Opus 10: The New Paradigm of Capital Part 1

Along with Impatience, Measurement, and Philosophical warfare

“In reality, the laborer belongs to capital before he has sold himself to capital. His economic bondage is both brought about and concealed by the periodic sale of himself, by his change of masters, and by the oscillation in the market price of labor power. Capitalist production, therefore, under its aspect of a continuous connected process, of a process of reproduction, produces not only commodities, not only surplus value, but it also produces and reproduces the capitalist relation; on the one side the capitalist, on the other the wage-laborer” - Karl Marx, Capital

A close friend recently reminded me that everything is cyclical save for the rare revolutions and paradigm shifts, as Thomas Kuhn writes. This cyclicality was touched on in the previous Opus on the bundle, unbundle, and rebundle cycle happening now within media. I believe we are on the brink of one of these paradigm shifts within capital. Capital was once a scarce good, like all other commodities. It is quickly transforming into a limitless technology that is at the behest of monetary and governmental bodies. In this Opus, we will explore how we got here, its effects, and what it may mean moving forward.

Capital Then and Capital Now

Karl Marx wrote his ubiquitous Capital in 1867. It is the single most cited publication within social / economic science and defined the capital vs. labor relationship. That relationship has changed throughout history, and today is beginning to enter a new paradigm. As one pages through Marx’s pages of analysis about the capital vs. laborer relationship, it is mystifying how Marx, a man that understood the relationship so intimately, still got it all wrong in his recommendation of a communist system over a capitalist one. That discussion, though, is for another time.

For the vast majority of our history, we have operated under a fundamental assumption: scarcity. Marx’s Capital's opening pages outline the basis for all production in the Commodity, a scarce good that in Marx’s eyes, “are merely definite quantities of congealed labor-time.” Labor was naturally scarce as the human worker could physically only work for a set amount of time, unlike today, where automation has augmented physical labor hours. Tools and technology have driven incredible gains in productivity, but we are seemingly approaching the frontier.

Capital was never created out of thin air as it is today but rather fought for and dug out of the ground. It was zero-sum by nature but compounded when applied to production. Capital required labor to be created and labor required capital to operate.

The experiment all modern economies have been running since 1971 has completely redefined this relationship as capital has become a limitless good. Capital no longer requires work and is clearly not driven by the market but rather by a select handful of individuals, the central bankers, that have the unilateral power to create or destroy capital via money creation and interest rates. And boy, have they created a whole bunch of capital: 35% of all US Dollars that exist have been created in the last 300 days due to the Federal Reserve liquidity programs. Never before in history, even after adjusting for population, has there ever been so much money that is nearly free in nominal terms and actually negative-yielding in real terms after adjusting for inflation.

Returning to Marx, the argument between capitalist and communist systems revolves around a single idea: capital allocation. Should the market, and therefore the individual, have discretion over capital allocation, or should the government? We have entered a new era of capital. As Peter Thiel warns: “the time for Marxism comes when interest rates are zero” - if the market has no good uses for capital any more then it has, by definition, failed to allocate capital effectively. This is not a historical cycle by any account - it is capital’s new paradigm.

Capital Distortions

We see this new era of capital and its effects everywhere we look. Over one-third of all the US Dollars to ever exist were created in 2020. This is by no account a cyclical event. This explosion of capital has permeated its way through every market: credit, both sovereign and corporate, equities, currency, and commodities. Distortions are tangible too - one example being the bike and scooter companies like Bird that have created graveyards of their assets shown below:

Looking at the intangible, currently, ~20% of all credit is nominally negative-yielding with a far greater unknown amount negative-yielding in real terms. In other words, countries and corporations are getting paid to lend money out and the lenders are seemingly happy to pay. As touched on in Opus 7, this has been a long term “suprasecular” trend as global growth rates continue to decline. But, the monetary bodies have worsened the trend beyond anyone’s expectations (note the below is in nominal terms):

This phenomenon within the credit world has credit downstream effects within their sibling equity markets. Financialization has eaten the world and equity values are at all-time highs relative to the fundamental output of economies - the “Buffet Indicator” as many call it. The decrease in credit yields and inflation implies that growth is approaching all-time lows, but equity levels would suggest otherwise as they are at all-time highs on a fundamental basis, implying growth going forward will be high:

Looking at my world, private market growth capital is outpacing its demand base of comapnies like never before. Since the financial crisis, the amount of VC dollars raised per new business started in North America has doubled. Yes, a tiny minority of new companies receive venture funding in the grand scheme. Still, the asset class is starting to approach systematically important levels (rough calculations show this number spiking to $70,000 in 2020):

This outpacing of new venture capital (yes, I understand the hypocrisy of this stance considering I work at a brand new growth equity fund) has allowed entrepreneurs to focus on narratives and stories rather than fundamentals and legitimate businesses - it also pushed creativity into the innovative rather than the inventive as touched on in Opus 4:

A common statement within S1 filings as of late is the fear of never becoming profitable. Companies and their management are admitting that their businesses very well may never work fundamentally. One recent example is DoorDash, the restaurant delivery platform.

DoorDash may literally never make money ever again. Let me rephrase; I don’t think DoorDash will ever cash flow beyond the brief blip earlier this year. For the nine months ending September 2020, the company had a negative (8%) operating margin during the best period ever for food delivery. On a more granular basis, they could eke out a 3% operating income from April to June, a period in which marketing shrank 25% of revenue and G&A sat at 13%. Please note, all of these efficiencies were lost from July to September as the country opened up slightly.

Our Finance 101 professors would be upset with that analysis since we know that value is a function of all future cash flows, not the past or present. With that in mind, let’s look to the future. Time for a quick rant.

If you believe their market share claims of 50% market share with $32B in annualized GMV in Q3 2020, this implies a $64B annualized GMV market opportunity right now in North American food delivery. Structurally, the company right now cannot make more than 15% GM on GMV as driver COGS, restaurant royalties, and other variable costs have become asymptotic on their lower bound. Their best markets are operating at 8.2% GM on GMV. Yes, once there are autonomous vehicles, fully automated restaurants with no dine-in costs, and their dispatch algos are fully optimized I am sure this number will push towards 20+%. So far, there are few developments to support those changes.

Let's assume they basically stop marketing, and they fire most of their workforce and other costs. Fully optimized, DoorDash prints 10% operating margin off of GMV - in the 3 months of Covid lockdown, they were able to do 3% operating income with some pretty funny adjustments in the best food delivery period in history.

Finally, let’s assume in the next 5 years that the food delivery market will double to $120B in North America and DoorDash moves to a 75% market share. That would imply $9B in operating profit in 2025. Discount rates are basically nothing today, with nominal rates at nearly zero and real rates teetering on the negative, but let’s use a conservative 5% annual discount — ~$7B in operating profit in today’s dollars.

With those assumptions, that would imply an 8.5x P/E. A steal! The music certainly needs to speed up to make today seem even remotely rational.

Moving from the public markets to the private paints an equally scary picture.

Views From My Seat

From my tiny island as a private growth equity investor, things are looking strange. Capital allocators have pushed it into high gear, and investments are now being made faster, with less diligence, and are bigger than ever. A dangerous recipe that rarely results in positive outcomes. This is clearly a hypocritical seat to be speaking from since I am not helping solve the capital vs. entrepreneur imbalance. But, I hope these thoughts still effectively show my concern.

The velocity of capital allocation is faster than I have ever seen, and when I speak to my peers who have been doing this for much longer than I, faster than they have ever witnessed in their investment careers. Prudent allocation takes time. The rise of the “founder-friendly” fundraising process has taken a dark turn for the worse as investors trade understanding a company for the speed of investment as a tool to win deals. This behavior generally works out if the companies continue to perform and investors are hands-off. But, when things go south and investors become involved they start to discover things they never knew about nor had the chance to understand in their initial discussions with entrepreneurs. It is scary to witness founders prefer the speed and unintrusive process over a slightly more involved and rigorous one that allows their investors to actually understand their business. Ignorance is bliss until it is not.

A saying as of late that scares me the most in the growth equity world is, “the company should raise more money as it allows the company to take a big swing.” Today, it is the mantra for mid to late-stage private market investors as they use capital, not technology, product, teams, or strategy, as the moat. This has created distortions beyond our wildest imaginations. Today's largest companies were far more efficient: Google raised $32M before IPO’ing with a $23B valuation, Amazon raised $8M before their IPO at $1.2B, and there are dozens of other examples from that era. Look at DoorDash, Airbnb, Uber, etc. for very different stories. Bessemer touched on this point briefly in their recent piece and I could not disagree more on the opening line:

Contrary to popular belief, starting a business has never been harder. Although startup culture sometimes feels more like pop culture in mainstream media, the number of new businesses formed each year is decreasing. Over the past 30 years, new business creation has declined almost 50%. As small businesses dwindle, large enterprises capture market share. This trend has only become more severe in the wake of the pandemic as the data reveals a disproportionate decline in survival rates and job opportunities at small businesses.

Most start-ups today exist to make starting and scaling another company easier. Stripe Atlas lets you incorporate and set up billing in minutes. The endless marketing tools allow you to capture customers quickly and efficiently, and the endless productivity apps make sure you can do this all at superhuman levels. It is paradoxical that growth investors today despise asset and capital intensive businesses but yet will gladly load them with capital. Scaling used to be naturally harder as “X as a Service” was not commonplace for all of a company’s different functions. Servers, payment rails, compliance, product development, etc., were not all pre-packaged and ready to scale, but yet, those companies still were more capital efficient years ago. Businesses actually had balance sheets and had ownership of their productive assets rather than renting it from someone else, something that is sacrilegious today - as Alex Danco says, “Everything is great, but nothing is ours.”

The so-called “creator economy” was supposed to fix these issues for the individual in addition to the company. Individual inequality follows the same distribution as corporate economic inequality. Companies like Patreon, Substack, Twitch, etc. set out with a mission to allow anyone to become successful. So far, these micro-economies have worse inequality than most macro-economies when you look under the hood at income distribution across the creators. Funny enough, one of the strategies to combat this poorly distributed income seems to be UBI, the exact discussion being had at the macro level for entire economies.

Markets have become binary as mid-market exit valuations no longer are enough to clear liquidation preferences at larger and larger funds. Entrepreneurs no longer decide their company’s fate as board and shareholder governance is taken over by investors with mega-funds that must have $1B+ outcomes to exist. Binary outcomes fuel an individual company’s performance both within the market — it is a winner take all or you don’t exist— and the financial outcome of the fund is either a fund returner or a zero.

It is a frightening sight across the board. Of course, something must happen before the music stops because the status quo will happily continue to operate. That something was Icelandic banks 12 years ago, but what will it be today? This past week, two upcoming IPOs (Affirm and Roblox) withdrew their listings as they feared mispricings and losing out on potential capital. While a N=2 is nowhere near significant enough to make a bet, it certainly shows the insanity of today.

Quick Tangent: Capital vs. Laborer; Platform vs. Entrepreneur

If the new paradigm of capital has completely changed its relationship with labor and production, where do the new relationships exist for the entrepreneur?

Li Jin has an interesting perspective here. The individual creator is now the laborer and instead of capital being the constraint, platforms and their control are. The factory owner used to control the distribution of his goods. As Li says, “Not everyone can own a factory, but everyone can start a blog, launch an e-comm store, etc.” Capital was an inhibiting factor for anyone as fixed costs in the pre-software world were so high and scarce that the capital owner was king of all distribution and production allocation. Today, you can start producing with a computer and an internet connection.

But, the power of capital and distribution has fallen to the platform's power - Apple’s App Store, Google’s Search Page, Amazon’s Marketplace, and so on. Capital concentration has switched to distribution concentration and it is as concentrated as capital ever was.

The Technologist’s Take: This Was Inevitable

An interesting rebuttal to the economist’s worry about all of the above is one presented by the technologist. As Balaji writes, “the purpose of all technology is to reduce scarcity.” Money and capital is nothing but another form of technology. Throughout time, every single innovation and invention has worked towards making the scarce more abundant, accessible, and affordable. But, time, or immortality, and money are the most scarce goods we have yet to create effective technology to tackle. I am not nearly qualified to speak to the scarcity of time - Balaji provides helpful links in the article.

Looking at capital, what if the natural endstate for money is one of a technological view? What if the new paradigm of capital, one of unlimited money, is not a subjectively negative development but rather an inexorable outcome and technology making its way into the monetary world? Rather than pre-existing physical or biological constraints, this technology was blocked by cultural and academic constraints in thinking.

Many will be quick to point out the historical failures when it comes to endless money: post-WWI Germany and the Deutschmark, Post-Soviet Yugoslavia, Zimbabwe, Venezuela, etc. Crypto evangelists and Milton Friedman supporters (two groups I place myself in) will throw up their arms and defend the sacrosanctity of scarce money but this technology would be antithetical to all before it. All technology has had failed iterations before its final success story. Infrastructure must exist, markets must be large enough, and cultures must accept any technology. This is no different in the realm of money.

A similar corollary within technology is that technology shifts luxury goods into common ones. Limitless capital has been a luxury enjoyed by the asset owning classes for over a decade now with the quantitative easing programs since the financial crisis. Under the veil of “market liquidity”, these efforts provided the capital class trillions in additional wealth - a luxury very few others ever got to see beyond their 401K’s growing slightly. With the Covid shock, governments had to democratize this luxurious access to capital for the common man via stimulus checks and direct payments. While some pundits rejoiced and others showed caution, the middle-class citizen had relief. Economists can try and dismiss that relief on the basis of economic poor practices, but people have had their first taste of this new world. The new $900B stimulus bill is being released as I write this and I expect it will have many, potentially limitless, follow ons.

Free capital is an addictive drug that is hard to withdraw from. We already witnessed this addiction to the new paradigm of capital within the markets and the markets are currently overdosing on this drug today. The American common man’s first taste of this drug, the $1,200 Covid stimulus, will be the first dosage. The coupling of the monetary and fiscal bodies creates a superdrug. Some will point to Modern Monetary Theory (MMT) as the first glimpse of this new reality - I think it goes beyond the economic and dips into the cultural arena. Capital is being redefined.

Returning to the Thiel quote, “the time for Marxism will come when interest rates are zero” - I think we are approaching this singularity. As it stands today, free markets (although those don’t actually exist) have categorically failed to allocate capital. People point to the financial markets with confusion as to how they can be trading where they are even as the economic and public health crisis is still very real. Hopefully, even as Covid becomes a memory, this new era of capital and government’s involvement will continue to strengthen. We have entered capital’s new paradigm.

Homework Reading

Impatience: a deep cause of Western failure in handling the pandemic?

Kafka in his Diaries writes that there are two cardinal vices from which all others vices derive: impatience and laziness. But since laziness springs from impatience, he writes, there is really only one: impatience. Perhaps it is time to look at it.

Measurement not Prediction

Expirations force a convergence of truth.

How To Wage Philosophical Warfare

Postmodern thinking radicalizes people, not because it makes them go crazy, but because it makes knowledge appear to be arbitrary and political. Postmodernism is the reason why everything seems to be becoming politicized these days, even if it shouldn’t be. It’s why academic journals rescind scientific research because some groups may find it offensive. It’s why corporations have begun to adopt slogans that have absolutely nothing to do with their products and please only a tiny fraction of their customers. It’s why politicians who lost elections claim the vote was fraudulent without any evidence. It’s why public figures unironically claim they have “alternative facts” as if the term wasn’t an oxymoron.

Today’s Music

I have been enjoying several contemporary minimalist composers recently:

Johannes Bornlof - Wolfpack

Ludovico Einaudi - Twice Solo

Sten Erland Hermundstad - Dreams

Piano Melancolia - Blue Mint