We live in a time of free money. Years of quantitative easing and low interest rates have built a wall of capital, a wall that is chasing all assets and pushing up prices across the board. Everyone has to work harder, be smarter or take on more risk if they want to achieve returns that keep investors interested.
The impact of rising prices is yield compression, providing the owner with a proportionally lower income derived from the asset but this is, to some extent, offset by increased capital growth and the lower cost of servicing debt. So, as long as the asset is producing a return (profit in the case of a company, rental returns in the case of property, etc.), then the impact of loose monetary policy can be managed.
What then, of assets that do not produce a return? I refer of course to the ever expanding market of Venture Capital and the many start-up companies which are funded but don’t turn a profit. According to a report by KPMG, a total of £1.55 billion of Venture Capital was invested in UK businesses across 244 deals in Q2 of last year alone, a significant proportion of these deals involved loss-making companies.
Of course, many of the companies that were funded have real prospects of making money in the future but many will undoubtedly fail. Therefore, two questions arise; firstly, why are VC funds so happy to invest in loss making businesses? And secondly, why are new businesses so eager to seek VC funding and the often onerous terms that accompany it, rather than to grow organically on their own terms?
The key to answering both of these questions lies in the goods or services that many of these new companies are creating. The products on offer draw their value from data, from users, from network effects, from lots of things that traditionally cannot be quantified. The analysis of consumer surplus is a useful proxy of value in these cases but notoriously unreliable and difficult to measure.
If a company creates something that cannot be valued and itself does not turn a profit and so cannot be appraised as a whole in a traditional way, then its founders and VC backers can justify almost any valuation. As soon as the company turns a profit, this creative licence is rescinded because any junior accountant can give you a decent idea of what the company is worth.
So as a founder, it pays to take Venture Capital while the company is loss-making, supercharge growth and hope for the best. Similarly, VC funds can rely on the same phenomenon when they exit with an IPO; just look at Uber!
Call us old fashioned but at SHC we prefer to invest in tangible, income-producing assets. Give us property any day.