bubble, as the mainstream media seems to think. We are in a risk bubble. Companies are taking on huge burn rates to justify spending the capital they are raising in these enormous financings, putting their long-term viability in jeopardy. Late-stage investors, desperately afraid of missing out on acquiring shareholding positions in possible “unicorn” companies, have essentially abandoned their traditional risk analysis. Traditional early-stage investors, institutional public investors, and anyone with extra millions are rushing in to the high-stakes, late-stage game.
With the downside for the investors being derisked either through hedges or warrants, and the risk of poor outcome being pushed on the employees and founders, the companies are actually being forced to take bigger risks and by taking bigger risks …
Remember what I said earlier, with warrants when a company has a liquidity event the early investors make most of the money. Consider a hypothetical company that has it’s paper set up in such a way that any liquidity event up-to 500 million dollars the employees get to split less than 50 million dollars. The employees and CEO are now motivated to go after a billion dollar outcome.
The problem is that it’s a lot easier to hit 500 million dollar exits (historically speaking) than 1 billion dollars.
So the CEO decides to go for it because only if he goes for it does he make any real money thus he increases the risk
The problem is by going for it – he actually is increasing the risk of complete loss.
So ironically by derisking the investment the overall risk is actually increasing.
Somewhere Nassim Nicholas Taleb is smiling