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How the SoftBank Scheme Rips Open the Startup Bubble

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Via Wolf Street

This scheme worked wonders for a while but has now run into trouble, and a lot is at stake.

This is the transcript from my podcast last SundayTHE WOLF STREET REPORT:

The biggest force behind the startup bubble in the United States has been SoftBank Group, the Japanese publicly traded conglomerate. It has been the biggest force in driving up valuations of money-losing cash-burn machines to absurd levels. It has been the biggest force in flooding Silicon Valley, San Francisco, and many other startup hot spots with a tsunami of money from around the world — money that it borrowed, and money that other large investors committed to SoftBank’s investment funds to ride on its coattails. But the scheme has run into trouble, and a lot is at stake.

The thing is, SoftBank Group has nearly $100 billion in debt on a consolidated basis as a result of its aggressive acquisition binge in Japan, the US, and elsewhere. This includes permanently broke Sprint Nextel which is now trying to merge with T Mobile. It includes British chip designer ARM that it acquired in 2016 for over $32 billion, its largest acquisition ever. It includes Fortress Investment Group that it acquired in 2017 for $3.3 billion. In August 2017, it acquired a 21% stake in India’s largest e-commerce company Flipkart for $2.5 billion that it sold to Walmart less than a year later for what was said to be a 60% profit. And on and on.

In May 2017, Softbank partnered with Saudi Arabia’s Public Investment Fund to create the Vision Fund, which has obtained $97 billion in funding – well, not actual funding, some actual funding and a lot of promised funding, which made it the largest private venture capital fund ever.

Saudi Public Investment Fund promised to contribute $45 billion over the next few years. SoftBank promised to contribute $28 billion. Abu Dhabi’s Mubadala Investment promised to contribute $15 billion. Apple, Qualcomm, Foxconn, Sharp, and others also promised to contribute smaller amounts.

Over the past two years, the Vision Fund has invested in over 80 companies, including WeWork, Uber, and Slack.

But the Vision Fund needs cash on a constant basis because some of its investors receive interest payments of 7% annually on their investments in the fund. Yeah, that’s unusual, but hey, there is a lot of unusual stuff going on with SoftBank.

Some of this cash to make the interest payments was obtained from selling the stakes in Flipkart and Nvidia, but SoftBank, according to Reuters, had to borrow the rest of the money to fund these interest payments.

So we’ll call this monster the Vision Fund 1 because there is now the Vision Fund 2.

S&P and Moody’s both rate SoftBank Group one step into junk, and have said they’re more likely to downgrade SoftBank, than to upgrade it, because of its debt.

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This debt and the credit ratings are important factors because they put a limit on how much the company can borrow to meet its cash needs, such as those for funding the interest payments of the Vision Fund 1, and to fund the initial investment into the Vision Fund 2.

SoftBank Group has promised to put $38 billion into the Vision Fund 2, but where is this money supposed to come from?

Other investors have not been gung-ho about the Vision Fund 2, and no big investor has stepped forward with commitments, only some smaller investors have, according to two sources that talked to Reuters.

The Saudi Public Investment Fund doesn’t have that kind of moolah at the moment, sources told Reuters, not until after it sells some big assets or until after Aramco’s long-delayed IPO, which is still not on the horizon.

The Abu Dhabi’s Mubadala Investment still intends to plow money into the Vision Fund 2 but is trying to obtain more say in the investments, a source told Reuters.

So, for now, the fund has just the threadbare pledge from SoftBank to put $38 billion into Vision Fund 2 though SoftBank doesn’t have that money, and may not be able to obtain that money, and everyone knows that.

Softbank is also facing the WeWork fiasco where it has the choice of throwing several more billions at it to keep WeWork alive long enough for an eventual IPO at a much lower valuation, or let it go to heck, and its $10 billion along with it. The money SoftBank plowed into Uber may also not be returning anytime soon.

So SoftBank Group could try to borrow more money. But last quarter, its operating cash flow was negative, and that doesn’t help a company with $100 billion in debt, according to a Reuters analysis of its balance sheet. While SoftBank had $27 billion in cash at the end of June, it would be needed to pay for its even larger liabilities that are due within a year.

Despite the misgivings of S&P and Moody’s, the company doesn’t see its debt as an issue – or as factor that would limit its borrowing ability. It tells investors that its leverage is actually low based on its low “loan-to-value ratio,” which measures the company’s net debt against the “value” of its investments.

The “value” of its investments that are not publicly traded are in the eye of the beholder, and SoftBank is the beholder.

SoftBank uses a leverage ratio that is based on the inflated “valuations” of its many investments that are not publicly traded, such as WeWork, into which SoftBank and the Vision Fund have plowed $10 billion. WeWork’s “valuation” is still $47 billion, though in reality, the company is now fighting for sheer survival, and no one has any idea what the company might be worth. Its entire business model has turned out to be just a magnificent cash-burn machine.

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But SoftBank and the Vision Fund have already booked the gains from WeWork’s ascent to that $47 billion valuation.

How did they get to these gains?

In 2016, investors poured more money into WeWork by buying shares at a price that gave WeWork a valuation of $17 billion. These deals are negotiated behind closed doors and purposefully leaked to the financial press for effect.

In March 2017, SoftBank invested $300 million. In July 2017, WeWork raised another $760 million, now at a valuation of $20 billion. In July 2018, WeWork obtained $3 billion in funding from SoftBank. In January 2019, SoftBank invested another $2 billion in WeWork, now at a valuation that had been pumped up to $47 billion.

With this $2 billion investment at a valuation of $47 billion, SoftBank pushed all its prior investments up to the same share price, and thus booked a huge gain, more than doubling the value of its prior investments.

Now, I wasn’t in the room when this deal was hashed out. But I can imagine what it sounded like, with SoftBank saying:

We want to more than double the value of our prior investments, and we want to pay the maximum possible per share now, in order to book this huge gain on our prior investments, which will make us look like geniuses, and will allow us to start Vision Fund 2, and it will get the Saudis, which also picked up a huge gain, to increase their confidence in us and invest tens of billions of dollars in our Vision Fund 2.

In these investment rounds, the intent is not to buy low in order to sell high. The intent is to buy high and higher at each successive round. This makes everyone look good on paper. And they can all book gains. And these higher valuations beget hype, and hype begets the money via an IPO to bail out those investors.

By this method, SoftBank has driven up the  “value” of its investments, which drives down its loan-to-value ratio. But S&P and Moody’s caught on to it, and now the market too – as demonstrated by the scuttled WeWork IPO – is catching up with SoftBank.

Due to these valuation gains, negotiated behind closed doors, the profits from SoftBank’s Vision Fund and the company’s Delta Fund more than tripled to $1.6 billion in the quarter ended December 31. Those were still the good times, before Uber’s disastrous post-IPO performance, and before WeWork’s downward spiral.

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In July, SoftBank reported a 62% return on its investment, including management and performance fees. This too was before having to grapple with a write-down of its investment in WeWork and Uber.

SoftBank made two phenomenally good investments. Its biggest success was the $20 million it invested in Alibaba in 2000. The stake would be worth over $100 billion these days. SoftBank started selling down its stake in 2016 but still owns a large chunk of Alibaba’s ADRs that are traded in the US. And it owns nearly half of Yahoo Japan which it helped build.

Those two enormously successful investments have created an aura of infallibility and guaranteed success that helped the company gather up large piles of money from other investors, such as Saudi Arabia’s Public Investment Fund.

But the debacle of WeWork, Uber, and Slack will force the Vision Fund to write down that investment value. And SoftBank’s aura of infallibility has been pricked.

In addition, the exit doors for investors in cash-burn machines with gigantic valuations and no hopes for profits are closing as a result of the WeWork fiasco and as a result of the plunge in share prices of the biggest IPOs in recent months.

SoftBank has been a huge factor in Silicon Valley, San Francisco, and other startup hotspots. Startups spent this funding – much of it locally, through office leases, payroll, equipment purchases, and the like. Uber has an outsized footprint in San Francisco’s economy. And there are many other investors that have plowed funds into these startups that are now relatively big companies with huge losses.

So if SoftBank and its Vision Fund halt investments or slow them to a trickle, it will put a further chill on other investors. SoftBank was the force that drove up the valuations. What happens to these boom-and-bust economies such as Silicon Valley and San Francisco that have become uniquely dependent on this startup moolah from around the world? Well, that was a rhetorical question. A good example of what happened before was the dotcom bust. And it wasn’t pretty.

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