Picture: 123RF/bluebay
Picture: 123RF/bluebay

My fascination with financial markets has recently peaked to a level I last experienced in the late 1990s dot-com craze, with many concerning parallels.

The 2008 global financial crisis resulted in central banks printing money (or quantitative easing) and reducing interest rates to zero without fear of any long-term consequences — provided asset classes kept producing positive returns.

About five years ago, after this interest-rate reduction trend, certain government bonds began trading with negative yields, meaning a guaranteed loss for an investor if held to maturity. More recently, as global recession fears have risen, the level of negative-yielding debt has increased to a hard-to-fathom $16-trillion, about 30% of the world’s investable bond universe.

The unintended consequence of “ultracheap” money has been to promote the wrong behaviour from corporates and investors.

For large listed corporates, it has become beneficial to borrow “cheap” and use debt funding to buy back shares at even higher prices. Instead of investing in growing their businesses and/or improving productivity, these companies are opting for more “guaranteed” and less risky ways to generate improved short-term earnings via share growth in an uncertain environment. It is therefore unsurprising that US corporate debt is at its highest level yet as a percentage of GDP.

The flight of investors’ cash to these riskier assets has allowed start-up unicorns to create business models that can make seemingly endless losses, provided they grow revenue aggressively

From an investor’s perspective, the effect on unlisted or private asset markets, home to the elusive “unicorns”, has been noteworthy. The term unicorn was coined in 2013 to describe an unlisted company that has a valuation of at least $1bn. Initially they were a rare breed (fewer than 50 in 2013), but thanks to much ultracheap money to finance their growth, there are 404 unicorns globally with a total valuation of $1.3-trillion.

Over the past five years there has been a big increase in investment money (about $4.4-trillion) flowing into unlisted assets, such as venture capital and private equity, where illiquidity and opaque corporate governance risks are multiple times higher than the listed environment.

The flight of investors’ cash to these riskier assets has allowed start-up unicorns to create business models that can make seemingly endless losses, provided they grow revenue aggressively. An example of this is recently listed and previously most highly valued unicorn Uber, a company that created a wonderfully useful technology that attacks the incumbent, somewhat lazy taxi industry.

The question is: when will this endless support for such companies end? It is instructive to look at prior cycles for signs of the bubble bursting.

The first indicator is the percentage of new companies listing in the US with negative earnings. The latest level matches the peak last seen at the height of the dot-com bubble in 2000.

The second indicator is the performance of these new listings. Uber’s share value is down more than 25% since listing in May 2019, with a market capitalisation of about $50bn. Before its initial public offering (IPO), it was touted as a $100bn super unicorn.

While some unicorn listings have succeeded, generally we see a similar pattern over the past two years in which aggregate US IPOs are underperforming the S&P 500 index as well as their private market counterparts, similar to market behaviour ahead of the equity bull market peaks in 2000 and 2007. In China, the second-biggest unicorn market after the US, IPO performance is even worse and venture capital funding has collapsed 77% year on year.

Capital clamouring

Valuation multiples for unlisted companies are potentially a third indicator, reaching levels not seen since the late 1990s dot-com bubble. Certain recent successful unicorn listings trade at price-to-sales multiples of more than 30 times.

There are many warning signs similar to ones seen in prior periods of irrational exuberance. What’s unique about the current cycle is the sheer quantity of capital clamouring for evermore expensive, evermore leveraged private market investments, which by their very nature are illiquid and opaque.

Ironically, when this cycle of seemingly endless ultracheap money inevitably ends, the pain may first be felt within public markets because investors, who need to raise capital quickly to repay debt, will inevitably sell the most liquid assets first regardless of relative valuation levels.

How this will end is difficult to judge given this cycle’s unique features, but investors who have flocked to private markets on the assumption that they have uncorrelated and low volatility exposure relative to public asset markets may be in for a rude awakening when the cycle does end.

• Buhai is portfolio manager at Stanlib Absolute Returns.

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