How the SoftBank Scheme Rips Open the Startup Bubble

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.

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.

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.

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.

You can listen to and subscribe to my podcast on YouTube.

Enjoy reading WOLF STREET and want to support it? Using ad blockers – I totally get why – but want to support the site? You can donate “beer money.” I appreciate it immensely. Click on the beer mug to find out how:

Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.

 

  40 comments for “How the SoftBank Scheme Rips Open the Startup Bubble

  1. 2banana
    Oct 9, 2019 at 8:34 am

    Greater fool theory in action.

    “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.”

    • raxadian
      Oct 9, 2019 at 8:51 am

      But investor, you are the greater fool!

      • 2banana
        Oct 9, 2019 at 8:56 am

        If you look around the poker table

        And don’t know who the pigeon is,

        It’s YOU.

  2. ZEPPO
    Oct 9, 2019 at 9:07 am

    Wolf……you did a great job pointing out the existing flaws and the flaws that are on the horizon. Creating a “fund” was a brilliant diversion from the concerns of the failing businesses. The leverage created, by having a fund where governments, investment institutions, and unrelated corporations could buy-in and run up the value of the same investments that Softbank made on its own, was a brilliantly strategy…….until those start-ups continued to spew mountains of red ink. It kind of reminds me of being on the wrong side of a swap: A hope and a prayer. Speaking of swaps, I wonder if either Vision fund has been employing them.

    • Vespa P200E
      Oct 9, 2019 at 10:13 am

      Agree great write up Wolf as didn’t know the Vision fund was paying “some of its investors receive interest payments of 7% annually on their investments in the fund”.

      Guess that’s 1 sure way to raise money with 7% yield with potential to get into IPO actions early on but the downside, of course, is what appears to be “malinvestment” like the perennial money bleeding companies like Uber and WeNoWok.

      But at the end of the day Son-san, once with Midas touch, is merely investing OPM with fat management fees?

      • Harrold
        Oct 9, 2019 at 11:20 am

        7%? Thats nothing.

        Madoff promised 20% to some investors.

        • nick kelly
          Oct 9, 2019 at 2:28 pm

          20 % would have raised all kinds of scrutiny. The genius of Madoff was to promise and appear to deliver a rock solid 6-8 % year after year for decades and touting his fund as ultra-conservative and therefore immune to risk. His many elderly conservative investors would have automatically run away from a promise of 20% knowing that such a return implies risk.

          As math guy Harry Marcopolous (sp?) explains in his book: ‘No One Would Listen’ it is mathematically impossible to return always even 6%. Madoff would deliver 6 % when the market was down 20%.

          So he approached the SEC and showed then Madoff was either running a Ponzi scheme, or he was using insider information. Most likely the former because insider information is not as consistent as Madoff’s returns.

          SEC staffers would drop in on Madoff and after being shown his fake trading desks (he never invested a cent) and listening to his split/ strike BS, they would often drop off their resumes, and report everything fine.
          All they had to do was confirm the trades instead of looking at docs he created.

      • wkevinw
        Oct 9, 2019 at 12:24 pm

        Basically these people are one-trick ponies/monkeys on the typewriter. When the window opens for their “systems” they do great. (Hedge funds are another category- and even the investment gurus-even Nobel laureates-

        https://geoffblades.com/investing-we-dont-invest-we-gamble/ ).

        The smart ones sell/retire when they are still winning.

        There are probably no publicly available “systems” of investing that beat the market over (very) long periods. Some come pretty close to market returns with less volatility/risk as an example of added value of an investment “system”.

  3. IslandTeal
    Oct 9, 2019 at 10:05 am

    Good article Wolf..Thank you. Time for a re watch of “The Big Short”.

    • cas127
      Oct 9, 2019 at 10:16 am

      WR,

      Yes, WR, excellent – simply excellent.

      A short, precise explanation of how Softbank runs its self-licking ice cream cone by manipulating its paper valuations upward.

      And although the game is being played (mostly) in the private markets, one wonders when the avalanche of lawsuits is going to hit.

      Softbank is simply too vast and has relationships with too many players (some publicly owned or with public fiduciary responsibilities) to completely evade legal responsibility for share price manipulation/disclosure issues/etc.

  4. Vespa P200E
    Oct 9, 2019 at 10:23 am

    Great write-up Wolf!

    It feels like late 1999 if not bigger Dot-con bubble with VCs flushed with OPM liquidity focused on exponential growth never mind bleeding money on app-based gypsy taxi and sub-leasing office space (daycare for the Millenials).

    Time to load up on double short ETF QID as history does repeat and business schools in the near future will no doubt cover the SillyCON Don-COM bubble II with what were they thinking theme.

  5. Ted Byrley
    Oct 9, 2019 at 10:32 am

    Thanks for your reporting and I now starting to wonder it who needs a lot of cash in the repo market.

    • Jack
      Oct 9, 2019 at 6:34 pm

      Good point Ted,

      I think it’s time to write the next installment of this saga Wolfie :)

      My recommendations next

      DeutschBank

      and one may ask, why not make it a trilogy?!

      Every one think that that big four are immune? I reckon they’re a prime candidate to complete this trilogy!

      All power to your hand Wolf. Go strong.

  6. kiers
    Oct 9, 2019 at 10:38 am

    The debacle of WeWork is NOT just Softbank idiocy; Skadden Arps and other blue chip law firms likely helped write the IPO prospectus! (which was a crap prospectus) JPMorgan Chase and Goldman Sachs are the lead bankers. They are represented by Simpson, Thacher & Bartlett. AND THIS IS the net QUALITY of OUTPUT!!! Sheeple will swallow.

    • Michael Fiorillo
      Oct 9, 2019 at 11:48 am

      Ain’t meritocracy grand!

      • R2D2
        Oct 9, 2019 at 2:56 pm

        Love a good old “pump and dump” ;-)

    • Vespa P200E
      Oct 9, 2019 at 12:26 pm

      The underwriters and especially Jamie from JPM was reported to be wooing the wonder boy bending over backward (having sold their soul to the street) for the claim to fame (now infamy) and of course the fees.

      That said wouldn’t be surprised if JPM and Government Sachs tried to temper down the very 1-sided pie in the sky and 1-sided full of governance red lights but kowtowed to the wonder boy who also managed to fool Son-san.

  7. Bobber
    Oct 9, 2019 at 10:41 am

    If Softbank put $10B into WeWork, and then booked $10B gains to increase the valuation to $20B, one can reasonably expect a massive $15B write-down in coming quarters (including the quarter ended Sept 30th?).

    I don’t know the GAAP accounting rules in detail, but if a company can do quick write-ups based on market value, shouldn’t there be quick write-downs as well when things go south? If not, the accounting rules are very flawed.

    • Unamused
      Oct 9, 2019 at 11:16 am

      What are these ‘accounting rules’ you speak of? Please explain.

      • Javert Chip
        Oct 9, 2019 at 1:23 pm

        I doubt a private hedge fund is subject to GAAP. Some such funds may voluntarily produce audited GAAP statements for their investors.

        SoftBank appears to exclusively target huge, wealthy, supposedly “sophisticated investors, proving once more, you can’t stop stupid people from doing stupid things (even if they are filthy rich).

  8. Bobber
    Oct 9, 2019 at 11:06 am

    I read on Wikipedia that SoftBank is the #2 listed company in Japan. A drop in Softbank value would be a blow to Japanese who already dealing with negative interest rates. Now they face potential capital losses as well. They should blame their central bank for pushing stock prices to unsustainable levels. This was irresponsible.

    • Vespa P200E
      Oct 9, 2019 at 5:43 pm

      Heard that Jack Ma, CCP card-carrying cadre, lied and ripped off his initial Alibaba investors/handlers Yahoo and LimpBank not to mention very limited voting power despite shares held by using Chinese security law or something.

      Anyway LimpBank sold a big chunk of BABA 3 months ago as maybe facing some liquidity crunch? And shares of Grail is under pressure as rumor has it it’s few remaining positive return stake that may be sold to raise liquidity.

      Hey just like what the wonder boy pulled on the initial WeNoWork IPO prospectus. One would think Son-san learned but…

  9. gorbachev
    Oct 9, 2019 at 11:19 am

    So if I owned two properties on a street in any

    major city and i bought a third at an inflated price

    would that increase the value of my original two

    properties and then in turn would my bank

    lend me more money based on my increased equity

    • Harrold
      Oct 9, 2019 at 11:22 am

      Yes. The 3rd house would establish a new comp in the area. Appraisers would take that into consideration in valuing the other two properties.

  10. Tang
    Oct 9, 2019 at 11:51 am

    Thanks for pointing out the behind the scene forces. There are also piggy-back players. Yahoo almost vanished outside Japan after the dotcom collapse. Outside of Japan how successful then was where the modus operanti began. The yahoo team believably
    sometime moved to the baba land. Another non English speaking country. And after sowing the seeds with all the yahoo templates improves on the modus operanti. Of course than every enterpreuner sang the China song. Over a billion in population, business on-line, great geography etc etc etc. Even a lousy song sounds good. And the piper music was fantastic. Hypnotised investors hallucinated.
    Of course so much money is holding up the company.
    Is there a need to really visit the warehouse, scrutinised every inch of the operations? No players would want the cake on air to come crashing. Especially the banks where loans were made with baba shares in the safe. With more money seemingly success, the midas touching must go on.
    More money must be made. Just like the dotcom days. Setup a website www and your operations triple in value. Common sense does take time.

  11. c smith
    Oct 9, 2019 at 12:23 pm

    “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.” Can you spell “P O N Z I”???

  12. Tim_O
    Oct 9, 2019 at 12:30 pm

    Wolf – very interesting explanation of the schemes Softbank has been running to inflate the currently rupturing startup bubble. An additional reason that Softbank’s Vision Fund overpays for some investments might be to disguise Saudi Arabian payments to foreign officials.

    Softbank has made large investments in companies such as Mapbox, Compass, Lemonade, and many others which interestingly the Kushner family owned Thrive Capital owns large venture steaks in. All these investments began shortly after “Jared Kushner, President Trump’s son-in-law and Middle East adviser, dropped into Saudi Arabia for an unannounced visit to the desert retreat of Crown Prince Mohammed bin Salman, who was in the process of consolidating his power. The two men talked privately late into the night. Just a day earlier, Mr. Kushner’s younger brother, Josh, then 32, was flying out of the kingdom. Jared came to talk policy, but Josh was there on business.”:

    https://www.nytimes.com/2019/03/21/world/middleeast/kushner-saudi-arabia.html

    Josh Kushner and Jared Weinstein (who for three years served as President George W. Bush’s body man) together run Thrive Capital for its majority investor Kushner family. Things are apparently so good at Thrive that just this year Josh bought a private jet, and a stake in an NBA basketball team.

    https://www.nytimes.com/2019/03/22/sports/basketball/joshua-kushner-memphis-grizzlies.html

    • nick kelly
      Oct 9, 2019 at 2:46 pm

      Jared as part of his ME portfolio of everything was also point man handling the murder of the journalist on the orders of MBS.
      Job 1: convincing MBS there was a PR problem and that perceptions to arms supplier US were different than in the Kingdom. In thinking it was no big deal he was on the same page as POTUS: ‘of course he killed him. Who gives a f**k’

      But Jared had a possible solution: arrest and quickly execute the 12 man hit team. MBS said he would consider it.

      The above is from ‘Siege’ by Micheal Wolff. It true, Jared is conspiring to commit mass murder. If false, where is Jared’s law suit against Wolff and his publisher?

  13. Oct 9, 2019 at 12:51 pm

    Hmm big stake in Chinese ADRs? Wonder how much they are giving to the Trump reelection campaign?

  14. marc
    Oct 9, 2019 at 1:23 pm

    In the end the fake money (valuations are made at the margin) finds its way into the broader markets and feeds the positive feedback loop of everyday people retirement money.
    Then piles and piles of OTC, dark pool derivatives make the arrangement even more unstable.
    Until the marginal tile at the edge of the roof falls off…and the rest of the strong roof disappears overnight.
    Then everyone wakes up to ….we’ll see.

  15. Dan
    Oct 9, 2019 at 1:41 pm

    So:

    1. Early investors agree what the valuation of the company is.
    2. Later round investors agree what the new, higher valuation of the company is. Repeat a few times.
    3. IPO – institutional investors are required to buy at the current, high, valuation that based on nothing but the agreement of earlier investors.
    4. Early investors make a killing. Later investors and IPO buyers are screwed when reality hits and the share price tanks.
    5. Repeat for the next Unicorn.

    How is this not a ponzi scheme?

    • intosh
      Oct 9, 2019 at 4:02 pm

      It’s not really a ponzi scheme per se since there is no promise of return. That’s why these charlatans have been able to get away with it.

    • char
      Oct 10, 2019 at 8:31 pm

      Later investors have clawbacks. It is more we pay $20 a share but if the IPO is below $40 we get two shares. Fake high value is not as negative for late investors than it seems.

  16. Pat
    Oct 9, 2019 at 2:48 pm

    Unsustainable ‘growth’ valuations for InsurTech entrants have been an issue since unicorn status became the benchmark for success. Those who then benefited from exits based on those unsupported valuations were guilty of perpetuating the valuation myth, and for loading over-valuation onto those who came behind them.
    How many times have we seen, “$150 Mn investment resulting in a $1.1 Bn valuation? ” How does that equate?

  17. JZ
    Oct 9, 2019 at 4:32 pm

    I understand that SoftBank played financial engineering. But I can NOT avoid the question “what’s the difference between AliBaba and Uber/WeWork”. AliBaba worked! Uber definitely is where tomorrow’s Taxi industry goes. You can argue it’s valuation but you can NOT argue it’s direction. WeWork as MacDonald brand of office renting? Where everybody can do but WeWork/MacDonald does it best?
    I don’t know. And the thing is, the longer it takes, the more money is burns, is more entry barrier for competitors.

    • Oct 10, 2019 at 9:39 am

      “more entry barrier for competitors.” and by implication disinflationary? Uber practices wage suppression as its business model? Competition should be disinflationary, but running a company that loses money so you can pay workers less with no benefits is disinflationary, ie prison labor tends to lower the wages of all workers. Was Amazon kept out of Queens (and other places) because it doesn’t pay a living wage? I understand LW will be harder on China than current, so what about the workers gulag? Workers pay rent with stock profits?

    • char
      Oct 10, 2019 at 8:39 pm

      Alibaba worked because it has scaling working for it. With Uber scaling doesn’t make it more efficient and it already has already the whole taxi market so no natural place to grow.

  18. Dillinger
    Oct 9, 2019 at 7:51 pm

    Ah, people just lack vision! :) After all, when interest rates go down into true negative yield territories, then all of these money-losing, heavy indebted companies will be getting paid for their debt. They are just waiting for the day when the market is ready for their -1% bonds. Then everyone will recognize the true genius and foresight of the pioneers who recognized early that someday the world will pay them for the rights to loan them money.

  19. Iapetus
    Oct 10, 2019 at 12:31 am

    I can’t help thinking we haven’t learned much since the Financial Crisis of 2007 – 2008. During this last financial crisis, massive losses were created when investors poured imprudent and highly leveraged sums into mortgage backed securities that were filled with questionable consumer loans. These consumer loans were called ‘subprime’, and many were questionable because underwriting deteriorated to the degree that many borrowers had No income, no job, no assets (colloquially called “NINJA” loans).

    It seems we now have a situation where imprudent sums have been poured into questionable and highly leveraged corporate investments. These corporate investments include venture capital, IPO’s, equities, leveraged loans, and high yield bonds. Many of these investments are questionable because the corporations backing them have Negative Income with no path to profitability, No Governance, and ( almost ) no Physical Assets to liquidate in bankruptcy (what you could colloquially call “NINGPA” investments). This is essentially the same greater fools game that was played with housing prices before the 2007 crash.

    So similar playbook to 2007 – 2008 Financial crisis, except what backs these investments has switched from consumer to corporate obligations.

  20. Ian Davies
    Oct 10, 2019 at 8:36 am

    Ponzi by any other name. Glad to see Saudi fell for this, old MbS will have to cut down on the yachts next year.

Leave a Reply

Your email address will not be published. Required fields are marked *