This fourth piece to our five-part series draws valuable lessons learned from the 2000-04 dotcom bust and its aftermath. There is a blatant contrast between what the pioneers of the digital revolution aimed to achieve and what we actually yielded from the two tech investment cycles.
Q4 2019 hedge fund letters, conferences and more
From New Paradigm To Dystopia
Amazon’s Jeff Bezos was 1999’s Time Person of the Year, representing the expectations that people placed on how the Internet would help deliver books to the masses at an affordable price. One of Google’s stated aim upon its launch in 1998 was to fulfil a similar universal role, disseminating knowledge for free.
Twenty years later, Facebook’s Mark Zuckerberg is arguably the most influential person of the 2010s, demonstrating how the Internet has morphed into an egotistical platform infringing our right to privacy and propagating fake news. The Web went from being a liberating platform for user-generated content to one where self-promotion and misinformation take centre stage.
Everyone Needs To Make A Profit, Eventually
Amazon’s stock lost 94% of its value between December 1999 - when the fledgling firm was worth about $40 billion - and September 2001. Virtually all its e-commerce competitors of that era, from CDNow to Pets.com, have disappeared.
The reason why Amazon saw its stock rise in 2002 is pretty simple: in January of that year, it announced its maiden quarterly profit, seven years after launching. Public investors had reverted to their ancestral valuation method - the good old price-earnings ratio! Since inception, Amazon had accumulated $3 billion in losses. It went on to report its first full-year profit in 2003.
Unicorns will need to establish a path to profitability now that the appetite for fast-growth, money-losing businesses is on the wane. Because valuations appear stretched again does not suggest that all of today’s start-ups will perish in the next downturn. Some will successfully grow market share and demonstrate the sustainability of their business model. Others will exit at the top (like Netscape selling itself for $10 billion in AOL stock before dying in the face of Microsoft’s Explorer onslaught). Many more will fail. Over 50% of the class of 1998-00 reportedly disappeared by the time people took stock in 2004, when the market correction ended.
Building Monopolies In Fragmented Industries
Twenty years after receiving Time magazine’s accolade, Bezos is the world’s richest person. The source of his accumulated wealth is his company’s dominant competitive positioning in several of its key markets.
Amazon’s success provides the rationale behind the breeding of unicorns. They plan to establish leadership status in industries with low barriers to entry - think of Uber in the taxi segment or Airbnb in leisure accommodation. Such sectors have weak participants, often unable to launch price (or lobbying) wars to defend their turf.
Building a commanding market position is a capital-hungry activity. Which explains why many unicorns have unusually high cash-burn rates. Should they fail to secure leadership, their only hope for survival is to get acquired by one of the Big Tech groups willing to finance a buy-and-build strategy.
Yet, this is a perilous expectation. What many dotcoms discovered during the 2000-04 contraction is that, rather than acquiring a limping start-up with a broken or questionable business model, incumbents with a robust market presence often find it cheaper to grow organically or to purchase the assets of a bankrupt company out of administration.
The Internet offshoots of large corporations (briefly known as ‘dot-corps’ in those days of buzzword addiction) did hold their own in many sectors. Today, Walmart.com and the websites of most financial groups, from brokers to main street banks, show that dotcom start-ups did not uproot the bricks-and-mortar incumbents. Only fragmented industries, from fashion retail to book sellers and taxi services, have seen digital players flourish.
Although the Internet is now mainstream and mobile, fintech firms are unlikely to steal a meaningful share of the customer base of oligopolistic, centuries-old commercial banks. Their predatory pricing could hurt the margins of established players, forcing the latter to ‘buy and kill’. Size is of the essence to make unicorns desirable targets. But those that want to remain independent need to ‘go big’ in fragmented markets rather than compete in industries already consolidated.
Risk Of Contagion
It would not be surprising if some foreign unicorns are the ones running out of money before their larger, better-capitalized American rivals do. In 2000, the first dotcom to go bust was not US-based but London-headquartered clothing retailer boo.com - a firm that managed to burn $135 million from investors LVMH’s Bernard Arnault, the Italian Benetton family, Goldman Sachs and JP Morgan, in only 18 months of existence.
A unicorn crash would have a worldwide impact, but because it hosts approximately half of all unicorns, the American market would witness its own horror stories. One of the most overrated dotcoms was Californian grocery delivery firm Webvan. By the time it was liquidated in June 2001, it had blown $800 million of VC money, including a reported $160 million from SoftBank and $100 million from Goldman Sachs. Twenty years on, even Amazon is still trying to figure out a way to make money from online grocery delivery services.
As discussed, during the dotcom era the hysteria had spread to stock markets. This time around, the pricing contraction is more likely to contaminate other private capital segments. A PitchBook report reveals that, in 2019, almost 20% of VC portfolio exits happened through a sale to a private equity firm. In the early 2000s, that proportion was below 5%. Equally, many late-stage start-up rounds are being financed by traditional asset managers, including BlackRock and Fidelity, more traditionally focused on public equities.
Private markets’ lower liquidity can either be seen as a positive - it will soften the blow of a recession by avoiding sudden and extreme price volatility, or as a concern - it will take years for accurate asset values to be known.
Hard Landing Of The Tech Investment Cycle
What is certain is that, once this tech investment cycle has run its course and valuations have tumbled back down to their natural level, the majority of entrepreneurs and investors will realize that, instead of riding a unicorn at full pelt, they end up walking alongside a limping donkey or flogging a dead horse.
Based on performance data released by the University of California, the average 1999 venture fund generated an internal rate of return of minus 4.29%, and the average 2000 vintage had a negative return of 2.51%. Many VCs currently hold their portfolio assets at valuations that do not properly reflect the fact that a severe correction is bound to follow today’s euphoria.
The final part of the series will point out that careful consideration must be given to the valuation methodologies adopted by current venture capitalists and entrepreneurs
