Bloomberg is examining how circular funding is fueling the AI boom. The practice, where companies invest in each other and themselves, could lead to distorted market signals and financial instability. The dynamics are reminiscent of pre-2008 crisis conditions.
What is circular funding in AI?
Circular funding in AI typically involves a web of investments where companies fund each other, sometimes even investing in themselves. This can create a closed loop of capital that inflates valuations without corresponding real economic activity. For example, an AI startup might receive investment from a venture capital firm that is also backed by the same startup's major clients. These deals can be structured as equity investments, loans, or revenue-sharing agreements.
The problem is that such arrangements can mask underlying weaknesses. When companies are both investors and customers, it becomes difficult to assess true demand and financial health. The AI sector, with its high capital intensity and long development cycles, is particularly susceptible to these practices.
How circular funding distorts market signals
Circular funding can create a feedback loop that distorts market signals. When Company A invests in Company B, and Company B then buys services from Company A, both can report increased revenue and growth. This can attract more investment from outside parties who are unaware of the circular nature of the deals. As a result, valuations may become detached from fundamentals, leading to misallocation of capital.
In the AI industry, where many companies are not yet profitable, such dynamics can be especially dangerous. Investors might overestimate the sector's health based on inflated metrics. When the cycle inevitably slows, the unwinding could be abrupt and painful.
Parallels to pre-2008 crisis conditions
The current situation in AI has drawn comparisons to the conditions that preceded the 2008 financial crisis. Back then, complex financial instruments and interconnected lending practices created a web of hidden risks. When the housing market collapsed, the entire system unraveled. Similarly, the AI boom's circular funding could be creating a fragile ecosystem where a downturn in one area quickly spreads to others.
While the specifics differ, the underlying issue is the same: opacity and interdependence can amplify shocks. Regulators and investors may not fully grasp the extent of the interconnections until it's too late.
Potential consequences for the AI industry
If circular funding continues unchecked, it could lead to distorted market signals and financial instability. Startups might secure funding based on inflated metrics, only to struggle when they need to demonstrate real traction. Investors could face significant losses if valuations correct sharply. The broader economy could also be affected if AI is as transformative as many hope.
Some companies might be forced to restructure or shut down, leading to job losses and reduced innovation. The fallout could erode trust in the AI sector, making it harder for legitimate players to raise capital.
What to watch
Several indicators could reveal the extent of circular funding in AI. Watch for disclosures of related-party transactions in IPO filings or earnings reports. Pay attention to companies that both invest in and purchase from the same partners. Monitor regulatory actions, as authorities may soon scrutinize these practices more closely. The SEC has not yet announced specific rules for AI funding, but that could change. For now, the onus is on investors to dig deeper and ask hard questions about where the money is really coming from and where it's going.
