The End of Blitzscaling
Guest post by Ted Lamade, Managing Director at The Carnegie Institution for Science
A few weeks ago, Morgan recommended a documentary titled An American Experience: New York, which is a seven-part series exploring the city’s history as the “premier laboratory of modern life.”
The conclusion is simple. Over the past century-and-a-half New York became the world’s most dynamic city. Yet, like the financial markets that are inextricably linked to its fate, the Big Apples’s ascent has been anything but smooth or predictable. Instead, it has been full of booms and busts, catalyzed by equally volatile levels of confidence.
In the seventh and final part of the series, an architecture critic named Paul Goldberger characterized the city during one of the more severe periods of misplaced confidence – the mid-1960s.
“America has always believed in bigness. We particularly believed this in the 1960s when the World Trade Center was conceived. Americans wanted bigger American things — They believed bigger doses of American power were going to solve anything. It was the age when all cars were gargantuan and had fins, the age when we were sending troops to Vietnam, the age of going to the moon. The Twin Towers were the architectural equivalent of this notion of bigness.”
During this period, the original plan for rejuvenating Lower Manhattan was centered around the construction of a 60-story office building. However, in a pursuit of “bigness”, these plans morphed into the construction of not one, but two 100-story buildings* *that would end up oversupplying the city’s office market for years to come.
So, how did this happen?
In short, city planners threw caution to the wind due to the fact that believing the impossible was unachievable was considered a sign of weakness. In this era of bigness, the future was limitless. Acting as if it wasn’t was un-American.
After two decades of unprecedented prosperity and growth, skyscrapers were just the beginning. Americans became convinced they could build highways that covered the entire country, corporate conglomerates that knew no bounds, and shuttles capable of reaching the outer parts of space. They also thought the country could win any war, end poverty, and save the environment, all at the same time.
As we now know with hindsight, this ambition stretched too far. In pursuit of bigness, Americans had lost their discipline. The United States was ripe for a humbling. Economically, interest rates had remained too low for too long and too much money had chased too few productive assets.
In the decade that followed, nearly every investment tethered to this concept of “bigness” suffered — large swaths of office space went un-leased, overpriced growth stocks collapsed (e.g., the “Nifty Fifty”), large conglomerates stagnated, and long duration U.S. government bonds declined materially in the face of soaring inflation.
On the flip side, investments closely tied to profitability and cash flows did well – value stocks materially outpaced their growth brethren, smaller companies performed better than large ones, private equity firms emerged to break up the conglomerates, and on the heels of higher commodity prices, energy companies soared.
In short, the period that followed the bigness of the 1960’s was one of transition; a period that saw a dramatic shift from an emphasis on growth at any cost to one defined by leanness and profit.
It is still early, but we appear to be witnessing the early stages of a similar transition today.
Instead of bigness being defined by immense skyscrapers, highways, and space shuttles, the past decade has been defined by high flying technology companies and a concept commonly referred to as “Blitzscaling,” which is a strategy that prioritizes growth at all costs and emphasizes building for a future so far off you practically need a telescope to see it. Most notably, it was the strategy that the vast majority of venture capital investors promoted to their portfolio companies.
Blitzscaling worked well for the better part of a decade. In fact, it worked so well that it was largely responsible for creating hundreds of unicorns. The trouble, as we now know with hindsight, was that this phenomenon was fleeting in many cases and largely the result of low interest rates and easy access to capital.
A trend that, as it always has been, was unsustainable.
Because, as Edward Chancellor quotes Henry Hazlitt in 1946 in his new book “The Price of Money,”
“Easy money creates economic distortions. It tends to encourage highly speculative ventures that cannot continue except under the artificial conditions that have given birth to them.”
Then, as Seth Klarman said, 75 years later,
“Persistent low rates have wormed their way into everything: investment thinking, market forecasts, inflation expectations, valuation models, leverage ratios, debt ratings, affordability metrics, housing prices, and corporate behavior. Moreover, by truncating volatility, forestalling business failures, and postponing the day of reckoning, such policies persuaded investors that risk had gone into hibernation or simply vanished.”
Each time throughout history, when easy money and low rates vanish, so do the distortions, speculative ventures, and delayed business failures. This time has been no different.
Over the past year, higher rates and tighter money have forced private companies to shift from blitzscaling to conserving cash, public companies to focus less on total addressable markets and more on earnings and cash flows, and both venture capital and private equity firms to stop raising massive funds and instead dedicate more time to getting their existing companies through this downturn. That said, this is just the start. There is a lot yet to be worked out.
The question is, what will this “working out” look like?
New York and the Twin Towers could provide a clue.
Construction on the World Trade Center began in 1968, but wasn’t delivered until 1971. The trouble was that when it did, New York barely needed a 60-story office building, let alone two 100-story towers. The city was struggling financially, people and businesses were leaving for the suburbs, and the office market was already oversupplied. Many at the time characterized the Twin Towers as “pure speculation.” As a result, office vacancies in Manhattan soared, tax revenues plummeted, and the city even flirted with bankruptcy.
Yet, as is so often the case with New York, this short-term pain planted the seeds for future gains. The glut in office supply and rise in commodity prices caused office development to grind to a halt in the 1970s. This meant that while buildings like the Twin Towers suffered short-term leasing and cash flow issues, their future potential value increased due to the evaporation in plans for future supply.
Longer term, by the early 1980’s Manhattan office space was so scarce that landlords were able to increase rental rates on new leases four-fold from $10 per square foot to $40 for prime space in Manhattan (NYT). Meanwhile, the beneficiaries from New York’s struggles in the 1970’s (e.g., Connecticut and New Jersey) saw a reversal in their fortunes as vacancies reached nearly 30%.
Eventually, by the mid-to-late 1980’s, the Twin Towers came to define lower Manhattan. Financially, they turned a healthy profit, generating more than $150 million on an annual basis. Then, as New York City boomed through the 1990’s, the towers proved to be absolutely essential given the fact that without them, there would not have been enough office space in Manhattan to satisfy the rising demand.
This pattern is nothing new. In fact, we have seen it unfold many, many times throughout history — canals in the late 1700s, railroads in the mid-1800s, fiber optic cables in the late 1900s, and single family homes in the 2000s. Today, it just happens to be venture-backed high growth technology businesses.
When the dust eventually settles, countless companies that took advantage of the ebullient markets of the past few years will end up being considered “pure speculation.” The same will likely be said for the thousands of companies that received venture funding, as well as the majority of crypto tokens that have been issued. Many companies will struggle to raise capital or become profitable. Some will go bankrupt, while others will be sold at distressed prices. Frauds will be exposed and charlatans will be identified (FTX is likely just the tip of the iceberg.) Either way, it won’t be pretty for many founders and their investors.
As painful as it main feel in the moment, this is natural. It is capitalism’s way of cleansing and resetting itself. It will inevitably separate the strong from the weak. The durable from the fads. The necessary from the “nice to have.”
The bad news? Much like the period following the dot.com collapse two decades ago, I wouldn’t be surprised if the high-growth part of the market continues to experience more pain from here. After all, even though the NASDAQ’s ~30% fall so far this year has been tough to bear, it is likely not finished. After all, it is worth remembering that it fell more than 30% back in 2000, only to fall another 33% in 2001 and 38% in 2002 for an all-in decline of more than 75%. This, coupled with the fact that the its price-to-sales ratio is still close to historic highs and that even Amazon fell from 50x sales to less than 1x sales during the dot.com bust, makes me think we still have more room to the downside.
The good news? Many of the companies that make it through to the other side of this difficult period will likely go on to define the technology landscape much like the Twin Towers went on to define Lower Manhattan. While their value in the near-term may be impaired, their longer term value should be materially higher in a few years given the fact that their competition will have decreased, while their pricing power will have increased.
If the Twin Towers are any guide, years from now the best of these technology companies might even become downright essential parts of the economy and those who can identify, buy, and hold these eventual winners will be handsomely rewarded.