Fallacies of past performance; learnings from SoftBank

If one puts an infinite number of monkeys in front of (strongly built) typewriters and lets them clap away, writes Nassim Taleb in Fooled by Randomness, there is a certainty that one of them would come out with an exact version of the Iliad. That monkey then shows up at your door with his impressive past performance, and now that we have found that hero among monkeys, would any reader invest his life’s savings on a bet that the monkey would write the next, Taleb goes on to ask.

Sounds ludicrous, right? Who in their right mind would do that? What a rhetorical question, you may think. It may not sound so intuitive once you finish reading this article. But let me just start with a caveat: Although I refer to Taleb’s “monkeys on typewriters” analogy, I mean no disrespect to the characters discussed in this article. Like Taleb, I use it to make a point –

i.e., take the argument to its logical extreme (or as they say “reductio ad absurdum”) to convey the extent of absurdity. With that out of the way, let us get to the story.

“He had no business plan, zero revenue. But his eyes were very strong. I could tell from the way he talked, he has charisma, he has leadership” said Masayoshi Son, CEO at SoftBank on David Rubenstein’s show about Jack Ma – Son invested $20 million in Alibaba in the year 2000. That stake was worth $60 billion by the time Alibaba went public in 2014, and over $150 billion at its peak.

What an incredible decision, and what a phenomenal track record! In 2016, SoftBank acquired Arm, the British chipmaker whose technology powers Apple’s iPhone (and nearly all smartphones) for $32 billion. But these investments were for SoftBank Group (SBG) shareholders; why not let everyone else participate too? So, in 2017, SoftBank creates its first SoftBank Vision Fund (SVF1) with a whopping $100 billion in committed capital. Saudi Arabia’s sovereign wealth fund (SWF) contributed $45 billion and Emirati SWF $15 billion. In June 2019 results, SVF reported over $20 billion in investment gains. The going was so good that SoftBank announced the launch of SVF2, hoping to collect over another $108 billion. Saudi SWF didn’t participate in the

second fund but it still ended up with a total commitment of $56 billion.

When SoftBank reported its September 2021 results, the going could not have been better. SBG was at a high rejoicing Nvidia’s announced acquisition of Arm at a valuation of a whopping $80 billion (cost $32 billion), and the two SVFs were reporting a combined investment gain of over $56 billion. Earlier in the year, the market cap of SoftBank Group had reached $175 billion, up from just over $70 billion at the time of Covid lows. What could go wrong, right? Well, for one, the SoftBank group had operated in only one cycle so far, that of an extremely loose monetary policy. It was about to find out what happens when the tide turns (when interest rates rise, and liquidity dries out).

In the exhibit below, you will find two hypothetical companies. Company B is a traditional company that has been generating regular cash flows and keeps growing. Company A is a new-age tech business that incurs negative cash flows for the first few years, and generates large cash flows a few years out. The total cash flows of both companies are the same, but the timing is different, which results in hugely different outcomes in a rising interest rate scenario. At a 1% risk-free rate, the value of both businesses is similar; at a 4% risk-free rate, Company A is bankrupt!

How large was the impact on SVF?

Over $50 billion! Between September 2021 and 2022, the total acquisition cost rose from $120 billion to $144 billion, but the cumulative gains fell from over $56 billion to just about $1 billion. SVF2 and LatAm funds are now reporting investment losses since inception.

And it is not just third-party investments. SoftBank Group’s own investment in SVF is now at a loss; from over $30 billion in gains in September 2021, its combined investments in September 2022 (at $83 billion) stand higher than the total value now! (And total value includes management fees).

In a hit-and-run accident, we need to segregate the two outcomes. While the “hit” part could have been an accident (say one came running on the road without announcement), the “run” part is always a matter of choice. The investment strategy at SVF could be a subjective matter (we may or may not agree with its style of investment); the decisions at SBG (at the corporate level) have been objectively baffling.

In the first week of November 2022, SBG’s share price hit its one-year high (despite devastating results and continued rout in investee company share prices) as it completed a massive $2.3 billion buyback program (on the back of a huge buyback in May 2021). The capital allocation call is surprising, to say the least.

But that may make sense when we understand the dynamics of Son’s misaligned relationship with SBG. Son took a 17.25% stake in SVF2 and LatAm funds but chose not to pay for it right away (in effect, SBG loaned him the money). In September 2021 when the

performance was great, the value of Son’s stake was upwards of $2.8 billion. Given the fall, Son now owes SBG close to $5 billion, which he is under no obligation to pay for many years.

FT recently reported that Son has pledged both his stake in the funds and a portion of his SoftBank stake as collateral for the amount he owes the company. And yes, he has also provided a personal guarantee for the unpaid bill. The investment implications arising out of this saga are plenty. First, just because you got Alibaba right, does not mean you will get WeWork right too. (The attribution of your portfolio manager’s returns is important – a couple of investments driving most of the gains could be

a red flag.)

Second, pyramiding can become an issue. Son held no stake in SVF1 but chose to personally participate in SVF2 and LatAm funds after the success of SVF1. As investors, how often do we bet more on the next stock because we feel left out in the previous one?

Third, leverage clearly is an issue. The decision to personally participate is different from choosing not to pay for it upfront. When the going is good, all appears hunky dory; when the tide turns, you are in a bind for billions of dollars.

Fourth, the misaligned structure between a portfolio manager and investors always creates a rift when the chips are down. When other investors have paid for the investment upfront, the leniency offered to the portfolio manager to not pay for his stake in the fund for many years is unlikely to go down well. And lastly, other shareholders in companies where SVF is a large shareholder will always be worried.

Last Thursday, SVF sold 4.5% in One 97 Communications (PayTM) at about a fourth of its issue price just a year ago. After the sale, SVF still owns c13% of

and investors will always be worried whether SVF will continue to sell more.

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