Inflation Reaches Unicorns

Unicorn Herd

Investors are naturally (and correctly) concerned about inflation and/or recession affecting the stock market. They’re usually thinking of the public stock market, which of course is quite important but it’s not the only stock market.

A growing number of large, well-known companies are choosing to stay private long past the point where they would once have gone public. It’s become common enough to have a term. They’re called “unicorns.”

Here’s a number I bet will surprise you. As of January 2022, the US had 2,800 public companies with annual revenues over $100 million—and 18,000 private companies of that size.

Source: Hamilton Lane

Many of these companies have no plans to ever go public. They are family-owned or otherwise don’t need the hassles that go with an exchange listing. An IPO gives early shareholders an easier exit, but if they don’t need or want that liquidity, staying private is often more attractive.

Now, think about where a fast-growing private company gets its capital. The main source is by selling equity via private offerings to venture capital funds, institutional investors, or wealthy individuals, and (at later stages) to private equity funds.

From the investor or manager’s point of view, a portfolio of unicorns that might disrupt an industry is relatively more attractive when the alternative is a 2% corporate bond. This leads to a weird situation where companies go years not just without profits but sometimes without revenue, staying in business only because their VC investors believe a giant breakthrough is coming. Cash running low? Just do another round. The money will be there.

Now that model is breaking down—and it’s making inflation worse.

Disruption Plans Disrupted

With all that in mind, let’s look at a recent article from The Atlantic. It’s not economic analysis as such. The writer, Derek Thompson, simply observed some changes in his urban Millennial lifestyle—like $50 for an Uber ride that until recently cost much less—and wondered what was causing them.

In answering that question, I think he hit on something important. Here’s part of the story, with some of his key points in bold.

“With markets falling and interest rates rising, start-ups and money-losing tech companies are changing the way they do business. In a recent letter to employees, Uber’s CEO, Dara Khosrowshahi, said the firm needs to ‘make sure our unit economics work before we go big.’ That’s chief-executive speak for: We gave Derek a nice discount for a while, but the party’s over and now it costs $50 for him to get home.

“For the past decade, people like me—youngish, urbanish, professionalish—got a sweetheart deal from Uber, the Uber-for-X clones, and that whole mosaic of urban amenities in travel, delivery, food, and retail that vaguely pretended to be tech companies. Almost each time you or I ordered a pizza or hailed a taxi, the company behind that app lost money. In effect, these start-ups, backed by venture capital, were paying us, the consumers, to buy their products.

“It was as if Silicon Valley had made a secret pact to subsidize the lifestyles of urban Millennials. As I pointed out three years ago, if you woke up on a Casper mattress, worked out with a Peloton, Ubered to a WeWork, ordered on DoorDash for lunch, took a Lyft home, and ordered dinner through Postmates only to realize your partner had already started on a Blue Apron meal, your household had, in one day, interacted with eight unprofitable companies that collectively lost about $15 billion in one year.

“These start-ups weren’t nonprofits, charities, or state-run socialist enterprises. Eventually, they had to do a capitalism and turn a profit. But for years, it made a strange kind of sense for them to not be profitable. With interest rates near zero, many investors were eager to put their money into long-shot bets. If they could get in on the ground floor of the next Amazon, it would be the one-in-a-million bet that covered every other loss. So they encouraged start-up founders to expand aggressively, even if that meant losing a ton of money on new consumers to grow their total user base…

“This arrangement is tailor-made for a low-rate environment, in which investors are attracted to long-term growth more than short-term profit. As long as money was cheap and Silicon Valley told itself the next world-conquering consumer-tech firm was one funding round away, the best way for a start-up to make money from venture capitalists was to lose money acquiring a gazillion customers.

“I call this arrangement the Millennial Consumer Subsidy. Now the subsidy is ending. Rising interest rates turned off the spigot for money-losing start-ups, which, combined with energy inflation and rising wages for low-income workers, has forced Uber, Lyft, and all the rest to make their services more expensive.”

We talk about companies raising prices to preserve their profit margins against inflation. That’s certainly happening, but a whole other universe of companies lack profits in the first place. Some are quite large, too. Many are privately held. We don’t see their quarterly reports—but I’ll bet the last quarter or two had even bigger losses than usual.

Low interest rates enabled this but weren’t the only factor. It was low interest rates accompanied by an investor belief that enough cash and patience would produce the same kind of disruptive, exponential growth that made Jeff Bezos so fantastically wealthy. They all want the returns like a $10,000 investment in an Amazon IPO would now be worth (drum roll) ~$20 million. And if you put $1,000,000 in an early private round? I think the term is gajillions. Thus, the allure of chasing the next unicorn.

It really happens that way in a few rare cases. More commonly, though, these ultra-patient investors shielded their startup companies from normal market forces that tell management whether its plans are working or not. Often, they didn’t work, at least not at the subsidized prices they dangled to consumers whom they hoped to hook for life.

The stories were alluring. Taxis used to be super expensive; surely technology could deliver a better solution. Uber and Lyft seemed to be the answers. But now, having started to travel again, I can tell you the old-fashioned, regulated yellow cabs are often less expensive than the higher fares the app-based services now charge, if not as comfortable.

In other words, what we see as “inflation” often represents not higher prices, but the end of artificially low prices. Or, put differently, it’s not so much price inflation as price rationalization. These businesses are finally having to charge enough to cover their costs, which comes as a shock to customers.

The market will sort this out eventually. Companies that can turn a profit offering things consumers want at prices consumers can pay will survive. But the winnowing process won’t be fun.

That means, as we watch a bear market on Wall Street, a less visible bear market will be unfolding in Silicon Valley, and in the boardrooms of institutions who invested in venture capital funds. We won’t see the full story, but we’ll see the effects. The companies will cut costs with lower wages and/or layoffs. Some will default on debt payments or even go bankrupt, leaving those starry-eyed shareholders holding only an empty bag.

Animal Spirits

Something similar happened in the energy business a few years ago. A combination of low interest rates, regulatory changes, and new technology enabled low-cost production from previously unprofitable shale oil and gas deposits. Crude oil prices were mostly above $80 for almost five years (2010‒2014) with production costs less than half that level. The seemingly forever profits encouraged oil companies to leverage their production at friendly banks.

The resulting handsome profits drew in new players and a lot of new production which, combined with Saudi Arabia defending its market share, drove prices sharply lower. The US economy had a rough stretch in 2015‒2016 as the boom unraveled. It wasn’t technically a recession, but sure felt like one in energy-producing regions.

The old commodity saying, “High prices are the solution to high prices” has a corollary: Low prices are the solution to low prices, too. The years following 2015 gave little incentive to invest in new production. Then when crude oil dropped nearly to zero (and briefly below zero) in the COVID panic, the industry had a kind of near-death experience. I imagine some executives saw their careers flash before their eyes. This raised the threshold for making capital investments even further. The religion of ESG and the pressure on institutions not to lend to oil companies is quite real, driving up the cost of new capital investments.

If, hypothetically (because the real world doesn’t work like this), oil prices had simply held steady around $80 for the last decade, we might be in an entirely different world now. Oil producers would be making a nice profit, supplies would be adequate, and the present inflation would be much less severe. The boom-bust cycle doesn’t let it happen that way, though.

This leaves energy companies in the opposite position of those VC investors described above. They won’t invest in long-term growth because they’re not confident there will be any. They see both governments and consumers increasingly favoring renewable energy, environmental regulations making fossil fuel production more expensive, and higher interest rates raising the cost of the capital that would let them overcome the other obstacles.

On top of that, the very real possibility of a global recession cratering fuel demand in the next year or two, thereby rendering any new capital investments unprofitable, gives energy producers every incentive to extract as much cash as they can, now. That happens to be what their investors want, too.

© Mauldin Economics

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