"Nobody told me there'd be days like these
Strange days indeed, strange days indeed"
-- John Lennon
I have written on several occasions about the likelihood of a
correction and pull back in the venture market. I've also said that it
will be triggered by a correction in the stock market which drives
companies, in order to protect stock price, to slash costs and capital
expenditures. It works like a clock. It happened in 1987/89, 1991,
1999/2000 and now. The good news is there is no mystery to this. The
bad news is it just hit full force over the past two weeks.
While
forecasting is next to impossible, it is pretty clear what this cycle
is going to look like. This is the first credit driven correction in
our modern history. All of the other ones were triggered by the equity
markets collapsing. Why is this important and what does it mean regarding duration?
Credit
is the oil that greases Main Street. Companies hit the equity markets
from time to time to raise capital. So when it shuts down due to a crash, firms can generally manage status quo using cash flow or their
debt facilities (working capital lines, equipment lines, etc) to get
by. However, a credit crisis is different. Companies use their credit facilities on a daily basis to
fund equipment, inventory, receivables and facilities. When credit
contracts, their businesses contract. They can't buy the equipment they need, fund inventory for
product to sell and such. This means that this is going to be longer
and harsher than before. The last credit driven crash was in the Great
Depression when all of the banks started to go under.
In equity
driven situations, investors need to feel that prices have gotten low enough and they will come back in (fear turns to greed). In
credit driven crashes, the whole system needs to "de-lever" and the process is longer and more complicated. The core issue is that families have too much debt. So, the debt needs to go away to fix the problem. Unfortunately, because of cheap debt, poor oversight and
general greed, this debt party has gone on way too long. Consumers are
underwater on mortgages and credit cards and the government is
approaching the trillion dollar nut. Fortunately, corporations are generally not as bad off though some will get into trouble.
So, how difficult and time consuming could this possibly be? Wipe out a large chunk of debt to get it to an acceptable
level and move forward. One little issue: this would bankrupt all of our
banks and send us into the mother of all black holes. So, how do you wipe out this debt without wiping out our banks. You have to do
it gradually. People and firms use cash flow and savings (remember that
concept?) to pay off debt while cutting back on consumption. A number of families will be so underwater that a Chapter 11 elimination of their debt is the only way out. With each Chapter 11, the banks will become weaker (reduced lending capital base) and the
government will have to repeatedly step in to "recapitalize" the banks to keep
them solvent. This is why we see infusions, nationalizations,
guarantees and such hitting every month. The bad credit card debt hasn't hit hard nor other types (student loans, etc) so we are going to have a series of these crises rolling through the system. Credit will get harder to obtain as the banks increasingly experience these challenges.
Having consumers save is a good thing, isn't it? Yes, but when people save versus
spend, the economy contracts, putting more pressure on the debt loads as unemployment grows and less capital circulates through Main Street. You reverse the trends from the past 10 years. Instead of borrowing to spend, consumers will be saving to pay down debt. However, as Japan showed, getting this debt down to acceptable levels can take 7-10 years.
They referred to this process in Japan as the "Lost Decade" in the 1990's. Jim Rogers has said that if we don't take aggressive steps and let institutions fail and accelerate the downdraft, we will see a "Lost Decade" in America as the government tries to orchestrate a softer "de-leveraging" process. Who knows…
Ironically, while this is painful, it is actually a very healthy process. It is eliminating excessive waste and spending. It is encouraging saving and adding fiscal discipline back into the picture. It also rewards well run, efficient firms and prunes the weak and incompetent. This is not the end of the world as some may espouse but it will be tough going for the next number of years.
As with the tech bubble, I believe that we will have 2-3 years of hard sledding. Sales will take longer, marketing budgets will contract and technology expenditures will be slashed. This assumes the government is able to stave off a nuclear meltdown scenario in which case, all bets are off. After the hard sledding, we will have another 2-3 years of modest growth. In year 5 or 6, firms and people will grow more confident and growth will accelerate. So, entrepreneurs will have a good 5-7 years to build out their businesses and prepare for the next updraft. When this hits, there will be few competitors and a lot of money will be made. The key is being the last man standing.
The next post will be a synopsis of the various VC strategies to their portfolio companies to survive this 5-7 year period.