The SoftBank bubble keeps inflating, as does WeWork

SoftBank has announced the launch of a second Vision Fund that will raise $108 bn from investors including Japanese financial groups, Foxconn, Microsoft and Apple to invest in technology start-ups. It would seek to accelerate “the AI revolution through investment in market-leading, tech-enabled growth companies”.

Its first fund of $97bn, 60% backed by governments of Saudi Arabia and Dubai and launched in May 2017, had disrupted the global VC market. SoftBank said it would contribute $38 bn to the new fund, which surprisingly does not yet have any investment commitment from the Middle Eastern governments. 

The first fund was structured for the participants to hold some of their contributions as equity and the majority as preferred debt, with SoftBank being the only pure equity investor. In the second fund, reflecting the risks, the preference appears more skewed towards preferred debt and even less of equity. 

This is very interesting and communicates the essence of the first Vision Fund,

The Vision Fund has made 29 per cent annual returns for investors from May 2017 through March this year, SoftBank said, based on the higher valuations of the portfolio companies. The fund is notable not only because of its massive size but also because of its unusual structure. The Vision Fund is heavily leveraged, relying on an unconventional structure where 40 per cent of its capital is preferred securities that pay an annual coupon of 7 per cent. It remains unclear how the new fund will be structured. SoftBank recently raised cash through at least $4bn in loans against stakes in Slack, Uber and Guardant Health, which could be used to pay dividends to the first Vision Fund.

In simple terms, borrow using rising shares/valuations (itself based on questionable assumptions, as the names in the graphic above would show), use that as equity, and leverage more to construct a Fund. And furthermore, borrow using shares to even pay the dividends for the existing investments. Any different from a Ponzi. The triumvirate of low interest rates, rising equity valuations, and leverage underpin the Vision Fund. Each of the three are intimately dependent on the other. A shock on one, and the whole pack could unravel very quickly. 

And then there is also the issue of investment opportunities to deploy the capital raised,

“They’re starting to run out of runway. The scale they’re trying to invest in, billions of dollars per unicorn (a start-up valued at $1bn) — there’s not many of those deals globally. They’ve already had big exposure to a handful of them, and so a lot of it is just going to have to continue to fund their own deals.”

It is in this context that the case study of WeWork assumes significance. Ananth points to the latest developments at WeWork, an entity whose valuation is effectively backstopped by SoftBank, and which has become poster child for no-tech start-ups (though it is vigorously trying to show that it is as much tech as its tech peers). The company rents in long-term spaces, renovates and divides the offices, and rents them out on a short-term basis, thereby owning few properties. 

Ahead of its impending IPO, contrary to normal practice and raising questions, the company's founder, Adam Neumann, has cashed out more than $700 m for himself through stock sales and by taking on debt against his shares. Apart from this, the company itself is raising upto $4 bn in debt, with the possibility of going upto $10 bn, to finance expansion and thereby keep boosting its valuation. The company plans to use the cash flow from its individual buildings to finance the debt. 

Despite its spectacular growth, the company, with offices at 485 locations, has been losing money continuously, losing $3.5 bn since 2016. Its 2018 revenues of $1.8 bn was outstripped by its losses of $1.9 bn. Reflecting the concerns, a plan by Softbank to invest $16 bn, including $10 bn to buy out early investors, fell apart early this year, after Softbank's investors could not agree on a valuation. Softbank ultimately invested $5 bn at $47 bn valuation in January. To put its losses in perspective,

Since 2016 it has racked up a deficit of more than $3bn; last year it accumulated losses to the tune of $220,000 every hour of every day. Those narrowed slightly in the first quarter of 2019, to just under $219,000 an hour in the 12 months to March.

It is a reflection of what the market thinks of WeWork that its bonds were assigned junk ratings when it raised debt of $702 million last year at a high interest rate of 7.9%. And since then, those bonds have slid significantly, reflecting investor concerns. 

Interestingly, JPMorgan Chase has been helping him borrow personally against his WeWork stake as well as working with the company to structure the debt deal. 

While the exact stake is not known, Neumann's shareholding combined with the dual-class voting shares with owner's share having ten times the votes of the standard common stock means that he has voting control in the company. 

Neumann has been, separate from WeWork, personally accumulating properties. And in a very questionable practice which is pervasive in private equity, some of those properties have been leased to WeWork which is paying him millions a year in rent. After its IPO filing, in order to mitigate this conflict of interest, WeCompany, the parent company of WeWork, has announced that it would buy out from Neumann those properties of his where it is a tenant. Another exit pathway for the promoter?

Update 1 (23.08.2019)

Even as WeWork bleeds, sample the health of a competitor,

IWG, a landlord that has been renting flexible space to less groovy companies for decades, is on course to earn more revenue than WeWork this year and is profitable. Even so, it trades at about a tenth of WeWork’s private valuation.

Update 2 (03.11.2019)

NYT has this summary of the WeWork saga and excesses,

The last 80 days have seen an implosion unlike any other in the history of start-ups. WeWork filed for an initial public offering with a prospectus that was quickly ridiculed for its incoherence; investors learned of several red-flag financial arrangements by Mr. Neumann; the company’s valuation plummeted; Mr. Neumann was forced to resign; and the I.P.O. was withdrawn. Once estimated to be worth $47 billion, WeWork was reduced to $7 billion, after a rescue by the Japanese giant SoftBank. But WeWork’s astonishing downfall came with an even more astonishing exit package for Mr. Neumann: The 40-year-old could receive more than $1 billion after selling his shares to SoftBank and collecting a $185 million consulting fee. As the scope of the disaster comes into focus, the question on everyone’s mind... is how Mr. Neumann managed to fail up so spectacularly.

The answer has a lot to do with... an inexplicably persuasive charisma and a taste for risk... also had an uncanny ability to read people, from potential investors to reporters, gain their loyalty and then sell them on his vision of a “capitalist kibbutz” on a global scale... Crucially, Mr. Neumann was selling to an eager audience at the right time: WeWork’s rebranding of the office as an expansion of one’s personality made sense to a generation of the intermittently employed... It may have never reached the stratosphere, though, if Mr. Neumann had not found the perfect benefactor: SoftBank’s chief executive, Masayoshi Son.

And about the role of SoftBank funding,

Famously, in 2017, Mr. Neumann spent just 12 minutes walking Mr. Son around WeWork’s headquarters, prompting an investment of $4.4 billion...To WeWork insiders who know Mr. Neumann — most of whom spoke on the condition of anonymity because of nondisclosure agreements signed with the company — the SoftBank deal changed things precipitously. They talk about WeWork as existing pre- and post-Masa. The investment transformed the start-up from a mere unicorn into something with nearly unlimited ambition.

And interestingly,

Mr. Son and Mr. Neumann became acquainted in 2016 in India, during a gathering of start-up luminaries with Prime Minister Narendra Modi.

Update 3 (15.12.2019)

The realms of post-mortems about WeWork reveals that Adam Neumann excellent at selling dreams to investors and the company's Board. Now we all know that not only were those dreams were just that, dreams, and that he was also indulging in downright unethical corporate governance. Even ten years back, such a businessman would have been rightly called out as a con-man!

A good WSJ investigation about WeWork, and especially how its distinguished Board presided over one of the most spectacular corporate implosions.

This graphic of WeWork's heady valuation climb followed by even steeper downfall is instructive.

This graphic highlighting the divergence between WeWork's net income projects versus actuals is truly spectacular.

Update 4 (05.01.2020)

Matt Stoller describes WeWork as an example of counterfeit capitalism,

What predatory pricing does is to enable competition purely based on access to capital. Someone like Neumann, and Son’s entire model with his Vision Fund, is to take inputs, combine them into products worth less than their cost, and plug up the deficit through the capital markets in hopes of acquiring market power later or of just self-dealing so the losses are placed onto someone else. This model has spread. Bird, the scooter company, is not making money. Uber and Lyft are similarly and systemically unprofitable. This model is catastrophic not just for individual companies, but for their competitors who have to *make* money. I’ve written about this problem before. Amazon has created a much less competitive and brittle retail sector. Netflix’s money-losing business is ruining Hollywood.

Endless money-losing is a variant of counterfeiting, and counterfeiting has dangerous economic consequences. The subprime fiasco was one example. Another example was the Worldcom fraud in the late 1990s, which forced the rest of the U.S. telecom sector to over-invest into broadband. Competitors have to copy their fraudulent competitors. It’s a variant of Gresham’s Law, which says that "bad money drives out good.” If you can counterfeit something for cheap, the counterfeit will eventually take over the entire market and drive out the real commodity. That is what is happening in our economy writ large, a kind of counterfeit capitalism as ‘leaders’ like Neumann are celebrated and actual leaders who can make things and manage are treated like dogshit.

This kind of counterfeit capitalism is terrible for society as a whole. At first, with companies like Walmart and Amazon, predatory pricing can seem smart. The entire retail sector might be decimated and communities across America might be harmed, but two day shipping is convenient and Walmart and Amazon do have positive cash flow. But increasingly with cheap capital and a narrow slice of financiers who want to copy the winners, there is a second or third generation of companies asking Wall Street to just ‘trust me.’ As euphoria in capital markets takes hold, predatory pricing scheme come to entirely wastes capital on money losing enterprises, and eventually these companies become Soviet-style generators of white elephants and self-dealing. The men and women who run them have to be charlatans, because they are storytellers justifying losses. Powerful men like Dimon are sucked in, consultants start explaining to old-line economy companies how they too can become like WeWork, and eventually more and more of the economy just adopts counterfeit capitalism.