How are the financial results analysed?

Secondly, gains from companies going public—primarily Uber, where SoftBank is the largest shareholder.

Finally, unrealized “paper” gains in companies whose valuations were marked up due to new investment rounds—notably OYO.

Therein lies the rub

Acquisitions such as Flipkart’s are rare, especially given the stage at which SoftBank enters these companies.

Public listings such as Uber’s are rare as well as whimsical. For one thing, large investors such as SoftBank are typically constrained from offloading their entire stake at the time of the IPO and can, at best, liquidate a part of their holding.

For another, public markets tend to value technology companies far more clinically than private investors by focusing on fundamental business metrics such as revenue, growth, and profitability rather than vanity metrics that got these companies huge valuations from VCs. This means that the value of the stake investors such as SoftBank hold in companies like Uber can easily be lower than their entry prices.

This leaves us with the third category of gains—unrealized paper gains that SoftBank has booked in companies like OYO. Last year in September, SoftBank led a $1 billion investment round in OYO that pushed the company’s valuation up to $5 billion.

What were the investments?

That figure is 13 times higher than when SoftBank first invested in OYO in 2015, according to investment data tracker Dow Jones VentureSource. This investment allowed SoftBank to record a 154.2-billion yen ($1.4 billion) valuation gain in OYO.

While this figure is only 12% of the overall segment income for the Vision Fund, notice that unlike the other portfolio companies where there were external market forces at play, the valuation gain in OYO was achieved simply by internal diktat. Considering the fact that SoftBank owns nearly 50% off OYO, any money that it puts into the company is akin to SoftBank taking money out of one pocket and putting it into another.

In turn, these unrealized paper gains allow the Vision Fund, and by extension SoftBank itself, to shore up its financial results. These stellar financial results, in turn, allow SoftBank to borrow more at better rates both at a corporate level as well as margin loans with shares of its portfolio companies as collateral.

SoftBank has a long history of availing margin loans using shares that it holds in companies such as Alibaba as collateral. At one point in time, the margin loans on Alibaba alone were worth more than $8 billion.

Notice that the high valuation of these shares allows SoftBank to borrow increasingly larger amounts of capital—while most margin loans are on publicly traded stock, it is not uncommon for bankers to arrange loans on private company shares as well. This facility lets SoftBank service annual interest payments to their quasi-debt LPs without requiring any real-world cash returns from its portfolio companies.

So essentially, SoftBank is using debt to service debt. Normally, this would be a classic debt trap, but SoftBank uniquely has the leverage to book unrealized gains and pump up numbers to the level it so desires.

In others, a Ponzi.

Layer cake

But this is not just any other Ponzi. This is a Russian-doll Ponzi, where there are multiple nested iterations.

How so?

Let’s take SoftBank’s original $100 million investment in OYO in 2015. Would OYO’s business fundamentals at that time justify a valuation of $400 million? Absolutely not. But that is how VC investing works in any case—you are investing for the future potential of a company rather than the current metrics.

So you could argue that the $400 million figure is justified as it factors in OYO’s potential to become a large budget hotel aggregator/operator in India—presumably a large market with a big opportunity.

But once that investment has been made, it bakes in these expectations. From that point on, it is incumbent on the startup to “grow” into that valuation by executing on its plans. The problem though is that markets are unpredictable—it takes much longer to penetrate and grow, competitors can take away your business and unit economics can turn out to be far more challenging than anticipated. So this might call for further investments.

However, it is difficult to justify higher valuations for these investments, given that the original hypothesis had already baked in the full addressable market size and opportunity.

 

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