When federal regulators seized control of Silicon Valley Bank (SVB), Twitter predictably erupted into its usual stew of derision and snark. The sight of elitist techies desperately trying — and failing — to withdraw hoards of cash they had perhaps unwisely parked in one bank was a perfect opportunity for some schadenfreude.
But no one was laughing when the seemingly isolated problems at SVB soon spread to other banks across the country and in Europe, prompting panic, government rescues, and political finger pointing.
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The big lesson is that, if there’s enough money involved, nothing stays confined to just one part of our interconnected global economy.
More importantly, our exposure to Silicon Valley is not limited to the psychological repercussions from just one shaky bank: you just might own a piece of an overvalued, lightly regulated asset poised to crack now that the era of easy money is over.
Chasing Higher Returns Through Unicorns
Over the past decade, investors have poured billions of dollars into high risk startups, hoping that these bets will result in monster IPOs like Google and Facebook, now Alphabet Inc. (GOOGL) and Meta Platforms Inc. (META). This influx of money has created a new class of startups called “unicorns” that sport valuations northward of $1 billion — all before going public and having generated zero profits.
What is the source of this money? Indirectly, you and me. Venture capitalists tend to write the checks but they increasingly get their cash from long term institutional investors like pension funds, family offices, and mutual funds.
Even more striking, some mutual fund firms have or currently directly invest into these late stage startups, including big names like Fidelity Investments, T. Rowe Price, John Hancock, Vanguard Group, and Putnam Investments.
As of the second quarter in 2021, CB Insights lists Fidelity as the 10th largest investor in unicorns with 45, including Stripe, SpaceX, and Instacart. Over 350 institutional investors had at least 5 unicorns in their portfolios, the research firm says.
This is quite the departure from how long term mutual funds and other institutional investors normally operate. Traditionally, these investors have adopted a more conservative approach to their portfolios, investing in comparatively staid but surer things like stocks, bonds, and real estate. Tech startups, even more developed ones, are high risk investments: much more fail than succeed.
So what prompted the shift? Two words: interest rates. Since the Great Recession of 2007-2009, the Federal Reserve has kept rates at or near zero. To boost stagnant returns, institutional investors started to chase higher risk assets like unicorns even though Silicon Valley operates by completely separate rules than Wall Street.
In 2014, Jagdeep Bachher, who had just assumed his role as the chief investment officer for the University of California, co-authored a paper that urged institutional investors to look at venture-backed startups. Bachher is currently responsible for overseeing the university’s $155 billion endowment.
“Making direct venture investments means asking (these investors) to step outside of their comfort zones,” according to the paper, titled “The Valley of Opportunity: Rethinking Venture Capital for Long-Term Institutional Investors.”
“The nature of the risks embedded in small capital-intensive companies places them beyond the reach of traditional investors. As such, various cultural and organizational adjustments may be required for institutional investors to be successful in financing … (such) innovations.”
But Bachher believed the risk was ultimately worth it.
“There is a unique opportunity for LTIs to carry venture-backed, capital-intensive companies to commercial scale and, in turn, participate in their success over the long term,” the paper concluded.
The industry apparently followed the paper’s advice. Thanks to massive amounts of funding, including from institutional investors, there are currently 1,208 unicorns in the world, compared to just 100 just 5 years ago. CB Insights estimates the total valuation of all unicorns at nearly $4 trillion dollars. That's a trillion with a T.
At the top of the list is ByteDance, a Chinese artificial intelligence startup valued at $225 billion. That’s more than the market cap of General Electric Company (GE) and Sony Group Corporation (SNEJF) combined.
Unicorn Valuations: Real or Illusion?
But valuations exist only on paper. And no one really knows how venture capitalists come up with such figures. We just take their word for it.
Ironically, startups tagged with a $1 billion valuation were called unicorns because they were rare or just didn’t exist. And there are plenty of experts who think they don’t exist.
"The concern is whether the prestige associated with reaching a sky-high valuation fast drives companies to try to appear more valuable than they actually are," said then-Securities and Exchange Commission chairwoman Mary Jo White in 2016. "There is a worry that the tail might wag the horn."
A year later, researchers form Stanford University and the University of British Columbia published a study in which they developed their own valuation model for 135 unicorns and compared their figures with the companies’ reported valuations.
The paper, published in the Journal of Financial Economics, concluded that investors inflated unicorn valuations by an average of 48% over fair value. The paper also found 14 unicorns that overvalued themselves by 100% or more.
Cracks in the Bubble
The era of easy money has ended now that the Federal Reserve has aggressively raised rates to fight inflation. How this will impact unicorns is unclear since they only ever existed in a world of low rates.
We are already starting to see some stress. Tiger Global Management, the country’s largest investor in unicorns, reportedly wrote down its portfolio of venture-backed startups by 33% in 2022, erasing about $23 billion in value.
The broader tech sector, which has driven the nation’s economy for years, has been retreating. Unicorns and publicly traded companies alike, including Microsoft, Amazon, Facebook, and Google, have been shedding thousands of workers with probably more to come.
On the venture side, CB Insights reports that total venture funding in 2022 dropped 35% to $415 billion. So-called “mega round” fundings of $100 million or more, which tends to create unicorns, fell 49% year over year. The number of new unicorns last year declined 52% to 258 from 538 in 2021.
Should the unicorn bubble pop, the impact on the broader public is unclear. There’s no data that tracks the overall risk of people’s 401(k)s and pension funds to Silicon Valley’s excesses. In fact, you might even say the exposure is minimal since institutional investors likely devoted only a small portion of their giant portfolios to unicorns.
But then again, people said the same thing about subprime mortgages before the Great Recession. Since subprime mortgages accounted for a relatively small portion of the overall U.S. housing market, the consensus was that it would impact only a sliver of the U.S. economy.
We know how that story ended.
