Dry Powder

Richard Kramer: Welcome to Bubble Trouble, conversations between the independent analyst, Richard Kramer, that's me, and the economist and author, Will Page, where we lay out some inconvenient truths about how financial markets really work.

Today, we will not be powdering your nose, but be sprinkling our conversation with a little dry powder. That's cash or marketable securities that look like it's low-risk and highly liquid and convertible to cash, but needs to be put to work.

Will Page: Well, I've been told by many of our listeners that the best podcast is when I act like the dumb kid in the classroom, and you act like the expert professor, which I call method acting. And this week I wanna get our head around dry powder, a term that's been touted in the press. And my basic understanding here is that dry powder is just, you have venture capitalists whose job it is to invest and hold the principal and is an asset in a startup. And they are stoking up all of this cash from the tech rally that we've been and gone, and they're ready to plow it back in. It's like an, a, a war chest, effectively. A war chest of cash ready to go to war with. Can you just detoxify this jargon that we get hit with in financial markets and walk me through, when people say there's a lotta dry powder out there, what are we actually talking about?

Richard Kramer: It's pretty simple, Will. Dry powder is the cash people have in the bank that is earmarked to invest. So, it's not the savings you might have for a rainy day, it's what you have accumulated in terms of capital, under management, with the goal of investing it, of putting it to work.

Will Page: So it's not, for example, set for dividends.

Richard Kramer: No. It's money that you have brought in with the simple idea that you're going to invest it to generate returns.

Will Page: And, if I use a term ring-fence, this means it can't do anything else but go to invest.

Richard Kramer: Well, for a lot of the folks that would say they're sitting on dry powder, their job is to invest that money.

Will Page: So, they've made their profit, they've paid their stuff, and this is the war chest which is directly to go to invest. That helps me, that makes sense in terms of money has a purpose, and this purpose has been designated to go back into the pot of investment, and find some more startups, and back some more horsies.

So, I want to get into a cyclical question for a second here, which is, a very well-seasoned venture capitalist once told [inaudible 00:02:23] that there it was easier to make money when bubbles were bursting than when they were actually bubbling. So, had we been doing this podcast three months ago, that bubble was bubbling nicely. Now, it seems to be bursting. And I love that contrarian thinking, it's when the bubble bursts that you make your money, not when it bubbles.

So, the market stays being upended, you know, I'd love to hear your high-level thoughts on that towards the kick-off. But, there's still so much tech entrepreneurial activity going on, and given it's [inaudible 00:02:51] 10-year horizon to back a startup and see it crystallize with a successful IPO, is now time to go back in? Or, is now the time to wait this out?

Richard Kramer: The first point I'd make about your seasoned venture capitalist is that I'm confined, as many VCs on the other side of that trade who would say, it's much easier to make money when markets are bubbling up, as long as you time your sales correctly. But, for the moment, there are a lot of reasons to be cautious.

The first is that we've had an environment of zero-interest rate policies for the last decade, and that's changing. There's gonna be no more free money. You can think back to the episode we had with Chris Leonard talking about the lords of easy money, and all the downstream issues that, that the Fed has caused by making interest rates close to zero for more than 10 years.

Second, we might be heading into a massive recession. You've had war, famine, pestilence, you know, you're getting the four horsemen of the apocalypse in the market right now. And, the market's pricing in what was probably a long delayed downturn that, kind of which we might have had if Covid hadn't completely changed the calculus for central banks.

And third, when people are in the midst of turmoil, they just aren't inclined to lean into the next big thing. And, you think of, of, of how we were all behaving in the first phase of Covid when we were hunkering down in our caves, and this is now an environment of risk-off, uh, reducing your risk, not seeking to back these risky or speculative ventures.

Will Page: Three relevant and well-presented points. I wanna just push back on each of them, just very briefly. When you talk about the zero-interest rate environment coming to an end, I think you're right. You know, we're looking at 2% rates pretty soon, and hiking potentially up to 3%, which the housing markets are really gonna struggle. But, the spread between the cost of financing debt and the rate of inflation has never been wider. So, if the base rate is 2% for learning purposes, and the inflation rate is 8%, well that spread is a lot wider than, let's say, this time last year where they were much more narrowly confined. Does that not make, you know, the end of free money is over, but [laughs], the, the day of, you know, free financing debt is just begun.

Richard Kramer: What I would say to that is that you have to bear in mind that inflation hits only certain segments of the economy. And, inflation is measured in a way that doesn't necessarily take in the totality of what could happen in all investments.

Will Page: Mm-hmm.

Richard Kramer: Inflation is mostly a measure of what we're paying to live our daily lives. Whether it's energy costs, or food costs, or, or wage inflation, or so forth, it, it, it trickles through. And, the cost of borrowing has, in some cases, many wider implications because that is the benchmark cost of capital for everyone trying to run a business. It raises the hurdle rate of what they need to earn to stay in business.

Will Page: On your point about recession, I mean, I get it. It's not a risk of recession, it's a risk of something economists call stagflation which is increasing prices and reducing economic output, two bad pieces of news for the price of one, effectively. But, do you think there's a argument that the central banks are talking us into recession with their doomy forecasts, and the way that they calculate these forecasts?

Richard Kramer: Uh, no. I don't think the central banks are talking us into recession. I think they are simply reflecting a very limited toolset of what they can do about the natural slowing down of economic activity after economies overheat. When you look back and think about the behavior, 6 or 12 months ago, we all kind of knew it was lunacy to have eight separate quick commerce startups in London willing to bring you a Snickers bar at the drop of a hat in 10 minutes. And, that funding all of these companies to compete for the last spot was gonna leave maybe one or two in the last spot, but six losers. You know that was a hiding to nothing.

As Chuck Prince said, uh, as CEO of Citibank, when we were heading into the last global financial crisis, "Hey, when, when the music's playing, you gotta get up and dance." So, no one could dare to stand aside from that hot market. And, now it's just the opposite. Everybody is hunkering down, and realizing that it's going to be a difficult time, there's gonna be less discretionary spending for consumers to fight for, and there's nothing you, uh, central banks can do, uh, in terms of stimulus that they haven't tried in the past 12 years.

Will Page: Again, helpful. So, we've had the theory and the reality of when inflation exceeds the cost of financing debt, the bitter truth that central banks are just reflecting what they're seeing going on in the market, and it doesn't look pretty. But then you said, your third and final point was that a lot of people are just not ready for the next big thing. I just wanna push back on that one finally here, which is, is that really fair? 'Cause that's not how startups work, if you think about the startups who were having ideas three or four years ago, those ideas are bigger now. If you look at fintech here in London, you know, the sort of, uh, press releases they were putting out three or four years ago have got bigger now, and they're gonna get bigger tomorrow as well.

So, the ambitions of technology to disrupt the status quo, to swing us from the old vine to the new vine, to quote my book, that doesn't stop just 'cause it's rough times. Those engineers keep coding, those developers keep developing, those investment relations teams keep on raising. Is it fair to say that we're just not ready for the next big thing 'cause of the uncertainty?

Richard Kramer: So, I think you've confused two really simple things, Will-

Will Page: Hmm?

Richard Kramer: ... and I'd like to set you straight. So, every single one of those hypey press releases that you've heard, making wild and outrageous claims about reinventing the future, we had those all three, five, ten, fifteen, twenty years ago.

Will Page: Mm-hmm.

Richard Kramer: The point about inflation is that the cost of realizing those ambitions, whether it's wage inflation or the input cost for all those startups, are going up. So, the hurdle rate for those companies to reach the magical point where they're actually generating instead of burning cash gets higher and tougher. And, alongside that, again, back to my point, in a recession, there's just less of that discretionary spend to go after. So, if you think of all those fintech startups trying to take a little sip out of that giant river of financial transactions, well, when they river starts to dry up, when there's less economic activity, it's harder for each of them to kneel down by the riverside and get a refreshing drink.

Will Page: And then, presumably, this brings us back to those two words which you've hammered into my head, and the head of all of our listeners over the past 45 episodes of Bubble Trouble, which is when you get the squeeze, inflation, interest rates, cost of goods, cost of labor, those two words which you just keep on repeating to me when we're, when I'm running, even if I'm 10 meters ahead of you on the track, cash flow. And this is where it's gonna come... I remember somebody saying to me, "Companies don't go bankrupt because of lack of demand, they go bankrupt through a lack of cash." And, the cash flow management now, in this new environment, presumably that's underlined, in bold, exclamation mark, correct?

Richard Kramer: Yeah. And, look, when you look at the dry powder in the market, there's cash sitting as a percentage of fund manager portfolios, and there's national savings state-owned cash, and there's VC funds sitting on cash. And, all of them are gonna have a hard time finding good ideas. There's no single clear measure of how much cash is out there, and there are very different cash needs for very different types of businesses. Retailers need a lot of working capital to buy in stock before their customers walk in the door, or click on their website, and buy it from them. Software companies don't need a lot of working capital, but maybe their customers take a really long time to pay until all the features are developed.

So, having that cash flow to hand, having that war chest behind you as a company, is absolutely critical for any planning, for any development cycle, to wait out till you can get through to a better economic environment.

Will Page: Well, it's my challenge to you in part two is to ask about smoke signals. I think one might be just the cost of engineers, like engineering salaries. Uh, it's, be very interesting to see how does that ripple through into the finances of tech. But, we'll come back to that in part two. Before we get to part two, let me just get the building blocks here. You've explained eloquently what dry powder is, a stock of cash that's ready to go back out into the investment pool. I get it. And you explained the uncertainty that's out there, um, both due politically, and then also in terms of the finances, the corporate finances of these companies at stake.

But, I just wanna wrap it up on part one with just understanding, if the uncertainty outweighs the dry powder, does the head of the venture capital firm say, "Okay, folks, stop placing bets for just now, it's just too uncertain," or, do they say, "Ignore what's going on out there in the world, the war in Ukraine, the rate of inflation in America. That cash, that dry powder needs to be invested, keep on pumping money into the market?" I'm just kinda keen to know, is it either/or? And, how do you think this, this stock of dry powder's gonna play out over the next, let's say, 12 months?

Richard Kramer: What I would say is it's something in between. Because, first of all, hey, no one gets paid big fees for looking after a bank account. These VCs are paid to source deals, and deploy capital, and generate returns. And, if they're not doing that after a reasonable period of time, maybe not six months, but maybe a year or two years, the limited partners of those funds will say, "Hey, give me the money back. I need it for something else," or, "I wanna deploy it elsewhere."

But, and this is the critical issue, what I think the VCs will do is say, "If we are going to deploy that capital, we are going to be much more careful about the types of companies we back-

Will Page: Mm-hmm.

Richard Kramer: ... and we're going to invest at far lower valuations, the kind that reflect the fact that, overall, the stock market for high-growth, change-the-world-type companies has come down by 60 or 70%." So, they're still under pressure to deploy the capital. But, they can be a lot more careful, and a lot tougher about the kind of valuations that they're willing to invest in, instead of all chasing in a, in a herd really, or in a pack, those VCs really chase together all of the hot deals, and they're all trying to get into the hot deals.

Well, the script might be flipped, and they might be much less eager to get into those incremental deals. They might be much more discerning about the types of companies they back. And, they might turn around to their limited partners and say, "Well, you know what? Your expectation of returns is going to have to come down, because we're not going to be generating the outsized returns that you expected to see after a couple years of absolutely rocketing tech stock markets."

Will Page: It's fascinating. It's fas-... if I just take it to the break here for a second, you kind of give the purpose of being. Like, in the back of my head, I'm thinking about a government economist, which I once was, and anything you had to do had to be justified against the option of the status quo, which was do nothing.

So, do I build a bridge? Hmm, do I build an airport? Do I build a train line? You compared all these options against do nothing, and it's like, is the purpose of being a civil servant to do nothing? But, what you're telling me here is my purpose as a venture capitalist is not to measure a treasury fund, not to short my cash and just put it into bonds for a rainy day, my job is to get back out there and keep placing bets. The nature of those bets changes based on the nature of the environment we're betting in, but my job is still to take that dry powder and throw it back in the market.

Richard Kramer: That cash sitting in the bank, let's say in the US mi-, right now, on a 10-year treasury bond, it's generating 3.15%, is losing value, versus the rate of inflation.

Will Page: So, you gotta place bets.

Richard Kramer: So, that does create a pressure to invest. However, it doesn't make it any easier to find good investments when we're heading into an economic downturn.

Will Page: And, I wanna build off that in part two, where I wanna ask a globalization question, which is, if interest rates are going up in America more than anywhere else, does that soak up the hot money which produces even more dry powder to invest in US tech? Back in a moment.

Richard Kramer: Welcome back to part two of Bubble Trouble where Will and I are talking about dry powder, all that money sitting in bank accounts looking for a home to invest, but having a harder time finding one. So, for me, the higher level narrative is the CNBC, uh, also known as bubble vision, you gotta be in it to win it. YOLO, remember, you only live once, and all that stuff. Uh, the stock market is a lottery that you can't afford not to play, even if the odds are completely stacked against you.

What we're learning, certainly in the past six months seeing all these growth stocks plunge, is that it wasn't really a one-way ticket to paradise. Maybe some people are going to be happy just losing a bit of mo-, value of their money in the bank to inflation, but not obsessively chasing the ups and downs of the stock market. Maybe this has been the marketing of, of Wall Street, Gordon Gekko, and 30 years of ignoring the downside of celebrating the financiers. But, certainly, there's a lot of people who dove into this meme stock crazy, remember that? And we've had episodes on, on Robinhood and others. And, ended up, now, sitting on a lot of companies that have plunged 70 or 80% from what those investors thought they were, quote-unquote, worth. What do you think about that, Will? Have you suffered those kind of losses in your own portfolio?

Will Page: I've taken a fair old kicking in the past month, I can be open about that one. But, haven't we all? I mean, isn't it true that Amazon is now trading at less it's market value that it was pre-pandemic? And, I think you've mentioned to me as well, is, it's sub-trading the Nasdaq as well. So [laughing], even those super-safe tech stocks, uh, are feeling the forces of gravity.

But, let's go back to just what happens to this dry powder. I think that's what our listeners wanna know. We, they get the point, there's a bunch of cash ready to go back in, and they also get the point which is, it's a terrible time to go back in 'cause of uncertainty. But, as you eloquently wrapped up part one, you still gotta go back in, 'cause your job is to place bets, not to sit on your, twiddle your thumbs. Again, I'm gonna cite PitchBook data to explore dry powder with, and combine it with monetary policy.

So, I got this feeling of a perfect storm going on, which is, you have valuations which are really low, and you're gonna see that in the open market and on the secondary market, and you've got a dollar that's getting really strong. Like, I can get 81, 82 pence to the dollar right now, it's a great time to bring dollar assets back into Stirling. Dollar is in a very strong position. And, you've got this interest rate dilemma which is interest rates are going up further and faster in America than anywhere else, which soaks up hot money.

Now, when we discuss globalization in tech, it's an interesting thing. In my world of music we say, "When you take down borders in streaming, does America just dominate the world?" And, it's true to say that the top three artists in the world are Justin Bieber, Drake, and The Weeknd, who, small point of a detail, are actually Canadian. Nevertheless, you can see how globalization changes when the market changes. Do you think this combination of huge amounts of dry powder getting piled up ready to go back in, dropping valuations, and raising interest rates means that, essentially, America just gobbles up the global tech community once again?

Richard Kramer: In this political climate, Will, I would say, not so fast, buster.

Will Page: [Laughs]

Richard Kramer: It's absolutely true that, uh, the dollar is super strong, and that none of these VCs or fund managers get paid for sitting on piles of cash, but if you look in the UK, the days of thinking that you can allow the likes of a SoftBank to buy a company like Arm, well, they could reconsider. Those deals are just not gonna be on the table anymore. And, and we've had also, uh, in our muscles from Brussels episode, we discussed the zeitgeist for big tech regulation in Europe. They're not looking to have all of these fantastic European startups sold to the likes of Google, Facebook, Amazon and Microsoft. Given that M&A is not possible from some of the biggest piles of cash in the market, sitting on those big tech companies, that limits things. And, for a lot of investors and VCs, it's the same situation.

And, you could see, for example, it even happens in America, that after the killing of the journalist, uh, Adnan Khashoggi, you know, no one wanted to take the Saudi money in the Valley. So, there's nice money and not so nice money, and welcome funding and less welcome funding. Just because you have a big pile of cash doesn't mean you can readily put it to work anywhere you want, and someone looking at their own crown jewels is not necessarily ready to put them on the market, uh, and allow anyone to come and nick them. You know, instead you have some, some coppers on the beat suggesting that that sort of robbery can't happen anymore, in the likes of the folks in Brussels, or, or even in the UK who say, "We'd like to keep our tech assets here, thank you very much, so that they can develop, uh, high paying jobs, and, and create wealth and attract more entrepreneurs in our economy."

Will Page: Agreed. And, you are an American, you spent a large part of your life living here in Europe, and a large part of that life living in the European Union, but, not so fast buster, volume two. It's obvious to me that it's a great time for American tourists to come to Europe, 'cause it's gonna be cheaper than it was before the strengthening dollar. It's an obvious time for American tech companies to come in and snap up some undervalued assets, because the point in the cycle, the macroeconomic environment suits them, just like the tourists suits them.

And, who's to stop a European tech entrepreneur based in, let's say, Croatia, where there's a, a lot of tech developing happening down there, saying, "I've busted my balls to build this startup for the past 10 years, I've got a 60 million exit waiting for an American tech company, and a European regulator in Brussels that I've never met before says I can't do because they've got and American passport." Do you really think that sort of scenario is gonna play out?

Richard Kramer: So, let's be clear about this. We need to talk about it at the level of scale. So, any of the household names, or large listed companies of European tech would pretty much be off limits, equally for a Chinese or an American company to come and buy. In the same way as, in America, you have this, uh, committee called CFIUS, Committee on Foreign Investment in the US, that any time a European or an Asian company, certainly a Chinese company, would come and try to buy US tech assets, they would review it on national security grounds. Now, whether you wanna call that protectionism, or preventing economic imperialism, or just nurturing the startup economy in our own culture, or our own country, you can call it what you want, but there is a tried and true protectionist impulse on the part of all of these countries that they don't wanna see their asset bases just sold off from under them.

And, equally, you see that, whether it's France, or the UK, or Germany, a lot of countries are emulating what you have in, in Singapore, or in elsewhere of having large sovereign wealth funds that invest in local entrepreneurs, not so that you can flip them to the Americans or the Chinese, but so that they can build up the kind of environments that you have... I think it's a mistake to think of it just around Silicon Valley, because it's in loads of other cities in America. But, loads of other cities in Europe, whether it's Berlin, or as you have mentioned, Croatia, or Stockholm, or, or Barcelona. There are plenty of pools of tech talent that are emerging across Europe. The idea that those efforts are just going to dress the bride so that they can be ma-, those brides can be married off to whatever suitor comes in with the biggest dowry seems a little fanciful.

Will Page: I hear it. Two remarks, though. O- one is, you seem to be saying, if you're big enough to hit the radar, you're big enough to be blocked from an American acquisition. I can understand that, but that's not necessarily the point about all this dry powder that's building up in America. They're not looking for stuff that's gonna hit the radar, they're looking for to bet on stuff that will hit the radar in 5, 10 years' time.

Then, secondly, and you may wanna grab yourself a pair of Rizlas 'cause you're gonna do some smoking in a minute, um, the second point is, are you talk about financial nationalism, financial regulation, if I can just give one example of cultural nationalism, or cultural regulation, in Canada, Canadian tax payer's dollars are used to keep Canadian musicians in Canada, on all levels. If you're a Canadian songwriter, a featured artist, a producer, there will be cash handouts for you to keep your business inside the borders of Canada. But, if you're a promising Canadian filmmaker, they'll finance you to go to Hollywood, because, why not? Why would you wanna try and make big movies in Toronto or Montreal? You need to be in Hollywood because of scale.

And, I just wonder if that analogy sits here, which is if your, if your aspirations as a tech company are that big, you need to be in the Valley, 'cause there's nowhere else like it.

Richard Kramer: Those days are completely over, Will. That's an outdated approach that might have worked 20 or 30 years ago. But-

Will Page: Did the pandemic crush it?

Richard Kramer: No, I think globalization and decentralization of tech crushed it 20 years before the pandemic came along and read the last rites. So, let me give you another Canadian example, they have done a tremendous job subsidizing the development of video games in Canada, specifically in Quebec.

Will Page: Plus one to there, it's phenomenal.

Richard Kramer: It's phenomenal. And, that is done, in part, because they wanted to build a critical mass of well-paid jobs in, in video game development, because they had the education infrastructure to train young Canadians, and others from around the world, to work in that industry, because they provided generous government grants and incentives to set up there. It's a tried and true strategy.

Now, in the case of Europe, if you look at a company like Infineon, which is the chip supplier to most of the German automakers, that's seen as a, as a national treasure. And, the entire German auto industry will set their technology roadmap in, in concert with the likes of, of an Infineon or a Bosch, or these sort of, these household names in the local economy. And they wanna keep those chip designers in those high-paid jobs and the training that they provide the younger engineers that they bring into the business, they'll wanna keep that going in sites in the country.

So, it's a logical strategy from managing your economy, to make sure you keep the talent, uh, in your borders. And, it means that, in a decentralized world, Infineon has offices all over the world. They bought a US company called Cypress Semiconductor, they will be developing in Southeast Asia, in Germany, in the US and elsewhere. They will have, uh, talent spread around the globe, but it's where the company has its center of gravity, and changing those centers of gravity is, is just as difficult as it would be to, to wrench one of the big US tech firms out of Silicon Valley.

Will Page: All right, we're gonna get your smoking in a minute, but I have to make one, traditionally, one homeland anecdote on every podcast, which, as you mentioned Montreal's gaming community, which is phenomenal, Canadian policies in gaming, to be encouraged elsewhere. But, Montreal cannot compete with the gaming culture in Dundee, Scotland, which is the home of Grand Theft Auto. Uh, you may wonder why a game called Grand Theft Auto, is about late night violence on the street came from Dundee, but I call that method acting. Smoke signals, Monday morning, I wake up, I listen to this podcast, then I go to Bloomberg and I read a headline which says, "Get ready to pile back into the market 'cause this dry powder's gonna turn the economy around."

And, I read down what the smoke signals in that article I should be looking out for to make myself realize, "No, Richard Kramer on that podcast warned me it's not the environment that we're in anymore, it's changed. This dry powder will be used, but it's gonna be used differently." What's, what's the smoke signals that's gonna help out listeners, you know, be able to not get fooled again?

Richard Kramer: Will, you gotta bear in mind it takes three to tango, when you think about everything is just gonna get acquired now. First of all, there's the entrepreneur, they started the company, and did and IPO 70% higher, and they're not gonna wanna sell it that cheap. Remember, six or nine months ago, they were the unicorn jockey on top of the world. Then there's the acquiring company whose stock is also down 70%, and they know the shareholders, they wanna see cash flow and profits, not some deal to conquer the Earth. And then, finally, you've got the investors, and they've gotta be backing these acquisitions, and instead, they're treading cautiously, and they have taken a very different attitude towards risk tolerance.

So, this is the first time in close to a decade where we've seen telcos an utilities perform incredibly well, far out-performing the growthy names in tech.

Will Page: Risk tolerance, I get it. Now, you're close to bogarting that joint, my friend. So, please light up another and give us your second smoke signal.

Richard Kramer: Well, the other one is that tons of money does not necessarily mean great returns. We can look back in the last 20 or 30 years over the history of tech, and see tons of areas where people poured money into, and no one made a profit. So, just because there's a wall of money coming after a space, it more likely means that everyone is gonna lose their shirt than that one person emerges, uh, unscathed. And, you could see many, many areas where you have eight or ten companies pursuing the same dream, and there's no easy way for them to consolidate themselves, or join together on a vision, and they all end up flaming out.

Will Page: Well, in hop, skip, and jump our way through this podcast, you've very quickly illustrated what dry powder is, a war chest of cash that needs to go back in, the uncertainty in the market, which suggests it needs to go back in, but it needs to go back in differently, more cautiously than before. Then, finally, the macroeconomic climate, which raises the prospect, challengeable, but the prospect that we could have another winner takes all, American owns tech scenario playing out again. Or, we could see an outburst of tech nationalism and tech regulation which perhaps make the lay of the land a little bit more even than before.

Fascinating podcast, I wanna thank my co-host, Richard Kramer. You've been with Bubble Trouble, and we'll see you again next time.

If you're new to Bubble Trouble, we hope that you will follow the show wherever you listen to your podcasts. Bubble Trouble is produced by Eric Nuzum, Jesse Baker, and Julia Natt at Magnificent Noise. You can learn more at bubbletroublepodcast.com. Until next time, I'm Will Page.