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The Economy Looks Like It's Picking Up, Which Could Mean a Slowdown in Tech Investing

A healthy jobs report and housing stats might lead to a rise in interest rates. Translation: Less money to invest in hot startups.

Flickr / nikkytok

Think tech valuations are frothy now? Just wait for the summer.

Signs of an economic upswing may prompt a mad rush to invest in alluring startups before policy changes curb the flood of cash into the Valley.

Earlier this morning, promising national housing construction statistics landed, two weeks after a relatively strong monthly jobs report, with both indicators suggesting the economy is finally waking from its recession lull. Both are signs that the Federal Reserve, after keeping interest rates so low for so long, may soon hike them, likely in September.

That could mean the end of easy money in tech. Not only have several startups raised funds at dizzying valuations, but they have done so at a dizzying rate. Since 2013, 20 nascent companies have raised three sizable VC rounds in under 18 months, according to data from CB Insights.

The list includes everyone from anonymous social networks like Whisper — valued at $200 million — to grocery delivery service Instacart — valued at $2 billion. Other companies that have done fast successive funding rounds are behemoths like Uber and Airbnb, valued in the tens of billions.

It’s partly due to the way the venture industry raises cash. To prime the economy, the Fed has kept the effective borrowing rate near zero since 2009. That’s left investors with few places to park funds if they want steady returns. So they park in tech, where the returns can, periodically, be spectacular. Financiers at hedge funds and mutual funds are buying into private funding rounds at 150 percent the rate of five years ago, according to Bloomberg.

Fed Chairwoman Janet Yellen is expected to introduce a small interest rate increase in the fall. Savvy tech investors are prepared and may pump more into startups, should a rate hike curb the cash flow.

“This is the most telegraphed rate hike in history,” said Charles Sizemore, an analyst with Sizemore Capital Management. “If you’re doing anything that involves borrowing cheaply, you’re already pricing that in now.”

Three venture capital investors that Re/code spoke with don’t think the interest hike will hurt their ability to raise funds from limited partners. “Most institutional LPs are incredibly thoughtful about their asset allocation across classes. Venture capital is a relatively small slice of their asset pie,” said Satya Patel, an investor at seed-stage venture fund Homebrew. “So an increase in interest rates doesn’t seem likely to impact the overall amount of [venture capital] dollars in a noticeable way.”

Startup funding at rapid rates and sky-high valuations has brought comparisons to the dot-com bubble of 2000. That debate rages on. But there is some evidence that this time around, it’s different. For one, the biggest private companies, such as Uber and Airbnb, are unlike those from the first Internet boom since they actually show credible cash flows. One outsized metric VCs used to measure a startup’s value in the early bubble days was “burn rate,” or how fast it was spending money, despite not bringing any in.

Also, the damage from a potential bubble burst is limited largely to a set of private investors, unlike the last rush or the debt-laden housing crash. People aren’t taking out second mortgages to invest in Uber.

Still, macroeconomic conditions are similar. With investment yields suppressed, abundant credit is gravitating toward businesses with unproven payoffs. “Obviously, chasing risk is de rigueur,” said Jared Bernstein, an economist previously in the Obama administration.

He and other economists are worried about hints that the risk in tech is starting to spread. A handful of public pension and mutual fund investors — like Fidelity, BlackRock and Janus — have begun pouring money into the venture companies backing these astronomic startups. It’s a small portion of their overall portfolios, and the institutional investors are well hedged (BlackRock’s investment in Jawbone, a case in point). But it’s a troubling trend, reflective of the housing bubble, said Bernstein. “You’re beginning to invoke a potentially systemic problem — and we know how that movie ends.”

Yellen, for her part, has voiced concern about the lofty valuations of tech stocks. However, if she does move rates soon, she is expected to do so very gradually and cautiously.

Some tech observers see Yellen’s decision as a non-factor for rocketing startups. For one, other borrowing rates across the globe, particularly in Europe and China, remain low and show no signs of abrupt change. More critically, the market conditions are so unprecedented — rates have never been this low for this long — that the impact of changes is difficult to predict.

“The money is just going to keep flowing,” said Howard Lindzon, a hedge fund manager and angel investor. “It’s going to be a shock from something else. Nobody knows what it’s going to be.”

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