Technology Sector Private Equity and the Emergence of a New Speculative Bubble - Term Paper Example

Technology Sector Private Equity and a New Speculative Bubble C.J. Bordeleau Economics September Technology Sector Private Equity and the Emergence of a New Speculative Bubble The rapid valuation growth of young private technology companies such as Facebook and Twitter is something that is often been highlighted in the media in recent months. With estimated valuations (from secondary markets) at $76 billion and and $7.7 billion respectively, it is hard to ignore that these private companies have certainly gained investor interest. Most recently Facebook has completed a funding round of $500 million with Goldman Sachs and Digital Sky Technologies. Goldman intends to resell many of the shares to high net-worth individuals through its wealth management division. This “special investment vehicle” will exploit a loophole in securities law regarding private company ownership. According to US securities law, a private company is not permitted to have more than 500 individual investors without making its financial information public. Being a private company, Facebook is not required by the SEC to share financial information with investors at this time. Due to these above mentioned conditions surrounding these companies, speculation continues to be a driving force surrounding these investments. In this paper, we will take a look at the history and features of speculative bubbles including the technology bubble of the late nineties (dot com bust) in an attempt to use economic data to analyze today’s environment to detect the presence of a bubble and its potential impacts. The Origins of Speculative Bubbles Speculative bubbles have long fascinated and puzzled economists across many time periods. From the original Tulip Mania of the 1630’s to the Dot- Com bubble of the late nineties, these phenomena have kept economists on their toes for centuries, in trying to pin down substantive causative agents that are responsible for the swift increase in the market values of particular assets. Till today, experts have been unable to chalk down exact reasons for the emergence of such bubbles as they can rise up even in the most predictable markets; where the market participants can very accurately calculate the intrinsic value of the assets and where speculation plays no part in the actual valuation process. What is the origin of bubbles? Simply put, speculative bubbles are caused by “precipitating factors” that have the ability to bring about a change in the public’s perception about the value of an asset and about the future prospects of that asset, which can have an immediate impact on demand (Shiller , 2000) One of the most famous economists of all time, John Maynard Keynes pointed out in his book “The General Theory of Employment, Interest and Money”, that abrupt and immediate stock price changes have their roots in the “collective crowd behavior” of the various market agents more than anything else and that in almost all such scenarios, these rises in prices have little to do with the values that can be derived from “careful analysis of present conditions and future prospects of firms”. This seems to be a certainly accurate description of the conditions which surround the emergence and bursting of the speculative bubbles as seen in the past. Kindleberger in his book “Manias, Panics and Crashes: A History of Financial Crises” (1978), presents a summary of his observations regarding the historical pattern that these bubbles usually follow. He states that the increase in prices typically starts with the emergence or birth of opportunity, usually in the shape of new markets or cutting edge technology or some major change in the political landscape of a particular region which can pull in investors looking for excellent returns on their investments. This is followed by rising prices of the particular asset. In this phase, more and more people rush after the overpriced commodity, feeding fuel to the bubble, increasing prices further and feeding the mania, and at the same time causing credit expansion. The author points out that after this stage, people invest for the sake of getting rich quick, “without a real understanding of the process involved”. Eventually, after a point, the market stops rising any further and the people who have invested heavily by borrowing from different sources find themselves in a state of ‘distress’ which furthers into unpredicted failures, followed by ‘revulsion’ or ‘discredit’. According to the author, the final stage in the collapse of these bubbles is initiated by a ‘self-feeding panic” where people who have over-invested seek to unload their bought assets at greater losses, causing crisis and upheavals in the financial and economic markets. Detection and Prevention of Speculative bubbles: A possibility? In the recent past, the U.S housing bubble has garnered worldwide attention due to the economic crunch that was suffered by financial institutions across the globe as a result of its bursting. This collapse of the U.S housing Bubble was not only detrimental to the property values in the United states, it had direct effects on the American real estate market, mortgage market, Wall Street Hedge funds which were held by major institutional investors and ultimately foreign banks; a long chain of events that threatened to de-rail the American economy. According to Scheinkman, a theorist working in the group of “bubble-watchers” working under Ben Bernanke, the U.S Federal Reserve Chairman, “ Advanced economies are extremely dependent on the health of the financial systems. What this bubble did was destroy the capacity of the financial system to finance the U.S economy” (Lahart, 2008). Simply put, these bubbles have widespread reach that is effectively quite capable of annihilating entire economies. A predominant feature of all such bubbles therefore is the fact that although it starts small, the feedback from initial price increases fuel speculation and lead to further price increase; a self-sustaining mechanism that “amplifies the effects of the precipitating factors” (Shiller, 2000; Sornette, 2003). According to the authors, if the prices of an asset or stock are rising rapidly, there is much added word of mouth communications which spread optimistic stories, causing an ‘over-reaction’ effect and is the hall-mark of a classic speculative bubble. The abnormal highs and lows in financial markets caused as a result of the emergence and subsequent deflation of these speculative bubbles has lead stakeholders the world over to raise questions about why people are unable to identify the existence of such bubbles in time and why necessary steps are not taken to ensure that the upsurge and downfalls in prices do not cause lasting damage to the economic markets. In this regard, one of the world’s leading economist, Alan Greenspan is of the opinion that the nature and dynamics of the process itself are such that it makes these bubbles and their detrimental effect on financial markets “virtually impossible to anticipate”. However, Fisher and Statman (2002) have laid claim in their paper “Blowing Bubbles”, that surveys carried out by Gallup have indicated that a large number of individual investors believed that the market was in a bubble in the late 1990’s and they expected the bubble to inflate further. They further point out that the forecasts of institutional investors, as surveyed by Business week, imply that they were also of the opinion that the market was in a bubble in the late 90’s and were expecting the bubble to burst soon. This disagreement between the market agents’ ability to detect the emergence of a new bubble puts the subject in a murky light, causing further concerns about whether it is possible to design any strategic frameworks which can help predict and determine the course that a pricing high on an asset or financial commodity may take. Re-visiting the Tech-bubble of the 1990’s In 1998, the private equity branch of the Goldman Sachs Capital Partners initiated a new $2.8 billion fund mainly directed towards investments in internet stocks. Although previously, the firm had made very few technology related investments, within one year, this new fund made 56 technology related investments, of roughly $1.7 billion, averaging about $27 million per investment. This was the era of the dot-com frenzy, when everyone wanted a slice of the internet market and at the height of which, internet stocks changed hands three times as frequently as other shares (Lahart, 2008). These same firms went from handing out Initial Public offerings to filing for bankruptcy within months as the bubble bust and among those who lost money was Goldman Sachs which lost nearly 40 percent of the $1.7 billion that it invested. In that same era, many other Wall Street firms such as JPMorgan Chase and Stanley Morgan made investments in ventures such as Kozmo.com and Carsdirect.com, ventures that went bankrupt when the market deteriorated. Webvan, one of the most sought after stock on the internet in the era, an online grocer, had raised nearly $1 billion in start-up capital from institutions such as Softbank of Japan and Goldman Sachs, which eventually lost $100 million as the lead underwriters of the business. (Rusli and Kopytoff, 2011). Looking back, there is a systematic pattern that can be observed with the venture capital failures of the past tech-bubble, with too many people buying too rapidly and without taking into account the realistic risks associated with the ventures. Today, with Goldman Sachs investment of $450 million for private equity in facebook, it is prudent to take a look back and revisit the era of the Dot com bust and compare the current situation with the tech-frenzy that ensued then. While most experts believe that over valuation of the social media giant’s stock may happen, some are of the opinion that facebook is now too big to fail (The Post, 2011). That being said, analysts the world over are speculating about the chances that we are indeed in the process of seeing a new tech bubble rise up and that the sales and IPO’s of tech firm that have been planned for this year seem to be clearly highlighting that fact. . Are we heading towards a new social media bubble: Implications According to Ronan Lyons, an economist with Daft Media, there are four main ingredients of a speculative bubble; namely “an innovation, ready credit, big price increases and a frenzy in transaction”, and according to the author, in the current scenario we can see all four at play in the market.(The Post, 2011). With Microsoft buying Skype for $8.5 billion, a valuation that certainly seems to surprise a number of analysts, and Linkedin, the social networking site aimed at the professional, becoming a publically traded firm, there is a rising chance that there might indeed be a new economic bubble on the horizon. Arun George, a technology analyst quoted by cnbc.com in an interview is of the opinion that at this stage, there is a great demand for shares of such social media websites and although, this appetite will remain for a while, this stock will be “massively over-valued” (cnbc.com, 2011). If there is indeed a bubble on the horizons, now is the time that the private equity investors will make rapid returns, thereby fuelling even more price increases, repeating the historic pattern. Currently, this great risk of the over-valuation of social media stock can cause sudden and swift increase in the prices of such stock. The implications for this are as serious for the financing institutions as well as the individual investors. Examples as recent as the News Corporation’s acquisition of Myspace at $580 million are clearly indicative of the fact that there is a misleading case of over valuation of such firms in the market. MySpace’s decline is a clear example of how organizations can make misjudged investments as only recently News Corp has announced that the profits for the firms first quarter returns have gone down a whopping 24% and these losses are continuing to grow in the current quarter (cnbc.com, 2011). In this scenario, it is also prudent to point towards the role that independent financial institutions play in the creation and development of such speculative bubbles. Institutions such as Goldman Sachs which is a bank holding company, thereby ensuring its investors security by being able to borrow from the Federal Reserve against any kind of asset in the time of need, are ultimately at the safer end of the bargain. This brings to light the question of “Moral Hazard’ i-e, are such institutions which are fully secured against all and any form of major collapse really able to make careful and prudent choices at all times?. An analysis of the history provides ‘NO’ as a clear answer and it is further unclear whether it is really safe to allow a highly leveraged bank such as Goldman Sachs to have such “non-transparent” and “unfair” control of the financial market and the economic system (Johnson, 2011). Conclusion Although it cannot be said as a matter of fact that we are indeed witnessing the rise of another speculative bubble, it is far better to be prepared and to monitor the market keeping in mind that although these bubbles and the pattern in which the rise and fall are case-specific, there are certain signals which can be seen from afar. According to most leading experts on the subject, there is indeed a rising social media bubble but as of now, its course is difficult to predict. These experts agree that the rising boom in “cloud media” and mobile connectivity” was an interest that was not going to wane anytime soon, making this tech bubble quite an non generic one, therefore making it doubly hard to truly say whether it would ever burst or have major or widespread economic repercussions. By making an in-depth comparison of the current situation and the of the market situation in the late 90’s, proves that while the prices of the tech-stock at this stage is on the rise, there is a chance that after an IPO, these companies will have trouble meeting their over-valued estimations and this is the stage at which the “famed” bubble- if it exists- will burst. However, it is also important to note that although all the tech firms with high priced stock to sell are trying their level best to keep themselves fresh and relevant, it is only too long before even the social media market experiences fatigue. Although at this stage, social media websites such as facebook are considered foolproof and too big to fail, it is only wise to remember similar websites such as Orkut which became a hype and then was over taken by other websites such as MySpace and ultimately Facebook. It is therefore, safe to assume that eventually, there is a high probability that someone, somewhere will come up with a better idea than some of these current social media sites creating a hype and will replace them. References Fisher, K .L., and Statman, M. (2002).Blowing Bubbles. The Journal of Psychology and Financial Market, Vol. 3, No. 1, pp- 5.3-65. Greenspan, A.(2002). Economic volatility, At a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming August 30, 2002. Johnson, S . (2011) .Why Is The US Taxpayer Subsidizing Facebook – And The Next Bubble?. www.baselinescenario.com. Keynes , J. M. (1934).The general theory of Employment, Interest and Money . Harcourt, 1934. Kindlberger, C. P. (1989). Manias, Panics, and Crashes: A History of FinanciaL Crises , MacMillan, London. Lahart, J. (2008). Bernanke’s Bubble Laboratory. The Wallstreet Journal. Rusli, E. M., and Kopytoff, V. G. (2011).Investing like its 1999. Published March 27, 2011. www.nytimes.com. Schiller, R. J. (2000). Irrational Exuberance. Princeton, New Jersey: Princeton University Pres.. Social Media may be the next Tech Bubble. The Sunday Business Post Online. Published 9 Jan, 2011. www.thepost.ie. Sornette, D. (2003) Why Stock Markets Crash .Princeton University Press West, M. (2011).Watch LinkedIn for Signs of Social Media Bubble. Published May 17th,2011. www.cnbc.com Read More