Why Startups Should Be Wary Of "Tourist" Investors
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For the last few years, tourists have descended on Silicon Valley. But these aren't tourists in the traditional sense: They're investors — big mutual funds and hedge funds — that come from out of town looking for a sunny holiday. These tourists have poured buckets of money into companies like Uber, Dropbox, and Zenefits, fueling lofty valuations.
But as any resort owner will tell you, tourists are a fickle bunch. Once the weather turns nasty or the local politics get complicated, they're on the first plane home. And there are signs the financial tourists of Silicon Valley are getting anxious.
The tourist analogy comes from Mohamed El-Erian, chief economic advisor at the German financial company Allianz and former CEO of mutual fund giant Pimco. He fleshes out his theory of "tourist dollars" in his new book, The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse, describing what happens in emerging economies like Brazil and India when investors from the developed world respond to slow economies at home by seeking more profitable climates abroad.
Ranjan Roy, a former emerging-market currencies trader who now runs a tech startup, wrote a Medium post this week connecting El-Erian's "tourist" theory to the mutual fund investors that have flooded Silicon Valley with cash in recent years. The post was pretty convincing, so we decided to see if El-Erian agreed.
He does. And he worries about what those tourist dollars are doing to the locals.
"In phase one, if you are a startup, it's wonderful. You have people knocking on your door with money," he told BuzzFeed News. "Phase two is very different. Phase two, you find that they don't re-up, they become much more difficult about things that are the inevitable bumps of any startup. And the big mistake that developing countries make, emerging economies make — and that startups can make — is to assume that this capital is permanent. It's not."
Jason Reed / Reuters
Just as major American investors recently poured money into Brazil (until economic and other problems led to significant losses), big investors from the East Coast and overseas have been hunting for the next Facebook or Google among the well-caffeinated offices of the Bay Area. The hunt is motivated by an expectation of lackluster returns from the stock and bond markets, places where these investors typically do business.
El-Erian says these "tourists" have been "pushed" by conditions at home, rather than "pulled" by any expertise about opportunities in the new market. In the interview with BuzzFeed News, El-Erian teased out this analogy.
"It's cold, it's rainy, they pick up a brochure, and they look at the pictures of a sunny developing country. And they book the ticket, mainly because they want to escape the dark, cold, rainy environment they're in," he said. "They get to the country, and everything is fine. And then, as typically happens in these countries, something goes on. The most likely reaction of a lot of these tourists is to immediately go back home, to go to the airport. They have a very strong home bias. The reason why is because the push factor is stronger than the pull factor."
Or, stated more literally:
"When expectations of returns become low in public markets — think of the traditional bond market, the traditional equity market, the S&P — there's a push to stretch for return. That means a lot of these crossover investors are pushed into sectors they don't understand well. And then, inevitably, something happens. And then the capital is pulled back. Or the capital is no longer as readily available."
Signs of this shift are appearing right now in tech, El-Erian noted. Starting last fall, big mutual funds marked down the value of their holdings in a number of high-flying startups — including Dropbox, Snapchat, Zenefits, and Blue Bottle Coffee. It's been harder to raise money in recent months, startup founders and venture capitalists say.
The arrival of tourist investors creates the risk that startups will take their capital for granted, El-Erian said. The local investors — venture capitalists and angel investors — tend to stick around, even when things go badly. Being accustomed to startups, they generally are more understanding and helpful when problems arise.
The tourists are more flighty. Also, they're really big. As El-Erian says in his book, an investment that may be small change for a pension fund with many billions in assets can be enormous from the perspective of the emerging market (or the startup world), having an outsize effect.
"The biggest danger is that the start-ups see abundant capital, they massively increase their burn rate, thinking that they can go back to the well over and over again, and then they find out that they can't," he continued. "And then they have to hit the brakes in a massive way, and that becomes very disruptive to their business model."
At a certain point, when the market is overrun by tourists, local investors — or, the smart ones, at least — will pull back, El-Erian said. Is that already happening in Silicon Valley?
"Not as yet," he said. "It will happen, but not as yet."
via BuzzFeed - Tech http://ift.tt/1QIyscj
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