When the markets peaked around 2007 and 2008, there was a pervasive approach to investments – in every segment from corporate fixed income to consumer credit to equities – that was predicated on refinancing risk rather than repayment capacity, on exits rather than interim cash flows. In this manner of making capital allocation decisions, the analysis of capital flows and market liquidity is of equal (or greater) importance to an appraisal of the underlying asset that is being financed. The bet is on an escape valve, a handoff, in an ongoing flow of ownership or credit, and in such a scenario financial capital is permanent, financial assets are rented rather than owned. In such a scenario, “technical” is the new “fundamental.”
At its most uncouth, we refer to this structure as a Ponzi. At its most refined, we think of it as monetary policy, excess liquidity, savvy trading. If this is taken to an extreme, and if the second shoe does not drop, (if the handoff is not made), the underlying business does not produce the necessary second (what should be the first) way out. When this occurs, we complain about a bubble that has burst, but we rarely do so while the bubble is brewing. Rather, we point to “excess liquidity” and take the capital gain.
This was the case a few years back, and could become the case again as the market is beginning to show some similarities to the period then ended. The behavior of capital markets now, at least in pockets, can only be explained in terms of liquidity, and many have even given up on economic rationale. There is an interesting analogy that we can look to, that for the last fifteen years or so has also seen its share of liquidity ebbs and flows, that has also been highly reliant on refinancing or replacement, rather than the cash flows of an underlying business: Venture Capital.
In venture investing, the underlying asset has little if any fundamental value at the time of entry. The value is in the option, and the realization of value is in the trade: the follow-on round, the IPO, the M&A event. In terms of the broader market, this would be equivalent to the Fed keeping its rates low, or overseas capital continuing to be injected. One of the interesting – and in some ways frightening – aspects of this discussion, is the almost circular system that includes the public markets, the universe of M&A alternatives, and venture capital. Each one is influenced by and in turn influences the others, and to the extent that a bubble pops in one, the others suffer the effects and in ways could be the cause.
While this has always been the case and does not in itself signify a new development, the novelty of today’s landscape is in the very analogy of each of the other two segments to venture capital, as suggested. And while different segments of the capital markets could in the past be distinguished by differences in style and risk appetite, which differences served as a balancing mechanism of sorts, this may become less true in a market almost purely driven by optionality.
The discussion is more than theoretical and academic, I believe, and it is perhaps even more than an observation to elicit a “duly noted” response. The consequence of “technical” as the new “fundamental,” of market liquidity and business value competing for top billing, and of exit (refinancing) out-ranking interim cash flows in order of emphasis, is that the system makes venture capitalists of us all. And venture investing is a highly specialized field, an acquired skill, that is not as easy as it looks.
