23 October 2019

Capitalism

The curse of SoftBank

The Japanese group’s investment fund poured a torrent of cash into Silicon Valley. But did it gamble blindly on a series of overpriced unicorns?

By Alexi Mostrous

For technology executives gathered at the Langham Hotel in Pasadena, California, last month, no expense was spared. Long-term residents of the five-star property were cleared out and a private chef brought in to cater to more than 100 CEOs invited to the three-day retreat by SoftBank, the giant Japanese conglomerate that has turned Silicon Valley on its head.

John Legend, the Grammy-award winning singer, performed while a four-legged robot from Boston Dynamics, a SoftBank-backed company, stalked the 23-acre gardens. Visitors were handed a goody bag containing expensive gifts including a “sustainable” water bottle worth nearly $100, according to one person who attended the private event.

John Legend performs on stage

While the luxury was ostentatious, the message from SoftBank’s charismatic founder, 62-year-old Masayoshi Son, was plain. The days of not caring about profits or good governance were over, he warned the executives, who had all received backing from the bank’s huge venture capital fund. Now it was time to start making some money.

The speech was a turning point in a two-year journey for Mr Son, who is known by everyone as Masa. In 2017 he launched SoftBank’s Vision Fund with almost $100 billion in funds, including a $45 billion investment from Saudi Arabia. At a stroke, Son had more cash to spend on tech start ups than the five biggest venture capital firms in Silicon Valley combined.

Suddenly, founders who had to scrabble around for $5 million were handed cheques worth 20 times that amount. The minimum cheques size the Vision Fund would sign over? They started at $100 million.

SoftBank was like a kid turning up to a frat party with a truck full of beer while everyone else brought six packs,” David Gibson, Astris Advisory Japan chief investment advisor, said. “It changed the game.”

In less than three years, the Vision Fund had invested almost $80 billion into 83 technology firms, pouring billions into world-famous “unicorns” such as Slack, Uber and WeWork as well as more random outfits such as Wag, an on-demand dog-walking app that received $300 million in 2018.

Masayoshi Son, chairman and chief executive officer of SoftBank at a news conference in Tokyo in August 2019

The theory behind the fund was simple. While other venture capital firms put a few million each into hundreds of early stage technology companies, hoping that one or two would go supersonic, Son would focus on making massive investments into already-established firms. Providing such companies with billions of dollars would turbocharge their growth even at the expense of profits. The aim was to grow so big that everyone else was knocked out of contention. In Silicon Valley, the tactic is known as “blitzskaling”.

“The important thing is to lead, to dominate market share,” Rajeev Misra, a former Deutsche executive who runs the fund alongside Son, said this year. “That’s everything. You have to grow and grow fast.”

The Vision Fund was so flush with cash that several founders had to be persuaded to take more money than they had asked for. “Half of them we have to convince to take more,” Misra, 57, told a New York conference last year. “We work with them to come up with a new business plan that’s global, that’s more aggressive, because we believe that winner takes all.”

What’s new here?

  • Expensive water bottles, robots and John Legend: what went down inside Softbank’s lavish CEO-fest
  • Rajeev Misra, the head of Softbank’s free-spending tech fund, was part of a Deutsche “CDO machine” which contributed to the financial crisis
  • WeWork was so aggressive in its London expansion that it parked branded food vans outside rivals’ headquarters
  • Steve Blank, the Silicon Valley entrepreneur, accuses venture capital firms of running “legal Ponzi schemes”
  • Big funds are staying away from investing in Vision Fund II, leaving SoftBank the sole investor

To implement the blitzskaling, Misra assembled a group of former Deutsche bankers to work with him at the Vision Fund’s headquarters: an opulent townhouse in London’s Mayfair district, almost 10,000km away from SoftBank’s headquarters in Japan. Their financial wizardry was evident from the start. In a highly unusual arrangement, instead of being asked for a simple equity investment, Vision Fund investors were able to buy so-called preferred shares that paid out a guaranteed 7% return a year, just like a loan.

Rajeev Misra, CEO, SoftBank Investment Advisers in April 2019

The promise of regular payouts helped Misra and Son raise more money in less time than anyone in the history of venture capital. Saudi Arabia, for example, holds more than half of its $45 billion through preferred shares. The downside for SoftBank is that it must pay out as much as $2.8 billion a year in coupons whatever happens to the fund, a risky move given the unpredictability of its underlying investments.

Misra, who smokes an electronic cigarette, wears bangles and sometimes greets visitors barefoot, is no stranger to risk. As head of credit trading at Deutsche in the years before the financial crisis, he helped transform the bank from a staid German lender to a financial powerhouse willing to use complex financial instruments such as credit derivatives to make huge bets.

During that period, the Indian-educated banker was the boss of Greg Lippmann, a star trader who made billions of dollars for Deutsche by “shorting” a type of derivative called a CDO. In the middle of the naughties, Lippmann realised that the instruments, at that time sold by investment banks on an industrial scale, could collapse if the US housing market tanked (Ryan Gosling played Lippmann in The Big Short).

Steve Carell, Ryan Gosling, Hamish Linklater, Jeremy Strong, Rafe Spall, and Jeffry Griffin in The Big Short (2015)

But Misra and other senior Deutsche executives were uncomfortable with Lippmann’s trades, testimony suggests. When Lippmann first wanted to short CDOs in 2005, Misra only “reluctantly” gave permission, according to a US subcommittee investigating the financial crisis. “Mr Misra believed mortgage related securities would continue to increase in value over time,” Lippmann told them. At that time other parts of the bank were aggressively selling CDOs, making huge fees even though Lippmann described some of those securities as “crap” and “pigs”.

Even by 2007, when the prices of CDOs were beginning to fall, and Lippmann’s trades were making money, Misra suggested that his star trader cash in his chips. “He thought prices were in a short term dip and the profits might disappear later on,” Lippmann said. He persuaded Misra to keep the bets open. The tactic worked. Five months later, the major credit agencies downgraded the securities and their value plummeted.

Lippmann cashed in, making about $1.5 billion – the largest profit obtained from a single position in Deutsche’s history. Overall, however, Deutsche made losses of about $4.5 billion thanks to separate bets backing mortgage related holdings.

In a 650-page report, the committee found that the bank was part of a “CDO machine” which bankers had little incentive to stop since no-one wanted to give up fees of between $5 – $10m per CDO product. “Reduced CDO activity would have led to less income for structured finance units and smaller bonuses for executives,” the committee stated.

Deutsche itself was “a cautionary tale about how complex structured finance products gain advocates within an organization committed to pushing the products through the pipeline to maintain revenues and jobs, regardless of the financial risks or possible impact on the marketplace”.  No wrongdoing has been alleged against Misra. He declined to comment for this piece.

Some in the technology industry now see parallels with the Vision Fund operation.

“Is the Vision Fund Deutsche all over again?” one financial analyst told me. “Masa is ultimately in control and the companies are supposedly subject to independent valuations. But there are parallels.”

Pepper robots by SoftBank Robotics during CES 2018 in Las Vegas

 

Some staff have questioned the fund’s commitment to transparency and compliance. There is little disclosure on how its private investments are valued, or how much cash the firms are burning through. One employee told the FT last year the atmosphere was “like the Wild West”, with processes set up for “maximum speed”. Several employees are understood to remain concerned today.

Initially, however, the Vision Fund’s strategy seemed to pay off. As of June 30, the fund earned $6.4 billion in gains, of which $2.5 billion went to pay back investors and $1.6 billion went to make coupon payments, according to WSJ calculations. Son boasted that 16 companies in the fund would go public by March 2021, generating even more cash.

Last month, however, one company threw this entire strategy into doubt.

As Son was addressing executives in Pasadena, he knew that WeWork was unravelling, and fast. He had invested in the hipster co-working company after meeting its founder, Adam Neummann, a 40-year-old Israeli Navy veteran, for less than 30 minutes. SoftBank and the Vision Fund eventually put almost $11 billion into We, as it was recently rebranded, acquiring nearly a third of the stock and a seat on its board.

Last month, Son and Neumann had planned to cash out by offering WeWork’s shares to the public in a process called an Initial Public Offering (IPO). The firm had been valued at a $47 billion following its latest fundraising round in February. If public investors bought the shares at that price, SoftBank and Neumann would have made billions in profits.

A WeWork office in San Francisco. Days after withdrawing its registration for an initial public offering, WeWork also warned employees that the company could be set to lay off nearly 2,000 people, about 16 percent of its workforce

But instead WeWork imploded. The investing public refused to pay anything close to $47bn for a loss-making real-estate company run by a floppy-haired founder famous for smoking weed, flying on private jets and drinking $149-a-bottle Don Julio Tequila.

They also baulked at a raft of corporate governance failures exposed in a prospectus filed by WeWork as part of its IPO process.

WeWork’s 359-page S-1 form, filed with the SEC on 14 August, began with an epigram. “We dedicate this to the energy of we – greater than any one of us, but inside all of us.” When investors dug deeper however, even greater horrors emerged.

Neummann owned an interest in four buildings that WeWork leased. He’d accepted personal loans from the company at favourable rates and had a $500 million line of credit secured by his shares. He’d even bought the trademark to the “We” name and then been paid $5.9 million a year by WeWork to licence it. Neumman also had near total control. Even if he were to die, his wife Rebekah, a cousin of Goop founder and actress Gywenneth Paltrow and a devout follower of Kabbalah, had the power to name a new CEO.

Adam Neumann and Rebekah Neumann attend the 2018 Time 100 Gala, April 2018 in New York City

The S-1 also raised serious questions about WeWork’s business model, which is based on leasing large spaces, transforming them and renting them out to individuals and companies at a higher price. Last year it lost $1.9 billion on revenues of $1.8 billion. In the US, the company signs leases for 15 years, compared to an average 15-month commitment from its members, who can terminate with just one month’s notice.

In the UK, one housing industry executive who has met with Neumann, told me that WeWork would undercut competitors to fill its buildings at the same time as engaging in aggressive practices such as parking WeWork-branded food trucks outside rivals’ offices. “WeWork would offer nearly half off that for a big account,” the executive said. “At that rate they’re not making any money, even if they’re full.”

A WeWork spokesperson said: “London continues to be one of our most successful markets, where, as our most recent Companies House filings show, the three buildings in central London that reported full accounts each delivered a profit of more than £1m in 2018.”

Within six weeks of the S-1 filing, Neumann had been forced out as chief executive – a move orchestrated by SoftBank and Son in the days after the Pasadena retreat. It wasn’t enough. On Sept 30, WeWork announced it was postponing the IPO.

Fast forward three weeks, and WeWork’s valuation now stands at just $8 billion. The company is on the verge of accepting a bailout offer from SoftBank which will value WeWork at 83% less than the $47 billion valuation the company received only 10 months ago. As part of the package, which is expected to be announced this week, SoftBank will emerge with between 60 – 80 percent of WeWork’s equity, the FT reported. Son will pay Neumann about $200 million to leave the board of directors and give up his voting shares. Meanwhile, thousands of ordinary WeWork employees are expected to be sacked.

Instead of WeWork’s IPO validating Son’s reputation as a master investor, suddenly the man who wants to be known as “the crazy guy who bet on the future” was facing uncomfortable questions about why SoftBank had failed to tackle the company’s problems before the IPO was announced.

Masayoshi Son passes a ball to a robot called Pepper

“WeWork is a perfect case study of governance gone wrong,” Claudia Zeisberger, professor of entrepreneurship at INSEAD, told me. “Anything in the S1 should not have been a surprise to board members. I don’t know, but I assume that SoftBank was cognisant of those facts and either consciously decided not to tackle them or didn’t think they were a major issue.”

Most successful start-ups go through several rounds of funding, from early stage seed funding right up to late stage financing when a business model has been proven and revenue established. Each fundraising round typically has a lead investor that sets the price and terms, puts in a large proportion of the money, and potentially agrees to sit on the board.

Professor Zeisberger said that in most cases, the lead investor for an early fundraising round would not set the price in subsequent rounds.

“In WeWork’s case, what needs to be highlighted is that the last three rounds [of fundraising] were all led by SoftBank,” she said. “That’s highly unusual. While early investors may continue in subsequent rounds, they usually come in after the pricing has been set by a new investor with a fresh set of eyes. Without a new investor to do due diligence and arrive at an objective price, the later WeWork rounds were not arms’ length transactions.”

The Vision Fund declined to comment. An investor briefing from February 2019 states that all investments are independently valued by a “renowned valuation specialist”. The fund is compliant with six different regulatory bodies, the briefing discloses. Mr Misra has previously said the Vision Fund looked at more than 2,000 investment opportunities but invested in just 80 of them, and had a “ very rigorous investment process”.

Analysts estimate that the Vision Fund’s write-down on WeWork could amount to as much as $5.93 billion. More worryingly for SoftBank, many are questioning the valuations of other Vision Fund companies. Market sentiment is turning against Silicon Valley’s famous unicorns. Could WeWork be the canary in the coalmine: an early warning that many tech companies might not be worth anything close to their valuations?

“The business story of the month is WeWork’s meltdown,” Professor Scott Galloway, a professor of marketing at the New York University Stern School of Business, wrote on Twitter. “The bigger story will be SoftBank’s Vision Funds impairment. The 2020 story will be a 50%+ decline in the value of privately traded unicorns. The world is not as impressed with Silicon Valley as Silicon Valley is with itself.”

Of the Vision Fund backed unicorns to have gone public, the most famous – Uber and Slack – are both trading at significantly lower prices to when they were listed earlier this year.

Its private portfolio are also under scrutiny. Didi Chuxing, a Chinese-ride hailing giant with 550 million users which attracted an $11 billion Vision Fund investment, lost 2% of every fare paid in 2018, according to its chief executive Chen Xi. An initial public offering was called off after two women were murdered in Didi cars last year, raising concerns about safety. The Information, a Silicon-Valley focused digital media outlet, reported last week that Didi’s shareholders were trying to sell their stakes on the secondary market at a significant discount to the company’s most recent $57 billion valuation.

Cars of Didi Chuxing park outside Dalian International Conference Center, Liaoning Province of China

Oyo, an Indian hotel startup which has grown into the world’s third largest hotel chain, has seen its value increase from about $300 million since 2015, when SoftBank first put in $100 million, to $10 billion today. In 2017, SoftBank sold its stake in Oyo to the Vision Fund for double the price it paid. Since then either SoftBank or the Vision Fund have led increasingly large financing rounds, pushing the startup’s value to around $10 billion – about 30 times higher than when SoftBank first invested.

A third Vision Fund company causing concern in some quarters is Wag, the dog-walking app once described as “Uber for Pets”. Wag is reportedly losing ground to its main US rival, Rover, despite the $300 million. Earlier this year, Wag laid off 38 employees in Los Angeles and plans to lay off another 54, according to a company regulatory filing.

Vision Fund proponents point out that it has recorded significant wins, including a $1.5 billion windfall from the sale of its stake in Flipkart, an Indian e-commerce company and the sale of its Nvidia shares for $3.6 billion in February.

Whatever the reality, the WeWork debacle is highly unhelpful to Son, who has spent years cultivating the image of a far-sighted and hard-nosed investor. In 1999, he famously placed an early bet on Alibaba, the Chinese technology giant, turning a $20 million investment into a $108 billion holding. The win added credibility to Son’s boast last year that he had a 300-year plan to turn SoftBank into a leader in artificial intelligence and robotics.

In 2016, he burnished his reputation further, after meeting with then President-elect Donald Trump to pledge a $50 billion investment in the United States, creating 50,000 jobs. “This is great,” the mogul told reporters at Trump Tower. “The US will become great again’.” Critics pointed out that the money was already projected to come from the Vision Fund, and which was always expected to invest heavily in the US.

President-elect Donald Trump walks out with SoftBank Group Corp founder Masayoshi Son who had visited him at Trump Tower in New York in December 2016

Son had hoped by now to begin investing a new massive technology fund. Vision Fund II had been promised $108 billion from companies such as Microsoft and various Japanese banks, but so far SoftBank is the only confirmed investor, with a commitment of $38 billion. Ibrahim Ajami, the head of Abu Dhabi’s Mubadala Investment Co, told a Bloomberg conference this month that the state had not yet decided whether to participate.

Saudi Arabia, already reeling from a string of embarrassments and scandals, including the assassination of Jamal Kashoggi and the botched IPO of Aramco, has reportedly got cold feet. Discontent between the Kingdom’s public investment fund (PIF) and Son bubbled to the surface this month, with sources telling the WSJ that PIF was concerned about SoftBank’s practice of investing in companies and later transferring the stakes to the Vision Fund — as happened with Oyo.

Son sounded a note of contrition, telling Nikkei Business Magazine that he was “embarrassed and impatient” by SoftBank’s growth record. CNBC reported that Son was planning to take a “more active” role in selecting investments for Vision Fund 2, hinting that SoftBank’s elder statesman might be less than happy with the performance of Misra and his Deutsche collective. A Vision Fund spokesman said that any shift referred to Son “working more closely with founders to drive performance” and did not imply any “dissatisfaction with the Fund, its strategy or management.”

To help finance its contribution, SoftBank is reportedly pressuring its own executives to contribute about $15 billion to Vision Fund II by borrowing more than 10 times their salary. Several executives told the FT that it was “expected” that they would take out the loans, which will be offered through a UK-based subsidiary – set up by Rajeev Misra. A Vision Fund spokesman said the scheme was “designed to ensure strong alignment of interests between key staff and our limited partners”.

The WeWork debacle cannot not be separated from an explosion of “growth capital” which has upended the tech industry in the last few years, analysts said. Venture capital firms are raising money faster than at any point since 1998, figures show, with much of the growth concentrated in so-called “mega rounds” that are increasingly taking place when the start-up is at a late-stage and already well established.

Whereas a few years ago a successful start up might IPO after six years, such companies are now typically offered to the public markets after 10-12 years, according to analyst Mark Suster. The consequence is that the value generated by the start-ups is increasingly funnelled to venture capital firms rather than to public-market investors.

Steve Blank, the Silicon Valley entrepreneur who launched the so-called Lean Startup movement, described Silicon Valley as “unrecognisable” from a generation ago. Venture capital firms were running legal “Ponzi schemes”, he said, where early stage investors were paid by later investors who then looked to others to pay them. “At some point the music is going to stop,” he warned.

“There were zero unicorns in 2008,” Mr Blank said, referring to technology start-ups valued at more than $1billion. “Now we’ve got 300, 500, I don’t even keep score anymore. The whole notion of growth capital and keep companies private longer and taking the profit was driven by SoftBank funds.

“In the 20th century we invested in things that made society better. VCs had some kind of interest in products and services which were aligned with hardware or lifesciences. The explosion of software and social media said that’s nice, but look at the multiples. Now there are no rules.”

Mr Blank said WeWork was either “a bump in the road or the beginning of the end.” One’s going to be right, he said. The same may be true for the SoftBank Vision Fund.

All photographs Getty Images, Paramount Pictures

This story was first published on Wednesday 23 October and amended on Thursday 24 October. The earlier version stated that Masayoshi Son was “embarrassed and impatient” by the Vision Fund’s performance. In fact he was referring to SoftBank’s own growth when compared to US and Chinese tech giants. 

 

Further reading

– If you fancy a 650-page forensic dissection of the financial crisis, look no further than this surprisingly accessible Senate report (Deutsche makes a special appearance).

– “Dedicated to the energy of We”. Here is the full text of WeWork’s infamous IPO prospectus form that plunged the firm into crisis

A list of all 407 unicorn start-up companies, from Bytedance to Monzo, plus their valuations and owners: here

One of the most influential business books ever published: Eric Reis’s The Lean Startup (based in part on the writings of Steve Blank)