The JP Morgan “Twitter Fund”

The announcement last week that JP Morgan is launching an investment fund for certain digital companies has proponents of the “greater fool” theory crawling out of the woodwork and pointing to the wreckage of the tech bubble from ten years ago.  This announcement closely follows the news that Goldman Sachs is offering clients an opportunity to buy into Facebook at a valuation of $50 billion.  While many have pointed to the copycat nature of the JP Morgan fund, I believe that the bigger theme is a nearing peak in valuations for social media companies.

First, the facts.  The fund is going to have no more than six companies in it, and Twitter alone will represent over half of the fund.  Not surprisingly, this opportunity has quickly been named “the Twitter fund.”  JP Morgan intends to raise $500-750 million from wealthy investors from its Private Banking division, each of whom must pony up a $1 million minimum.  The other companies have not been identified publicly and may not be known yet even within JP Morgan.  Fund manager Larry Unrein has confirmed that the terms of the investment give Twitter a notional value of $4.3 billion, up slightly from $3.7 billion in December, based on an earlier round of funding.

A quick dive into the numbers show some frothy sentiments from investors.  Twitter had actual revenues of $45 million in 2010, and the most aggressive predictions put the upper limit for 2011 at $150 million.  Using this assumption, JP Morgan investors value Twitter at nearly 29x revenues.  By way of comparison, Goldman Sachs investors value Facebook at 12x 2011 revenues of $4.1 billion.  Keep in mind that we are talking about revenue multiples, not earnings multiples.

Now, this lofty valuation could be justified if Twitter opens up its ad platform to the general public and starts bringing in billions of dollars of ad revenue over the next three years.  And it could be justified if one assumes that either Google or Facebook will buy Twitter very soon and integrate its functionality.  But neither scenario is likely to happen.  Twitter doesn’t have the eyeballs necessary for advertisers to pay top dollar, and most Tweets don’t occur on twitter.com anyway, so potential users won’t see the ads.  All user metrics point to far lower levels of engagement on Twitter than on other leading social media sites.  As for a buyout, Google and Facebook have both had on-and-off talks with Twitter for over two years now, but there has been no offer.  Why?  Both companies are wary of overpaying for a company that isn’t likely to ever hit a billion dollars of revenue.

So ten years after the collapse of the tech bubble, why are investors lining up to take more pain?  Isn’t it obvious that when retail investors buy companies at insane valuations, most experts call the top?  Is it different this time?

No, it isn’t different this time.  Twitter management insists that its consumer database alone is worth billions, but in the end, valuations always come down to multiples on earnings.  JP Morgan itself isn’t putting any money at all into the Twitter fund – that should represent a clear warning sign.  Unless there is someone else out there willing to value Twitter at $6-8 billion, the JP Morgan fund could take a beating if consumer sentiment changes directions quickly.