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Interest Rates, Unicorns And What The Fed Means To Silicon Valley

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Most citizens of Silicon Valley see the drama around the Fed’s activities as only marginally relevant to innovation and entrepreneurship.  

But three big macroeconomic forces have supported, if not driven, the extraordinary growth of Silicon Valley startups over the past several years, and changes in these forces could have a dramatic impact on Silicon Valley and other startup hubs.

Of course, macroeconomic trends have always had an impact on startup fundraising and venture capital investment. Interest rates, commodity prices, currency rates, and regional economic growth rates are all relevant to the investment climate. But lately Silicon Valley has seemed insulated from this reality. If you joined the startup world in the past five years, you might think that the explosion of new companies, new venture funds, and new unicorns is just the natural order of things.

Now, changes in these macroeconomic forces — starting with the interest rate hike — could have a dramatic impact on Silicon Valley and other regions.

First, the extended era of low interest rates has pushed asset managers to seek out new opportunities for return.  Traditionally, economists talk about “easy money” spurring increased business investment, but venture capital is not particularly sensitive to interest rates directly.  The impact of low interest rates has been indirect.

Asset managers seeking higher rates of return saw an opportunity in the venture capital asset class, and so we saw a bunch of new investors jump into the space who were not commonly considered players in venture capital — massive firms like Goldman Sachs and Fidelity Investments.

Great news, right?  Well, the problem is that venture capital is actually a very tiny asset class.  The main asset classes, like public equities, bonds, real estate, commodities, and currencies make venture capital look like a kindergarten sandbox in comparison.  Each year, tens of billions of dollars go to venture capital investments.

By comparison, each year tens oftrillions of dollars go to stock market or bond market investments.  Goldman Sachs alone has over $1 trillion of “other people’s money” under management.  That’s probably ten times more than the entire U.S. venture capital industry.

Changes in these macroeconomic forces — starting with the interest rate hike — could have a dramatic impact on Silicon Valley and other regions.

So if only a tiny bit of money flows out of one of the major asset classes into the venture capital market, it can have a huge distorting effect.  And that’s exactly what we’ve seen over the past five years.  Venture capital investing has expanded dramatically as this “trickle” of money — only tens of billions of dollars — has shifted from low-return assets to venture capital.

The majority of this new money has come in the form of “late stage” investing and corporate investing.  The result?  Unicorns!  When more money chases a limited stock of investment opportunities, prices (in this case, valuations) go up.

Second, compounding this run up in asset prices is the appreciation of the dollar on the global currency markets.  Because the world was anticipating an increase in U.S. interest rates, the value of the dollar has been increasing for the past two years, since the Fed started signaling that it would eventually raise rates.

Historically, an increase in the value of the U.S. dollar tends to correlate with a decrease in commodity prices. So global asset managers tend to shift assets out of commodities, like gold and oil. This accelerates the above problem of money managers chasing returns.

This disparity in global pricing is not lost on startup companies.  Entrepreneurs in Europe and elsewhere see that their counterparts in the U.S. are getting investor valuations that are sometimes 2x to 5x higher than anyone in their local markets can get.  Not to mention the harsh reality that in most parts of the world, the venture capital base is very thin.  So every day, on pretty much every plane landing at San Francisco International, another team of entrepreneurs arrives in Silicon Valley to seek out their fame and fortune.

Third, the slowdown in global industrial growth has, ironically, added to the unicorn phenomenon.

Corporations all over the world have discovered that most of the low-hanging fruit from the last thirty years of global growth have been plucked, and continued growth is going to get harder and harder.

As a result, corporations have embraced the concept of “open innovation,” which means buying growth rather than inventing it yourself.

This has prompted a thundering herd of corporate venture capital groups to set up shop in Silicon Valley and partner with startups who might otherwise disrupt them out of business.

All this has been great for Silicon Valley.  At least, as long as you are participating in the increase in jobs, salaries, and equity.  (If your only exposure to the ebullience is increased traffic and rent, it’s not so much fun.)

Entrepreneurs who are hoping to raise a few hundred million dollars and play with the unicorns will be sadly disappointed.

So now the big question is, when will the music stop?  Will an increase in interest rates reverse the flows?  We have learned that markets are driven by expectations:  Buy on the rumor, sell on the news.  As interest rates go up, and rumor becomes news, will the flow of assets into venture capital reverse?  Will the prices of unicorns come down?

It is very hard to see how the trend of the last few years can be sustained.  Already we can see that the public markets can’t possibly absorb all the unicorns at their current prices.  And very few unicorns can get comparable prices from corporate acquisition.

Meanwhile, the overwhelming bulk of the returns that venture capital firms are reporting to their limited partner investors are “unrealized” returns — increased valuations on paper that have not yet turned into cold, hard cash.

The most likely path forward, or maybe it is just the most hoped-for path, is a series of modest disappointments as valuations deflate.  But even at half their valuations, almost all the unicorns and their lesser brethren (companies worth only a few hundred million dollars) will generate very nice returns for most of their venture capital investors.

Some late stage investors will get burned — those that didn’t negotiate a ratchet in their investment agreements.  The flow of money into venture capital will weaken, and it will get harder for everyone, investors and entrepreneurs alike.  But innovation and disruption will continue, and investors will still chase the next big things.

Where does that leave venture investors? A few will still do well. Those that have focused on companies with real core value, with novel technology and a sustainable competitive advantage, will stand to benefit as these companies mature into a later-stage environment now cleared of overinflated expectations.

Entrepreneurs who are hoping to raise a few hundred million dollars and play with the unicorns will be sadly disappointed.  With luck, the markets will not overreact in the other direction, and solid, disciplined execution will once again be rewarded.