Why are private markets booming now?

By Felix Salmon
April 1, 2011

I’m spending Friday at the Kauffman Foundation’s Economics Bloggers Forum in Kansas City. A dozen bloggers are giving short presentations, and I’m flattered to be one of them, along with the likes of Tyler Cowen, Bryan Caplan, Ryan Avent, Dean Baker, Steve Waldman, and Virginia Postrel. We’ve all been encouraged to write a post about our talk.

Following on from a question I asked Mohamed El-Erian at the Thomson Reuters Newsmaker event today, I’m planning to talk a bit about a favorite subject of mine, private stock markets like SecondMarket and SharesPost. They’re hot these days, and one of the questions I’m hoping to put to the bloggers at the Forum is why that might be.

Certainly it’s easy to see why these private markets serve a useful function. Take Pimco: it gives out shadow equity to a lot of employees, which vests over a period of years. But once they have that equity, what are they meant to do with it? Pimco can unilaterally announce a price for it, and say that it will buy back its own stock at that price. But that seems a bit unfair: one of the reasons that many banking partnerships went public was that they were buying back their stock at book value, even as the public markets were valuing banks at significant multiples of that. And in general, if there’s only one buyer for an asset, that buyer always has an incentive to lowball the price.

That’s why Pimco turned to SecondMarket, to take advantage of their web-based Dutch auction system. Pimco employees entered bids and offers into the system — the amount they were willing to sell their shares for, and the amount of money they were willing to pay for new shares. The bids and offers then cleared at a certain price (I didn’t get the opportunity to ask what the price was, and I’m sure that El-Erian wouldn’t have told me if I had), and that price by its nature is a fairer value for Pimco stock than anything determined according to a formula.

El-Erian said, and I believe him, that the auction didn’t see a lot of volume: there simply weren’t all that many people interested in selling their equity. It’s easy to see why: Pimco is doing very well these days, and it pays well too. Some employees might have difficulty paying their tax bill as their equity grants vest, but most are rich enough that they can do so quite easily. Most of them, too, probably reckon that employees-only equity in Pimco is likely to be a better investment over the medium term than anything they might be able to do in the current market with the proceeds of any sale. That’s the reason that shares of SecondMarket itself have yet to trade on SecondMarket: there aren’t any sellers, only buyers.

In the specific case of Pimco, there are always rumors that it might get sold or spun off from its parent, Allianz. A strategic buyer might well be prepared to pay a substantial control premium to get its hands on more than $1.2 trillion of assets, and Pimco’s employees would surely like to collect that premium themselves rather than sell the right to receive it to someone else.

So as is quite common in these situations, buyers — including El-Erian himself — outnumbered sellers. Which raises a common objection to private markets: that they don’t allow for short selling, which is an important contributor to the way in which public markets perform their role of price discovery.

There’s also my public-policy objection: that even if these markets make sense for the companies in question, they’re bad for the general public, which gets shut out of the opportunity to own equity in strong, attractive companies. Pimco’s not a great example on this front, since it’s possible to buy shares in Allianz. But if you look at the poster child for private markets, Facebook, the only people able to buy equity are a small group of elite and well-connected global rich people. And that doesn’t seem fair.

Historically, workers have been able to get access to the class of investments available to the rich: they have had defined-benefit pensions, run by pension plans which qualify as rich and sophisticated investors and which therefore have a large universe of asset classes to invest in. But as we move from defined-benefit to defined-contribution plans, that universe shrinks.

It’s quite easy to see why companies like Facebook might not want to go public — although the NYT is now reporting that an IPO might happen early next year. Being public is expensive and annoying: CEOs almost always prefer to be public. Public shareholders are litigious; public stocks tend to move in lockstep with each other rather than due to company-specific fundamentals; and the minute that your stock price is public, everybody pays an enormous amount of attention to it and judges you by it. Given the amount of money in private markets, what upside is there in going public? Especially when SecondMarket and its ilk allow shareholders to liquidate their holdings quietly and at a good price.

What’s less easy to see is why this trend is happening now. Is there something special about the USA circa 2011 that makes private exchanges particularly timely? Yes, there’s a lot of liquidity sloshing around — but that was true in the mid-oughts, too. Yes, Sarbox has made life for public companies that much harder — but Sarbox has been around for a while as well. Maybe it’s simply the fact that SecondMarket and SharesPost have come along and executed well in a space which no one bothered to put much effort into before. I’m reminded of the current rise in couponing: there’s absolutely no reason why Groupon, LivingSocial, and the like should all be exploding now, rather than during say the first dot-com boom of the 1990s.

Markets aren’t that efficient: sometimes it takes a while for an entrepreneur to spot a big gap in the market. But if there is a good reason why private markets are booming in the USA today, I’m sure the bloggers assembled at Kauffman will be able to think of it.

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Comments
8 comments so far

1) Why do you think buyers outnumbered sellers (whatever that means in the presence of a clearing mechanism with voluntary participation)? There was a large group of sellers (employees), and as you point out most of them didn’t participate (suggesting that the anticipated clearing price was too low). On the buyers’ side, however, there are some strong restrictions (as your public-policy objection points out).

2) Do you really think it’s good portfolio management for employees to hang onto their company’s equity, particularly given its lack of liquidity?

The way I see these markets, the prices reflect an equilibrium between prices that could be “too low” (due to constrained demand, as evidenced by regulation) or “too high” (due to constrained supply, since only a small fraction of equity is available at any given time). So you get shallow valuations determined by a limited group of buyers. Since the auction format puts the competitive pressure on the buyers’ side, it seems reasonable that would lead to overpriced valuations – but then why wouldn’t more employees participate? It’s not at all obvious how it plays out, so the public policy claim has shaky empirical grounds (are workers clamoring for access to a winner’s curse?).

Posted by absinthe | Report as abusive

err, should read “(is the public clamoring for access to a winner’s curse?)”

Posted by absinthe | Report as abusive

Felix:

Maybe while you’re there, you could ask the conference organizers why there aren’t any of the qualified economists from UMKC on the panel, even I see they’ve managed to work in Megan McArdle, of the chattering class.

After all New Economic Perspectives is right here in KC, just like the conference itself, so they’d save themselves a plane ticket — not negligible in these parlous times.

http://neweconomicperspectives.blogspot. com/

Could it be that any MMT advocate is persona non grata at events like this?

Posted by lambertstrether | Report as abusive

Government policies are increasingly favoring rich investors at the expense of the little guy. The gateway for becoming an accredited investor was recently narrowed by increasing net worth, liquid assets, etc. required to pass through… SarbOx is certainly biting. And look at why Goldman took their Facebook shares overseas: restrictive US policies on dissemination of information ahead of an offering.

Posted by mhrand | Report as abusive

This is building somewhat on absinthe’s comment above, but I see two fundamental flaws in this article.

First, regarding the lack of activity in PIMCOs auction. I do not buy the argument that for PIMCOs employees their best investment is to keep large portions of their wealth tied up in PIMCO stock. For an employee of a firm, that is a huge amount of personal risk tied to the fate of one firm. If employees really are not accounting for this risk I wouldn’t be so sanguine about PIMCOs future prospects.

This leads to the second problem with the article. Put aside the unlikely outcome that PIMCO employees don’t want to diversify their risk away from their source of income. This implies that lack of sales is a result of poor prices (perhaps because the buyer and seller pools are small and homogenous, all being employees of the same company). This, in turn, implies that the likes of SecondMarket are not exactly solving the problems of private markets.

I find your argument that certain constituencies, like employees, are left out of the gains in private ownership both more compelling and a more compelling argument for why this shift is occuring. Private markets have gotten large and efficient enough at facilitating transactions that large capital holders can take advantage of these inefficiencies to capture a greater share of the pie.

Posted by Dan_K | Report as abusive

“public stocks tend to move in lockstep with each other rather than due to company-specific fundamentals”

I think that captures a lot of it. The public stock exchanges are so dominated by automatic trading that they no longer provide a useful price for a company’s securities. The real competition is getting in on the front edge of any transition, whether there is any rationale for that transition. Company prices have been completely decoupled from the fundamentals, and what we see as price setting is simply an artifact of the mechanism. The noise well outweighs the signal.

Private markets are much more heavily regulated and controlled. The market makers have reputations on the line, the way specialists once did. There is no high speed trading. Private markets move much more slowly and regularly, so that price setting reaches an equilibrium based on supply and demand, not reaction times and algorithms.

In fact, this might actually be a good time for someone to introduce a new stock exchange based on a sort of “slow food” movement for securities trading. Even with SEC scrutiny and all that entails, it would still offer many advantages for management, employees and investors. Of course, they’d have to have some control over the creation of derivatives, possibly allowing only puts and calls.

It sounds as if we may be watching the stock exchanges of the future in creation while such as the NYSE and OTC are growing increasingly irrelevant.

Posted by spiffy76 | Report as abusive

spiffy, the perception that “company prices have been completely decoupled from the fundamentals” is only accurate in the short term. In the long term, valuations fluctuate around earnings (albeit with a high-end P/E that is more than twice the low-end P/E, for the same stock). That is why people with a short-term focus are easily fooled.

You will remember the last time we were told that “fundamentals don’t matter” was in the 1999-2000 crash. And guess what? The companies that won that round were the companies with solid fundamentals! If you were one of the herd who bought that bogus line, you probably lost a LOT of money between 1999 and 2002.

Now we are hearing that again — for exactly the same reason. People have no sense of history, no memory, no understanding beyond the market fads of the last year. Thus they are doomed to repeat it.

Posted by TFF | Report as abusive

Here’s an additional thought…

How many times a year does a company release significant news? News that has the potential to increase the value of the company by 1% or more?

* Quarterly earnings reports.
* Mid-quarter outlook releases.
* Occasional product-specific events.

There are ~250 trading days each year, and only a dozen or so significant events. EVERYTHING ELSE is macro-driven noise, which by its nature affects the entire market (or at least entire sector) similarly.

So yes, the minute-by-minute correlations are very strong. In the absence of news they SHOULD be strong. But it is the newsworthy events that drive returns for investors (as opposed to traders).

You can obsess about the noise or you can simply look past it. Absent HFT algorithms, the latter is the better approach.

Posted by TFF | Report as abusive
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