More worries about companies staying private

By Felix Salmon
March 23, 2011
worrying about the implications of fewer companies going public. Tim Geithner thinks the same way:

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It’s not just me worrying about the implications of fewer companies going public. Tim Geithner thinks the same way:

At the earliest stages of funding, small companies have become more reliant on angel investors, universities, or sector-specific investment shops.

And as these small companies find their footing, they are waiting longer than ever to go public – financing themselves instead through multiple rounds of private equity or venture capital.

The number of IPOs in the U.S., for example, has decreased during the last two decades. And even though IPOs have picked back up in the wake of the financial crisis, an increasing number of U.S. companies are going public in other countries, or even deciding to stay private and access different sources of funding.

The reaction to my piece has been illuminating. Stephen Bainbridge, of course, blames Sarbox, citing survey data, among other things. I’m unconvinced, although I do agree that it’s a boon for accountants. Derrida, in the comments on my post, reckons that a stock-market transaction tax would help. I like that idea more: liquidity can be a bad thing, and throwing sand in the wheels of the stock market would almost certain bring correlations there down, thereby reducing the diversification benefit to investing in private equity. It would also, of course, make buying and selling stocks more expensive — and that’s arguably a good thing too, if we want shareholders who act like owners rather than short-term speculators.

The most interesting pushback came from Ryan Avent. It’s worth taking his points one at a time:

Mr Salmon hasn’t managed to convince me that this recent trend is actually a threat to American capitalism. For one thing, he’s argued persuasively that private ownership is likely to be advantageous for firms that don’t need to raise money in public markets. It spares them the need to deal with pushy, impatient, litigious shareholders, allowing the firm to focus on its private goals and long-term growth. From a public policy perspective, the incentives facing firms are of some consequence.

Well yes: which is why it’s a good idea to nudge incentives more towards public markets and less against them. In America for pretty much all of the 20th Century, and in the rest of the world even today, public markets have shown themselves to be a really good thing when it comes to value creation. Before we simply come to the conclusion that we were doing it wrong all along, and that the rest of the world is still doing it wrong, it might be worth asking whether public markets shouldn’t by rights be more attractive than they are. It’s also worth asking whether pushy, impatient, and litigious shareholders are creating or destroying value. I genuinely don’t know the answer to that one.

Ryan continues:

I’m also not convinced that this trend is likely to leave private investors shut out of capital ownership. If millions of Americans want to invest their savings in equity of some sort, and if firms are out there looking for funding (and if there aren’t firms out there looking for funding, the economy has a bigger problem than stock ownership), is it really plausible that the financial system won’t find ways to match the two? There are many things to be said by way of criticism of the financial system, but its inability to exploit a profit opportunity is not one of them. And letting trillions in small investor savings trickle into low-yielding bonds would represent a massive missed profit opportunity.

I’m not for a minute saying that individual investors are going to wind up in low-yielding bonds as a result of all this. I’m saying something worse: that individual investors are going to wind up in low-yielding stocks as a result of all this. The US stock market is still worth some $17 trillion — there’s no shortage of stocks to invest in. But I worry that individuals investing in the stock market are just going to be buying and selling stocks to each other, while being gamed all the while by high-frequency traders. The more important work of capital allocation, meanwhile, is being done by private equity and venture capital shops.

The point here is that while demand for stocks to invest in might well be a profit opportunity for Wall Street, firms are smart enough now to realize that things which make lots of fee income for Wall Street aren’t necessarily good long-term ideas. So given the choice between a Wall Street investment banker who says “I can make you rich in an IPO”, and a Silicon Valley VC who says “you’re already rich, I can give you all the money you want, I can personally help you become even richer, and you won’t need to worry about being public,” the latter looks a lot more attractive. Does that VC dream of an exit-via-IPO at some vague point in the future? Maybe, maybe not. But a delayed IPO is still better than one tomorrow. Meanwhile, individual investors will continue to invest in the stocks that already exist. They just won’t make that much money from them. Which brings me to Ryan’s final point:

A different question is whether small investors will earn a lower rate of return than the big, rich, connected guys. I’m going to go ahead and ruin the suspense: they will. Now, Mr Salmon wants to make the point that defined-benefit retirement plans can earn better returns than defined-contribution plans, because managers of the big plans can play on the same field as the rich, well-connected investors who get to put money in Facebook. Perhaps that would remain the case, or perhaps that premium would disappear if a larger share of workers invested in defined-benefit plans. I can’t say. But that’s a fundamentally different question from whether falling numbers of public stock offerings threaten to end ownership of capital by the masses.

Ryan forgets, here, that a larger share of workers did invest in defined-benefit plans, for most of the stock market’s heyday. And that during those years, defined-benefit plans did pretty well, considering.

I’m not worried that falling numbers of public stock offerings threaten to end ownership of capital by the masses. What I’m worried about is that the masses will end up owning the dregs of the capital world — the overpriced stocks which nobody else wants, and which they get automatically when they buy their index funds. Meanwhile, private companies will be owned by plutocrats, and will comprise an ever-increasing share of the US economy. Which might be good for both the companies and the plutocrats. But it’s clearly not so good for those of us with 401(k)s.


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Is there any evidence that there is an increasing number of emerging companies that are choosing to not go public, besides Facebook? Couldn’t the reason for the lack of growth in new IPOs be that there aren’t that many IPO-worthy companies?

Keep in mind that venture funding dropped dramatically after the end of the dot com bubble, and that it takes a while for companies to grow to be large enough to be publicly listed, maybe longer than its been since venture funding resumed in the middle of the last decade. The dearth of new offerings is more likely a symptom of a weak economy than a trend in finance. People don’t join startups to make private trades, they want to receive options in shares that will be publicly traded.

Posted by KenG_CA | Report as abusive

I am the Chairman and the co-founder of a $500M revenue-per-year closely-held private tech company. We are starting our 14th year in business. Our business is not capital intensive. The only incentive we have to go public is liquidity for the individuals involved and this is outweighed by the flow-through tax benefit of an s-type corporation. Every time we evaluate the benefits of an IPO – and we do, frequently – they are overwhelmed by the costs, e.g. Sarbox, distractions for our c-level execs in dealing with analysts, shareholders, the SEC, etc. Options can be an incentive for recruitment of talent. But they are, in our experience, not decisive. Over-the-top regulation of comp methods in the dubious name of slowing Enron-style abuse has rendered all of them unwieldy, public or private. We like our talent to be in for the long term. I’m not the least bit surprised that companies are electing not to go public in the US.

Posted by JCol | Report as abusive

Felix, I wish I could write a thorough rebuttal to you on this issue. Your comments are rife with questionable assumptions or arguably-misinterpreted data. A few counter-arguments:

(1) The oft-repeated claim that “correlations are close to one” obviously applies to the minute-by-minute trading patterns. Equally obviously, the price movement over months or years isn’t even remotely close to one. HFT lives by eliminating any short-term deviations from the market norm. Since HFT dominates trading activity, it is no surprise that short-term movements are now in near-perfect lockstep. So what? Who cares? If your holding period is measured in anything longer than minutes (days? weeks? months? years? decades?), then that correlation is broken.

(2) DB plans tend to beat DC plans because “dumb money” beats “stupid money”. The **best** of the advice out there for individual investors is that they emulate the investing patterns of the DB plans. (And despite the ability of the latter to invest in hedge funds, individual investors can come quite close to that IF they choose to do so.) Of course individual investors too often get suckered by slick-talking annuity salesmen, sell-side analysts, or other scam artists. Or they are so fearful of getting ripped off that they leave their money stagnant. But this is not proof that DB plans have some inherent advantage over small investors. What they *have* is professional management. A small investor who knows what he is doing will beat the DB plans every time. A friend of a friend runs a hedge fund — but aside from spending all his working hours studying investments, he doesn’t do anything that you or I couldn’t do. A long-term fundamentals driven investor. Spectacular results, unsurprisingly.

(3) Returns and prices are inversely proportional. If returns on publicly-traded equities were markedly lower than returns on privately-held equities, then there would be an OVERWHELMINGLY STRONG incentive to issue an IPO and sell at those higher prices. I suspect that publicly-traded equities offer *lower* yields, but not dramatically so. Especially if you take risk into account.

(4) “Buying and selling stocks to each other?” Have you forgotten about owning them for years and reaping the dividends they throw off? Buying and selling is, by definition, a zero-sum game.

Here’s a simple way to make a killing in the stock market — don’t lose money. Invest only in companies that are certain to be worth at least as much in ten years as they are today.

It isn’t that hard to find companies that fit this bill, and it isn’t a disaster if you make an occasional mistake as long as you recognize that mistake and jump ship as soon as there is the POSSIBILITY that your investment will be worth less in the future than it is today.

Gains are unpredictable. Sometimes business conditions are favorable and the business grows. Sometimes not. But losses (or at least the potential for losses) are easily predictable. Any novice investor can do THAT. If you forget about gains (trust that to chance) and work on minimizing the potential for losses, the portfolio will be fine.

Note that index investing isn’t even close to being the answer. There are probably 50-100 stocks in the S&P500 where I am highly confident that they will be worth more in the future than they are today. (Perhaps there would be a few more if I understood the businesses better.) If you invest in an index, you are picking up 400 stocks that have the potential to lose money vs. only 100 that are likely to make steady gains. Diversification is no protection at all *unless* all of the stocks in the portfolio meet the essential criteria for quality.

And that is why small investors are able to beat the heck out of DB plans *if* they have a solid investing philosophy and stick to it.

Posted by TFF | Report as abusive

Many good points by TFF.

“If you forget about gains (trust that to chance) and work on minimizing the potential for losses, the portfolio will be fine.” That is a fine point!

If you believe that in the future, there will always we a glut of savings, then returns may be poor for the public markets. But if you believe that in the future, capital will sometimes be in short supply, then returns in the public markets definitely have a bright future.

New capital is formed when countless individuals consume less than they earn and save the difference. Public markets are where this new capital gets put to use, often replacing capital that is exiting.

We are faced with the largest exiting of capital in history, the retirement of the enormous cohort of first-world baby boomers globally. New capital must be drawn into the markets for many years to compensate for this loss and a new generation of the saving public will have to be the source of this new savings, right?

The earnings yield on the S&P is 6%. The public is certainly getting an okay yield.

I totally agree that possibilities in the private world of business are better, but if a company is private and you are an owner, don’t you actually have to *do* something? Like, um, run the company? Or maybe have a smart family member who is charitable enough to carry the load while you ride on their work?

I rather enjoy dividends and capital gains rolling in while I do *absolutely nothing*, even if the upside is limited.

Posted by DanHess | Report as abusive

“New capital must be drawn into the markets for many years to compensate for this loss and a new generation of the saving public will have to be the source of this new savings, right?”

DanHess, if I understand the economics of this situation correctly, we are looking ahead to a couple decades of restrained growth (at least in Japan/US/Europe). As you say, capital outflows are likely to outpace capital inflows — and since that is essentially a logical impossibility, it implies that the exchange price will be lower than what we’ve become accustomed too. In short, P/E ratios will trend lower.

This will have the effect of boosting future returns for people buying at the lower prices, but it isn’t really good news for current shareholders. The primary driver of increased (future) returns for the market as a whole will be declining (present) prices. Or more likely, price stagnation while earnings creep upwards at a historically slow pace.

There is still strong real growth in parts of the world, but only some companies will benefit from that growth sufficiently to offset stagnation in their developed markets. The key is to figure out which companies these will be — and become accustomed to evaluating companies on their free cash flow (and dividends!!!) rather than their earnings growth prospects.

Speaking of which, it puzzles me how Felix talks on the one hand of “zero real return” investing and on the other hand is consumed with excitement over companies like Facebook. If you believe we are approaching decades of slow growth, then growth companies are the **WORST** investment choices. The instant that their growth is curtailed by economic malaise, their P/E and share price will plummet.

In contrast, companies such as P&G, Coke, and J&J will return solid value to their shareholders even if the global economy comes to a dead halt.

So which do you really believe, Felix? Do you believe in the unrestrained exponential growth on which that Facebook valuation depends? Or do you believe we are very close to achieving a “maintenance” economy that year after year continues to do “more of the same” with little change?

Posted by TFF | Report as abusive

“Ryan forgets, here, that a larger share of workers did invest in defined-benefit plans, for most of the stock market’s heyday. And that during those years, defined-benefit plans did pretty well, considering.”

Couple of things – the crash of 2008 has made many small investors quite leery of the stock market, which seems to many to have become Vegas-like in its operations.

The quote from Felix above is interesting re: the debate in Wisconsin over defined-benefit pension plans. Wisconsin has one of the more stable and well-funded pension plans, but they were socked by the crash of the markets and needed to tap into other funding sources for the pension benefits. Now the fixed benefit plan is being painted as a drag on the economic resources of the state by the GOP leadership.

And frankly, the defined benefit plan is nothing that has ever been offered to me from any employer – are they widely offered today? (I tend to enjoy working for rogue small businesses…)

Finally, the focus on shareholder return seems (to me!) to incent the C-suite to focus on short term gains that don’t necessarily benefit the long-term goals of the company. With so many publicly traded companies swirling in the toilet these days in sectors that include airlines, newspapers, banks, autos, etc., it is not clear that being traded on the stock market is actually good for the company.

Posted by MainStreetMuse | Report as abusive

First, if you find yourself continuing to think the same way as Tim Geithner, you may want to seek professional help.

Second, I’ve long believed that the reason large companies (& especially hedge funds) go public, it is because they believe they have squeezed out all the “alpha” their company can generate. Going forward, they see their company just matching the market, so they sell out.

As a general rule, I don’t invest in IPOs. That said, one I (and we all) should have invested in, however, was GOOG. So my view is not universally accurate.

I guess you do have to look at the specific objective merits of an IPO, but getting good data is difficult.

Posted by Lilguy | Report as abusive

We are talking about a period encompassing a huge tech bubble, a spectacular bust of the tech bubble (lots of failed companies), then a period of stagnant IPOs while credit financing was incredibly cheap and led to many buyouts of public companies. In the last few years, the stock markets have been extra volatile, which scares away a lot of IPO plans. Not sure I’m willing to accept there’s a major trend away from public listings yet.

Posted by newthrash | Report as abusive

Lilguy, I agree that getting good data on IPOs is difficult.

My philosophy is that I should never invest in anything unless I’m pretty certain that I will not lose money.

Without good data, you can’t be certain about anything.

Thus I have no regrets over passing on any and every IPO.

Posted by TFF | Report as abusive

As an executive in a small, private company myself, I fail to see the dire consequences of Mr. Salmon’s observation of fewer companies going public. Weak boards and shareholder apathy are often the order of the day, and as a result the actions of many public companies become motivated more by short term greed on the part of management and their investment bank enablers rather than any drive for long term growth or sense of duty to shareholders. Here’s a quick test I have for executives to gauge if going public is appropriate :
1) Do you see the IPO as the end of the game rather than the beginning of it?
2) When evaluating stock issuance versus corporate debt, do you see the latter as money you need to pay back and the former as money you don’t?
3) Do you see the management incentives dangled by IPO advisors as just reward for all your hard work and success in getting the deal done?
If the answer to any of these questions is YES, you should decidedly NOT go public, and those that do anyway should be considered investment hazards. Executives in private companies with “skin in the game” can be expected to act more responsibly than those in public companies playing with other people’s money.

Posted by cardinalrules | Report as abusive

Most of my customers run small business or family businesses. Only one or two of my customers work for businesses that would warrent a 100mm market value with a P/E of 15.

I think the reason that they would not want to IPO are many, but largest adversion to going public is extreemly counterintutive… they want to manage and grow their business while maintaining the LOWEST valuation possible.

Why on earth would anyone want to do that? Well if you company is worth 100mm than it’s pulling in an income of 6-10mm annually depending on the valuation you apply. That’s a pretty nice life. If you want to pass that business on to your 2 kids and you are gifting them shares in the business at the max tax free rate of like 13,000/year then it makes a big difference in what your P/E is.

It’s the opposite if you were selling it to a 3rd party… instead of getting the absolute max valuation you can your actually shooting for the minimum valuation. Once some people hit a level of income and wealth their comfortable with their perspective really changes.

If Mom and Dad have two kids then they can only pass roughly $52,000/year tax free. (13k gift exclusion x2 parrents x2 kids) Assuming mom and dad are 50 then they have at most 40 years before they are going to have to pay estate tax… by straight gifting they can only hope to move a couple million bucks worth of a 100 million dollar company to the kids. Add in another 10 million via the gift exclusion and your up to (12ish million out of 100mm)

Upon death mom and dad have a taxable estate worth 88mm x.35… please make that check paybable to the U.S. Treasury in the amount of $30,800,000… your country thanks you!

I have no problem whatsoever with taxing estates… probably the fairest of all taxes if you ask me… but in my mind that’s the largest driver to stay private and keep valuations low.

Posted by y2kurtus | Report as abusive

Wow, I never thought of it that way, y2kurtus. That makes perfect sense!

The real value of a company — as long as you own it — is in the cash flow. Market price is only relevant when you sell it (or transfer it to your heirs).

Posted by TFF | Report as abusive

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