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The bubble pattern applies to venture capital

Back in 2007, I wrote about “the bubble pattern,” which was a sort of not particularly insightful observation that assets that perform well generate demand that outstrips supply, which in turn leads to a massive reduction in the quality of assets in that class.

Last week, Felix Salmon turned up a report from the Kauffman Foundation that documented the failings of the venture capital industry. Here’s his conclusion:

The big picture, here, is that an enormous number of institutional investors are still chasing VC returns which haven’t really existed in the industry since the mid-90s. So long as all that money is chasing a relatively small number of opportunities, and especially now that valuations for early-stage tech companies are going through the roof, the chances that the average LP will make any money at all in VC are slim indeed.

This is exactly what I was talking about back in 2007. I’ve worked at a number of venture-backed companies over the years, and I’m very glad for the opportunities that venture capital has provided, but that doesn’t mean investing in a venture capital fund is a great investment.

The bubble pattern revisited

A couple of years ago I described the bubble pattern. It’s basically a three four step pattern:

  1. Clever investors find a class of asset that is undervalued.
  2. Dumber investors find out what the clever investors are buying, and pour their money into that class of asset.
  3. Bankers work as hard as they can to increase the supply of assets in that class, despite the fact that these assets are no longer really a good investment.
  4. The bubble bursts.

Chris Dixon explains how this pattern has manifested in venture capital.

The bubble pattern

We’re in the middle of the bursting of the real estate bubble, and one of the most interesting things is how unexceptional it is.

One of the best-documented bubbles in recent times was the junk bond market in the eighties that led to the collapse of the savings and loan industry. Like nearly all bubbles, it started when some smart investors figured out that certain assets were underpriced. In this case, it was junk bonds. All bonds are rated by bond rating agencies, and bonds with a rating below a certain grade are considered “junk bonds.” Someone realized that many companies with low bond ratings were actually quite stable and were almost certain to pay off their debt, and that the bonds were a good investment. (Basically, the bonds were not as risky as their rating portrayed them to be, so they payed more interest than they needed to.) People started making money by buying the bonds, soon the demand for junk bonds exceeded their supply.

As usually happens under capitalism, when demand exceeds supply, new suppliers enter the market. Corporate raiders added to the supply of junk bonds by buying companies via leveraged buyout. The idea was simple and yet crazy, you buy a company with borrowed money, and you use the company you’re purchasing as collateral. You could take a company with high rated debt (or no debt to speak of), buy it out via an LBO by issuing a bunch of junk bonds, and then sell those junk bonds to a ravenous market that would buy anything. The whole thing was facilitated by the investment banking industry, which gets paid for the transaction, not for the results.

As is the case with bubbles, as demand went up, quality went down. So while at the beginning, junk bonds were an undervalued and shrewd investment, by the time the heyday arrived, they were a joke, propped up only by the demand of other people who wanted to buy junk bonds. The people who got into the game late (like the savings and loans) lost their shirts when the bubble popped. In the end, taxpayers ended up picking up the tab.

The dot com bubble with which we’re probably all more familiar took on a similar pattern. Early investment returns on Internet companies led to there being a glut of capital looking for places to land. Suddenly, any idea could get funding and huge numbers of bad ideas did get funding. In the end, investors lost their shirts, employees lost their jobs, and everyone went home bitter.

Now we find the same pattern repeated in the real estate world. In this case, the asset in demand was mortgage-backed securities. Because people selling mortgages were packaging up and selling them off, they no longer had an incentive to make sure that people could actually pay their mortgages when making the loans, and because the companies turning the mortgages into securities had such an easy time selling those securities (due to the growing bubble), they had no incentive to check into the practices of the mortgage brokers. What we’re left with is perhaps trillions of dollars in bad debt that was eagerly lapped up by investors all over the world.

What’s the lesson in here for most of us? It’s that if you’re interested in value, beware scarcity. In markets where assets are scarce, prices go up and quality goes down. It’s one reason why you have to be careful when hiring Ruby on Rails developers. Right now there’s something of a bubble in terms of demand for Ruby on Rails skills. The best developers already have good jobs or are commanding a price premium, and there are a lot of other people out there claiming to be Ruby developers who don’t really have the skills. I think most companies would find more value finding good developers who don’t know Ruby on Rails and letting them get up to speed on the platform, rather than demanding Ruby on Rails right out of the box.

Scarcity is great for collectors of baseball cards or fine art, but for those of us who want to allocate our limited resources wisely, it’s best to be wary.

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