Opinion

Felix Salmon

How the public sees microfinance

Felix Salmon
Mar 24, 2011 16:31 UTC

In the wake of demonstrations protesting the ouster of Muhammad Yunus from Grameen Bank, the US publicity machine is gearing up, with a “special theatrical event” (Robert De Niro! Matt Damon! Suze Orman!) scheduled for March 31. Judging by the trailer, it’s going to be full of fluff, not particularly timely, and will concentrate mainly on the minuscule Grameen America — which has currently raised $275.40 towards building its first branch.

Microfinance is trendy these days, especially with the granola set — the Whole Planet Foundation has raised $3,185,685 to date in its annual microfinance campaign, mostly from shopper donations at Whole Foods checkout counters, as well as employee donations of $1.94 per paycheck. As a frequent Whole Foods shopper myself, I took advantage of my trip to Austin last week to pop in on the foundation, and had an interesting chat with Joy Stoddard, the main microcredit fundraiser there.

In principle, I’m a fan of giving grants to microfinance organizations to help them scale up and become self-sustaining. I think it’s a much better model than investing equity capital and then extracting dividends when the bank becomes profitable. But Whole Foods is conflicted about giving money to microlenders. Technically, that’s what it’s doing. But it goes to great lengths to try to ensure that all of it is used directly for “on-lending”, so that donors can be told that their money was lent out to poor borrower somewhere. (The main criterion for qualifying for one of these loans is that you’re poor, or, better yet, “the poorest of the poor.”)

The result seems to me to be a gratuitous step backwards: rather than leverage the power of fractional-reserve banking, Whole Foods essentially insists that the lenders it backs lend out pure capital. Wouldn’t it make much more sense for the lender to use the Whole Foods money as permanent capital and then fund itself in the domestic wholesale markets? Or, better yet, from local microsavings? Possibly it might. But then it becomes harder for Whole Foods to send out the simple message that your dollar is donated directly to a needy borrower.

Whole Foods, of course, has brought Yunus on as an adviser, which is one reason why some of the money raised — about $150,000 — has gone to Grameen America. Which isn’t nearly as revolutionary as the documentary makes out: community development credit unions have been doing something substantively identical for years. They just don’t tend to have the same star power.

I’m looking forward to talking about all of these issues at my Microfinance USA panel on May 24. US microfinance in particular is going to be a hot topic of discussion: do we need entities like Grameen America to parachute in and try to reinvent the wheel? Or should we be working harder to bolster and grow existing institutions, like my own? For the record, my answers to the posed questions are that borrower-owned institutions are always preferable to lenders owned by rich shareholders, in any country; and that microsavings, small dollar consumer loans, and alternative payday products are all absolutely part of microfinance.

More generally, what I’m looking forward to is a world where microfinance is viewed in a much more sophisticated way. But the world seems to be moving in the opposite direction: initiatives like Grameen’s theatrical event, or the Whole Foods fundraising drive, tend to oversimplify the issues at stake massively — even as the literature remains extremely unclear on the key question of whether microfinance really helps reduce poverty on a macroeconomic level. I’m sure the panel in May is going to be enlightening. But I do wonder whether any of that discussion is going to trickle down to the public-facing front lines.

COMMENT

Amen Felix!

Rather than lamenting the lack of philanthropic capital the hundreds of millions of poor need from Western investors, here are three steps I suggest those of us in the microfinance field concerned with poverty should consider focusing on instead:

1. Advocate for country legal frameworks around the world that enable institutions to mobilize poor people’s savings. This would: ensure only those institutions that are up to the task of safeguarding poor people’s money can; put poor people’s money in a safer place than under a mattress, as jewelry around a women’s neck, or in the form of cattle or other illiquid assets; put poor people’s money to work for them in ways that we take for granted; and, most importantly to the current debate, mobilize serious local money at lower cost than international borrowing to meet the serious unmet demand among the millions of entrepreneurially-inclined.

2. Support institutional forms like credit unions and cooperatives that make poor people themselves owners; reduce the cost of funds and, hence, the cost to borrow; and yield financial returns to the poor first and foremost rather than wealthy investors in Seattle, San Francisco or New York. An alternative might be to hardwire existing MFIs’ statutes in ways that ensure reduction in interest rates come before dividend payouts to investors when an institution produces a surplus. The weakness in this approach is that trustees/owners find ways to change the rules to meet their needs (I watched this happen first-hand at an MFI I founded, which now manages a $60 million portfolio and aspires to go public like Compartamos. Sigh…).

3. Support low-cost, simple, informal microfinance models that equip the poor to intermediate their money on their terms in places banks and microfinance institutions have proven they cannot and will not go: very rural areas. Here I’m talking about savings groups—also known as village savings and loan groups, self-help groups, etc.—that quietly serve the basic needs of hundreds of millions of very poor people in very rural areas across Asia, Africa and (to a lesser extent) Latin America. This is a powerful “good enough” approach that simply does not get the attention it deserves, most likely because someone on a computer or a high-net worth individual cannot claim a stake in it. What a shame.

Even a cursory look at the evolution of microfinance over the past 35 years points to the inevitable weaknesses of microfinance institutions as tools for anything other than market development. Any serious look at microfinance as a facilitating mechanism for poverty-reduction has to account for the fact that the most visible manifestations of microfinance—non- and for-profit institutions that focus primarily on lending rather than savings for low-income and non-poor clients in peri-urban and urban areas—fail to address the priority needs of very poor people: a safe place to save, health care, clean water, knowledge and skills, etc. Microfinance may not meet all of these needs, but certainly we can aspire to more than money lending with a mission.

Sean

Posted by Seankline | Report as abusive

Counterparties

Felix Salmon
Mar 24, 2011 05:01 UTC

Paul Amery on the spike in Japanese ETF bid-offer spreads following the tsunami — Index Universe

The best journalism-job want ad ever — Mother Jones; see also Romenesko

Lloyd Blankfein, representing: “We’re did you grow up?”…”Brooklyn,” [he] replied — Bloomberg

Newt Gingrich has a neck of purest brass — Think Progress

There has got to be a better way to donate after a disaster — Good Intents

Here’s the difference, Arthur: stealing a paper on 6th Ave is illegal — Forbes

A lovely David Leonhardt column on Charles Kenny — NYT

British rock stars to play Japan benefit concert — Reuters

COMMENT

WHERE did you grow up.

It isn’t a contraction for “we are did you grow up,” which after all makes no sense.

As the French say, “Pas de le Rhone qui nous,” which also makes no sense.

Posted by Christofurio | Report as abusive

More worries about companies staying private

Felix Salmon
Mar 23, 2011 20:43 UTC

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.

COMMENT

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).

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The Fed’s 1-cent-a-share dividend cap

Felix Salmon
Mar 23, 2011 20:19 UTC

Antony Currie wants a bit more clarity on why the Federal Reserve seems to be happy with Bank of America paying a dividend of 1 cent per quarter, but unhappy with a dividend of 5 cents per quarter. “It’s not clear,” he writes, “whether the Fed is worried about BofA’s core earnings falling short or about potential losses being higher than the bank projected, to pick a couple of possible concerns.”

My feeling is that the Fed’s logic wasn’t nearly that granular. There are basically three states that a bank can be in: it can pay no dividends at all; it can pay the minimum possible token dividend of 1 cent per quarter; or it can pay out a full and generous dividend. The Fed, in the wake of its latest stress tests, has determined that both Citigroup and Bank of America belong in the middle group. They can pay one cent a share, but no more — and in Citi’s case, they can only pay that much after doing a 1-for-10 reverse stock split and bringing the share price up above $40.

Paying a dividend is important from a symbolic perspective. It signals that the bank isn’t worried about insolvency, and it forces the bank to pay all dividends on preferred shares in full. If banks are paying dividends, that helps shore up confidence in the banking sector. If banks aren’t paying dividends, that keeps investors worried about what problems might lurk under the surface.

At the same time, the Fed has every interest in forcing banks to keep anything over one cent per share as precious capital, rather than sending it out to shareholders. The shareholders can’t do much with the money — not in this environment — while the system as a whole is clearly more robust the greater the amount of capital that banks manage to build up.

When Shira Ovide, then, characterizes the Fed’s stance towards BofA as “No Dividend for You,” she’s going too far. The Fed’s happy with BofA paying a dividend — indeed, astonishingly, BofA has been paying a dividend all along, with no objections from its top regulator. It just doesn’t want BofA paying out a dividend which is linked to profits. Not yet. For the time being, just like Citigroup, it’s being kept at that flat 1-cent-per-share level.

Update: I’ve heard a lot about mutual funds which are only allowed to invest in stocks which pay a dividend — sometimes with an explicit Berkshire Hathaway exception. Insofar as such funds exist, and I’m unclear on how prevalent they are, it makes a lot of sense to pay a de minimis dividend of one cent.

COMMENT

“I can say with 100% confidence that BofA’s deposits are money good.”

I very specifically was talking about corporate revolvers, not FDIC insured deposits. Corporate revolvers are not FDIC insured because 1) they are liabilities of the corporation not assets and 2) they are well over the FDIC limit. Corporate revolvers are an interesting product because, somewhat like swaps, the credit risk goes both ways in the transaction. The banks rely on the corporates to repay their borrowings under the revolvers and the corporates count on the banks to be able to fund the undrawn balance of the revolver whenever the corporation needs liquid funds. Some borrowers had to find new lenders to replace Lehman when it wasn’t able to fund its revolver commitments.

“They have repaid their goverment funding with interest and now they should be allowed to resume their dividend payout at a low rate.”

Shouldn’t they be earning money to pay out a dividend? If the dividend is higher than earnings (it is since earnings are negative) then leverage goes up (assuming steady asset levels). This is easy math here. Also, lets not pretend that BAC’s GSE settlement wasn’t a transfer of value from the Govt to Bank of America.

“All banks, every one depend on a an explicit govermental guarentee via the FDIC which can borrow directly from the U.S. Treasury.”

Which is exactly why regulators Govt regulators get to approve or deny dividend policy.

“If you want to curb the growth of the evil mega-banks and promote the growth of Credit unions and Mutual savings banks (like mine)”

I work for a competing “evil mega-bank” so I can assure you that was not the motivation of my post.

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The government’s narrow anti-bank suits

Felix Salmon
Mar 23, 2011 13:32 UTC

Liz Rappaport reports that the NCUA is getting tough with Goldman Sachs and other banks which sold corporate credit unions billions of dollars of toxic mortgage-backed securities:

In one of the broadest accusations that Wall Street helped cripple financial institutions during the crisis, the National Credit Union Administration, or NCUA, has threatened to sue several investment banks unless they refund over $50 billion of mortgage-backed securities sold to the five institutions, called wholesale credit unions…

Regulators seized the five wholesale credit unions in 2009 and 2010, inheriting a pile of battered bonds now worth only about $25 billion, or half of their face value.

This seems to me to be yet another form of weird selfishness on behalf of regulators who should really have the national interest, rather than their own self-interest, at heart. The FDIC’s suing WaMu directors? Yes, because the FDIC suffered losses. The NCUA’s threatening to sue Goldman? Yes, because the NCUA suffered losses. But what we’re not seeing here is any kind of government action against these banks which draws the logical conclusion: if Goldman needs to buy back all the bonds it sold to WesCorp, shouldn’t it also have to buy back all the identical bonds it sold to other investors?

What’s happening here is that Goldman is fighting a number of substantially identical claims on a case-by-case basis. Here’s its SEC filing:

Various alleged purchasers of, and counterparties involved in transactions relating to, mortgage pass-through certificates, CDOs and other mortgage-related products (including the Federal Home Loan Banks of Seattle, Chicago and Indianapolis, the Charles Schwab Corporation, Cambridge Place Investment Management Inc., Basis Yield Alpha Fund (Master) and Landesbank Baden-Württemberg, among others) have filed complaints in state and federal court against firm affiliates, generally alleging that the offering documents for the securities that they purchased contained untrue statements of material facts and material omissions and generally seeking rescission and damages. Certain of these complaints also name other firms as defendants. Additionally, the National Credit Union Administration (NCUA) has stated that it intends to pursue similar claims on behalf of certain credit unions for which it acts as conservator, and the firm and the NCUA have entered into an agreement tolling the relevant statutes of limitation. A number of other entities have threatened to assert claims against the firm in connection with various mortgage-related offerings, and the firm has entered into agreements with a number of these entities to toll the relevant statute of limitations. The firm estimates, based on currently available information, that the aggregate cumulative losses experienced by the plaintiffs with respect to the securities at issue in active cases brought against the firm where purchasers are seeking rescission of mortgage-related securities was approximately $457 million as of December 2010. This amount was calculated as the aggregate amount by which the initial purchase price for the securities allegedly purchased by the plaintiffs exceeds the estimated December 2010 value of those securities. This estimate does not include the potential NCUA claims or any claims by other purchasers in the same or other mortgage-related offerings that have not actually brought claims against the firm.

We’re given no indication, here, of the total amount of these bonds which was sold by Goldman: instead, we’re given the fraction of the bonds which are actually being litigated. And since the NCUA hasn’t filed suit (yet), that number is relatively small — less than half a billion dollars.

So long as government-run entities like the Federal Home Loan Banks and the NCUA look out only for their own self-interest here, both they and Goldman have every incentive to settle these suits out of court. But the government is meant to have a broader interest than that. Let’s say I bought one of these bonds but don’t have access to the government’s expensive lawyers. Why is it fair that the government should get Goldman’s money in an out-of-court settlement while I get nothing?

Yes, there are class actions pending against Goldman too, or at least putative class actions — they don’t seem to have been certified yet. But those class actions don’t have the extra force that comes from being brought by the government. If the government really believes that Goldman et al did something seriously wrong here, they should come down on those banks on behalf of all the victims. Not just the state-owned ones.

COMMENT

You are wise to note the incoherence of the federal government’s response to the financial crisis. However, the incoherence is not at all due to “selfishness” on the part of the FDIC and the NCUA. What they are doing is the opposite of selfishness. Instead, it is due to the fact that those two agencies are luckily still run by persons of integrity who are willing to do their sworn duty despite pressures not to do so from the top levels of the administration.

Everything else you say is true. There should be broad civil and criminal charges against large numbers of major banks, investment banks and individuals. Literally hundreds of billions in remedies should be being pursued by the Department of Justice. The money damages cases are obvious Section 11 claims based on misstatements in the offering documents themselves. The criminal cases are obvious fraud, conspiracy, insider trading and perjury claims that could be based in large part on millions of emails that the DOJ could easily discover.

There has clearly been a “hands-off” order for Wall Street issued by President Obama, influenced by his inner circle of Geithner and Holder. What you are seeing at the FDIC and NCUA is a couple of brave federal officials with integrity and independence who are actually doing their duty. The higher-ups dare not stand in their way (yet) because that would make their hypocrisy too obvious.

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Counterparties

Felix Salmon
Mar 23, 2011 04:48 UTC

Berkeleyside axed from Google News — Davos Newbies

Truth is stranger than fiction: wasn’t a boring version of this story a subplot of Franzen’s Freedom? — Rolling Stone

Insane: cops giving Central Park bicyclists speeding tickets for going >15mph in the early morning twilight — Gothamist

George Monbiot with a strong essay on how the lesson of Fukushima is that we need more nuclear power — Guardian

How the NYT paywall could turn out to be a success

Felix Salmon
Mar 23, 2011 04:45 UTC

There’s one aspect of the NYT paywall which hasn’t got as much attention as it deserves — and that’s the idea that the NYT will be able to charge higher CPMs for ads behind the paywall than it currently gets for ads on a free site. Gordon Crovitz, the former publisher of the WSJ who now has a paywall product of his own, points out that if people pay for a subscription, that’s an excellent indicator of the “engagement” that advertisers and agencies are looking for. As a result, he says, publishers can charge a CPM premium of about 30% for behind-the-paywall pageviews.

Of course, it’s hard to know whether the NYT can get that kind of premium. At the NYT, after all, most behind-the-paywall pageviews will come from people who aren’t paying for a digital subscription: either they’re print subscribers who get access to the website thrown in for free, or else they’re online-only readers who have taken advantage of the Lincoln offer. Do people who get free access behind the paywall count as “engaged” from an advertiser’s perspective? I’m sure the NYT sales team will do its best to persuade media buyers that they are.

What’s more, if those people are told clearly that they’re getting something worth hundreds of dollars for free, then they might end up using it more. So even if CPMs behind the paywall don’t go up a lot, it’s reasonable to assume that readers with a get-past-the-paywall pass will end up reading more NYT stories than they have done up till now.

Against that, of course, is a certain drop-off in traffic from readers who don’t want to pay for access, who haven’t taken advantage of the Lincoln offer for whatever reason, and who have no desire to engage in clever tricks any time they want to read a NYT story.

It’s all a lot of swings and roundabouts, but think about it this way: let’s say that 2 million web denizens have access behind the paywall, by the time that the NYT is done with its introductory offers, multiple accounts for home-delivery family members, and the like. I’m running about 150 articles a month, but I’m a heavy user; let’s assume that on average those 2 million people read 75 articles per month. That’s 150 million articles per month, and with some articles containing multiple pages, let’s call it 200 million pageviews per month, or 2.5 billion pageviews per year.

How much extra money could the NYT get from those 2.5 billion behind-the-paywall pageviews? If it manages to raise its revenue per thousand pages (RPM) by $10 for pages behind the paywall, then we’re talking about an extra $25 million in ad revenue — which compares to total digital ad revenues running north of $300 million per year.

It’s a big if, of course — the digital account for the family 9-year-old is a nice perk to keep the print subscription coming, but it’s not going to attract a lot of advertisers. But if the NYT can make the sale, then that $25 million could go a long way to helping to make up for any reduction in total pageviews which comes from introducing the paywall. At that point, the subscription revenues don’t need to offset a decline in ad revenues: they just need to pay for the cost of building the paywall in the first place, help to diversify the NYT’s income streams, and encourage readers to buy the NYT in its highly-profitable print form.

The point here is that the paywall is responsible for multiple revenue streams, not just its own narrow subscription revenues. It will drive marginal readers to the print product, especially at weekends — and thereby shore up or even increase print-ad revenues from the weekend paper. It will dissuade current print subscribers from dropping the paper on the grounds that they can get all the same content for free online. It will allow the digital ad-sales team to charge a premium for readers who have access behind the paywall. And, as we’ve already seen, it will allow deals where advertisers like Lincoln pay good money to sponsor that access.

Add them all up, and I’m beginning to come around to the idea that the paywall can make good financial sense — if everything goes according to plan. This is a complex system, and therefore prone to misunderstandings and mistakes: there have been predictable glitches in Canada already, and I was talking to one NYT staffer on Monday who was convinced that all of the blogs were free, rather than just the “blog fronts“. But over time I suspect that the NYT will manage to simplify both the system and the messaging, which Ken Doctor points out has proven rather tough and unfriendly at launch.

The NYT will surely proclaim the paywall to be a success no matter what happens. But if total pageviews don’t fall and digital advertising revenues increase, then it’s going to be pretty hard to make the case that the paywall was a bad idea.

If the paywall does succeed, I’ll be very happy indeed to have been proven wrong — the NYT is a great newspaper, and it deserves some financial good fortune. It’s a real possibility; let’s hope it becomes a reality.

COMMENT

For those making comparisons between print ads, consider the differences as well.
* I’ve never had a print ad crash my newspaper and force a browser restart.

* I’ve never had a print ad throw itself on top of the article I’m trying to read and insist that I find the “X” if I want to go on reading.

Perhaps the NYT has a higher class of ads than their subsidiary, but the Boston Globe is increasingly annoying to visit. The result, naturally, is that I’ve mostly stopped reading it. When I do, I navigate directly to the blogs or features that I want and avoid the aggressive main page.

I would pay for the Boston Globe if it eliminated the aggressive ads. But (as my viewing habits have shown) I will leave an ad-ridden website for free.

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The downside of companies staying private

Felix Salmon
Mar 22, 2011 20:42 UTC

I had a pretty involved Twitter conversation with TED today on the implications of the fact that fewer companies are going public. We’re both agreed that from a corporate-finance perspective, the trend makes perfect sense: the all-in cost of private equity is lower than the cost of going public. (For reasons why that might be the case, see here or here for starters.) But broadly speaking, from a public-policy perspective, is this a good thing or a bad thing? My thesis is that it’s a bad thing.

There are a few different reasons for this, but they basically boil down to the idea that it’s a good idea for stock ownership to be as broad as possible. What we don’t want is a world where most companies are owned by a small group of global plutocrats, living off the labor of the rest of us. Much better that as many Americans as possible share in the prosperity of the country as a whole by being able to invest in the stock market.

I’m not saying that individual investors should go out and start picking individual stocks. But I am saying that equities provide bigger returns, over the long term, than other asset classes. And that therefore it’s not good public policy for the ability to invest in an increasingly large part of the equity universe to be restricted to an ever-shrinking pool of well-connected global plutocrats.

Historically, this wasn’t much of an issue. Yes, there were private companies, but once they reached a certain size, they generally went public. Even after private-equity firms started becoming important players, those firms were largely funded by pension plans which were ultimately invested on behalf of relatively small individuals.

Nowadays, however, things have changed. There’s much more equity capital available for investment in the private markets than there has ever been in the past — which means there’s much less need for private companies to go public. On top of that, most of us aren’t invested in big pension funds and never will be: the country has moved from that model, based on defined-benefit pensions, to a model of defined-contribution pension plans where individuals invest their own money for retirement. And those of us with 401(k) plans or IRAs don’t have any real way of investing in private equity: our mutual funds and ETFs invest only in public equity and debt.

This is one of the important ways in which defined-benefit plans are better than defined-contribution plans: they give individual investors access to the kind of sophisticated pension-plan managers needed to be able to invest in private equity successfully. I’m not a big fan of the idea that middle-class individuals should be encouraged or allowed to invest directly in private equity — the risks and fees are too large, and invariably the real money ends up getting made by someone else. As for TED’s suggestion that we should just buy stock in Blackstone — well, for one thing Blackstone is a public company, not a private company, so it suffers from all the same problems of high correlation with other public stocks. And for another thing it’s pretty obvious that there’s a world of difference between buying a stake in a publicly-owned asset manager, on the one hand, and buying a stake in a privately-owned company, on the other.

My point here is one that Michael Kinsley has been making for a while:

Look. Small businesses are businesses like any other, and small business owners are people just like others—except that they tend to be wealthier…

There is an anthropomorphic fallacy here. Big businesses are not owned by big people, and small businesses aren’t necessarily owned by small people. The typical shareholder in a big business is a worker in some other big business whose pension fund has chosen to invest in that company. Or a retiree who has bought this stock as his or her nest egg. Or it’s somebody’s 401(k).

Broadly speaking, there are two ways of building wealth: returns to labor (work hard), and returns to capital (invest wisely). If you work for a company with a defined-benefit pension plan, then it will invest wisely on your behalf. If you’re stuck with a defined-contribution plan, however, the onus of investing wisely is on you — whether you’re qualified to do that or not. And the universe of asset classes that are available to you significantly smaller than the universe available to pension plans. As a result, defined-benefit investors outperform defined-contribution investors significantly (by about 3 percentage points per year, if I recall correctly; my internet connection right now isn’t good enough for me to get the exact number).

So American workers are facing a double whammy here: they’re losing access to private equity at exactly the point in time where private equity is becoming a very large and important part of the international capital markets. Meanwhile, it’s the rich foreign clients of Goldman Sachs — the global rentier class — who are getting that coveted access to equity in Facebook.

It’s not just Goldman Sachs, either. SecondMarket (a private company itself) now has a platform designed to match buyers and sellers of private equity in more than 12,000 companies; the company has also registered some 55,000 participants who are qualified to take part. Needless to say, those participants are not exactly representative of middle-class America.

So how do we put the brakes on this trend? Should we force companies to go public when they reach a certain size? Should we allow individual investors to have much more access to private equity and venture capital than they have right now? No: both of those are bad ideas, I think. The reasons for staying private are good ones, and the reasons for restricting investment in illiquid private companies are also good.

How about making a public listing more attractive by relaxing rules like Sarbanes-Oxley? Again, I’m not a fan: the literature is far from compelling that Sarbox was a significant contributor to the decline in public listings.

Indeed, I’m not putting forward any policy prescriptions at all here. I’m just pointing out a problem, while noting that it doesn’t seem to be an issue in the rest of the world. Maybe this move will just be an extra nudge pushing American investors out of the US market and into more international diversification. Which might not be a bad thing after all.

COMMENT

This would be less of a problem if all the nations of the world agreed to impose sufficiently progressive taxation that the wealth of the plutocrats was also funding a proper social safety net, including a defined benefit pension along the lines of that thing Matt Yglesias was talking about ( http://yglesias.thinkprogress.org/2011/0 2/they-could-call-it-social-security/ ).

At a fundamental level, if there simply weren’t enough people with sufficient wealth to fully fund significant sized companies — if the ONLY way to raise IPO-scale amounts of money was to ask for money from the top 10% richest, because there just wasn’t enough wealth available from the top 0.1% — then more companies would IPO.

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Counterparties

Felix Salmon
Mar 22, 2011 06:45 UTC

Interesting use of the Groupon strategy: offer a $50 coupon for a place where the average check is surely much lower — OpenTable

“If you don’t link to primary sources, I just don’t trust you” — Guardian

The NY Fed launches a blog. And immediately truncates its RSS feed — NY Fed

Wife Said No, Apple Said Yes — MacRumors

The video of my paidContent talk with Nick Denton is now online — paidContent

File under “improbable, but cute” — Atlantic

Om’s take on the AT&T merger with T-Mobile — “Everybody (Except AT&T) Loses — GigaOm

“If a Twitter feed or a blog carries the Reuters name, then the same standards of editing and sourcing apply” — Emirates 24/7

COMMENT

So what if the average check FOR ONE PERSON at that restaurant is lower. That just means you go with enough friends to bring the total up to the required level.

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