Opinion

Felix Salmon

The fraught politics facing Lagarde

Felix Salmon
May 24, 2011 19:52 UTC

To get an idea of the job facing the new head of the IMF, check out Patrick Wintour’s interview with Vince Cable, a UK cabinet minister who, perfectly sensibly, says that Greece is going to have to restructure its debts. Cable puts a positive spin on the idea: a “soft restructuring”, he says, with Greece staying in the euro zone, could lead to a closer political union.

Then, read the story of what happens when you so much as suggest such a thing to Jean-Claude Trichet, eurocrat-in-chief. Even if you’re from Luxembourg:

Jean-Claude Trichet, ECB president, walked out of a meeting hosted by Jean-Claude Juncker, Luxembourg’s prime minister. According to people familiar with events at the meeting, Mr Trichet was angry at talk of a so-called “soft” restructuring that could involve an extension of Greek debt maturities.

I can see why Trichet is so opposed to such a policy. Central banks, by their nature, hate restructuring assets: granting debt forgiveness is fiscal policy, not monetary policy. But the ECB holds a lot of Greek debt, and it’s almost impossible to see how it could fob that debt off onto the European Financial Stability Facility or any other body in advance of any restructuring.

In any event, the politics here are extremely delicate — note that Cable’s view is still just Cable’s view, rather than being the official view of the UK government — and the managing director of the IMF is the key broker who can forge some kind of consensus on this fraught subject both within Europe and more globally.

That’s why Pierre Briançon is wrong when he complains of Christine Lagarde that she isn’t qualified for the job:

Lagarde, who has no academic training in economics or finance, doesn’t even seem to have a strong set of beliefs.

Right now, a strong set of beliefs is something we don’t want in an IMF managing director. The job involves delicate negotiations with very large egos: it requires toughness, to be sure, but certainly not ideology. In that respect, the fact that it’s impossible to place Lagarde into an ideological hole is a big point in her favor — as is the fact that she seems to get on very well with the likes of Angela Merkel as well as her compatriot Jean-Claude Trichet.

Besides, “no academic training in economics or finance” doesn’t sound so bad to me, given the alternative.

COMMENT

Felix should read Simon Johnson on why Lagarde is not such a fine choice:

http://economix.blogs.nytimes.com/2011/0 5/26/the-problem-with-christine-lagarde/

Posted by GlibFighter | Report as abusive

Felix TV: The Ira Sohn conference

Felix Salmon
May 24, 2011 16:51 UTC

It’s the Ira Sohn conference tomorrow, with well over a thousand people paying four-digit sums, and sometimes more, for the privilege of listening to boldface fund managers talk about their investment ideas. The conference gets a lot of press, not least from Reuters, but these presentations are not the kind of thing that individual investors — or even financial journalists — are really qualified to judge.

Hedge funds — and venture capitalist funds, and private-equity funds — have a certain mystique which rubs onto their managers, especially when those managers have posted impressive investment returns over the past few years. The Ira Sohn conference has even more mystique, since with many of these fund managers it’s the only time they speak in public, and as a result the audience is primed to expect something very special.

But as with any investment, it’s important not to get caught up in hype. Precisely because the Ira Sohn conference has so much hype and mystique, everything coming out of it should be treated with extreme prejudice. If you find a great investment idea in an improbable and unexpected place, that’s likely to be a much better bet than if you think you’ve found a great investment idea coming from a professional fund salesman in a highly-artificial context.

Investing in hedge funds is hard enough; investing in individual hedgies’ ideas is pretty much impossible. The only people who should even try are other hedgies, or possibly endowment managers who see a lot of idea flow and have significant experience of getting caught up in a story and then seeing how it plays out. Sometimes the highest-conviction ideas are also the worst ideas. Unless and until you’ve lived through those kind of experiences, you’re probably best off simply ignoring everything coming out of the Ira Sohn conference.

Counterparties

Felix Salmon
May 24, 2011 05:36 UTC

Ryan McCarthy to Reuters.com! VERY excited about this — Romenesko

On McKinseyites, bullet points, and interview technique — Tumblr

Twitter acquires TweetDeck — CNNMoney

NYT social-media guidelines: “use common sense and don’t be stupid” — TBI

Top Ten lines from Charlie Gasparino’s “What I Read” interview — Tumblr

Great moments in US embassy design: ramps incompatible with the US presidential motorcade — Irish Times

Life in Silicon Valley: “we had a couch in the office that was really ugly, and we sold it for $5,000″ — Wired

Fantastic Vanderbilt column on “Children at Play” signs — Slate

LinkedIn, the limerick — Limericks Economiques

“The CPI doesn’t come out until a month after the fact. In turbulent times, that’s too slow.” Really? — TNY

Shiller’s still pushing perpetual GDP bonds. They’re still a bad idea — Fortune, Reuters

NYC Subways That Open into Buildings — Brier

COMMENT

Well, blogspot errs on my comment re. NYC subways that open into buildings, so i’ll just say it here.

You used to be able to get out of the 4,5,6 at Grand Central, walk through some winding hallways and get out in the lobby of the Roosevelt Hotel (45th and Madison).

You could get out of the uptown 6 at 59th St. and step out into Bloomingdales. Maybe you can still do this — i’m not sure.

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Are Warhol auctions being gamed?

Felix Salmon
May 24, 2011 04:31 UTC

I’ve been puzzling over Sarah Thornton’s post on the Warhol market, especially as I recently had drinks with someone expressing a very similar view. There’s something here, but I’m having difficulty putting my finger on exactly what it is:

“These sales are no longer auctions,” says Allan Schwartzman, an art advisor. “To attract material at the top end, auction houses pre-sell the material to ‘irrevocable bidders’. They are deliberate, orchestrated events.” Indeed, Christie’s evening sale featured 11 irrevocable bids, Phillips had ten, whereas Sotheby’s had only two. These deals spare the work the ignominy of being “bought in”, but they can create misleading benchmark prices that tend to flout ordinary rules of supply and demand. Guarantees can help auction houses by securing an important artwork around which an entire sale can be promoted. They may also appeal to a collector’s gambling instincts. If he chooses to be the guarantor, he can either win the work or win a financing fee or both. Whatever the case, when the work sells on one bid, a guaranteed lot is effectively a private sale done in public.

My first reaction to this was incomprehension. At an auction, all bids are irrevocable. If a painting has an irrevocable bid, that just means that a favored collector has managed to get his bid in first, before anybody else. That kind of deal makes a lot of sense for all concerned: the seller and the auction house are guaranteed a sale, while the bidder either gets the painting they want at a price they like, or else gets a percentage of the upside over and above their bid.

There are differences between this kind of thing and a normal auction. For one, there’s no underbidder, in a world where the existence of an underbidder has historically helped to ratify auction sale prices in the eyes of the art world. But that’s a minor point, I think: the main value of auction prices is simply that they’re a very public indication of how much someone was willing to pay, on a certain day, for a certain work of art. And that is unchanged in this context.

And I’m still unclear on what Thornton means when she says that these deals “flout ordinary rules of supply and demand”. The supply of any given painting is always fixed at exactly 1, and the auction house is still a place of competitive bidding: the higher the number of bidders, and the more aggressive those bidders are, the higher the final hammer price will be. The only time the rules of supply and demand are flouted is when the number of bidders is exactly 1 as well, and then, yes, as Thornton says, the final price does look rather like a negotiated private sale.

But what’s Thornton’s beef with private sales, especially when the final price is public? A $50 million Warhol is a $50 million Warhol, whether the sale takes place in public, in private, or somewhere in between — and whether the sale is deliberate and orchestrated or whether it’s chaotic and unpredictable. I can see how someone who thrills to the theater of the auction house might feel a bit cheated if many lots end up selling on a single bid. But the theater is really just a mechanism to get juices flowing and prices rising: it’s not the point of the auction.

Thornton does hint at something more nefarious going on, although she doesn’t quite come out and say it:

In any given contemporary auction week, a fair number of the Warhols will have been either consigned, underbid or bought by the Mugrabi family, sometimes in partnership with Larry Gagosian (who sits across the narrow aisle from Mr Mugrabi at Christie’s and one row ahead of him at Sotheby’s)…

Interestingly, the Warhol players often find themselves coming together…

The lots that are underbid by dealers or go from dealer-collector to dealer-collector inflate prices and create the appearance of trading volume in a way that is hard to track. And irrevocable bids often lead to public performances of private deals that are far more opaque than auction houses let on.

Here’s what would seriously undermine the validity of the auction prices. Let’s say the private deal was indeed far more opaque than auction houses let on, and included some kind of embedded put.

Here’s a hypothetical: Mugrabi wants to increase the value of his vast Warhol collection, using Sotheby’s as his vehicle. So he puts a painting up for sale, and Gagosian guarantees to the auction house that he’ll buy it for $50 million. Because it’s an irrevocable bid, Gagosian pays no buyer’s commission on that bid — and Mugrabi is a favored client of Sotheby’s, so he pays no seller’s commission. No one else is willing to pay anything like $50 million for the painting. So it comes up for auction, it’s sold to Gagosian with a single bid, and $50 million is transferred from Gagosian to Mugrabi via Sotheby’s. And then, a couple of weeks later, Gagosian exercises his put, and sells the painting back to Mugrabi in a quiet private transaction for the same $50 million.

What has all of this theater achieved? Mugrabi and Gagosian are back where they started: Mugrabi has his painting, and Gagosian has his $50 million. But now there’s a big $50 million public auction benchmark making Warhol look really hot. As Thornton puts it, “collectors and dealers with an affinity for Warhol have a clear sense of the auction room as a marketing platform”.

Now I don’t believe that anything quite that explicit and egregious is actually going on behind these irrevocable bids — although nothing would really shock me, in the art world. But maybe nothing that explicit and egregious needs to go on, if the number of clued-in dealers and collectors is small enough, and they all simply act in their own long-term best interest by bidding up each others’ work and attracting an ever-increasing number of ignorant plutocrats to the high end of the Warhol market.

Dealers have been buying paintings at auction for enormous sums for many years, because they know that in doing so they raise the value and desirability of the rest of their artists’ work. You don’t need an irrevocable bid to do that, although it helps if there’s an eager underbidder somewhere. Is Thornton implying that something much less ethical might be going on in the Warhol market? I’m not sure. But if she’s not implying that, then I don’t really understand what she’s saying.

Update: Thanks to absinthe, in the comments, who points out that irrevocable bidders do pay buyer’s commission if they win. So the cost of setting the benchmark is the buyer’s commission, which, on a $50 million hammer price, is just over $6 million. Even split two ways, that’s a lot of money.

COMMENT

If there is one bidder, no auction has taken place. I think it is deceptive at best. I suppose if you have a collection and you need to protect the value, publicly buying a painting at a set price can serve that purpose.
I would hope that the number of bids would be publicized so people could determine whether price could be a sham. Otherwise, I could see where this could be a tool to get unsuspecting buyers to believe paintings are more valuable than they really are. Auction houses could provide kickbacks later on to cover cost of the buyers premium so that the sale was really just a performance. I would stay away from Warhols knowing this. Let’s say
this happened in the stock market. Stock was sold to give the perception of value. Other people buying them thinking that they paid a fair value, but when they went to sell there were no buyers. That could be percieved as fraud. Eventually someone gets left holding the bag.
Maybe there aren’t any laws against this in the art world, but it is deceptive at best. If you have to pay someone to tell you how valuable a piece of art is, maybe you shouldn’t buy it. It is all just a big ego thing anyway isn’t it? Who can waste the most amount of money and smile about it.

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How to ethically improve your customer reviews

Felix Salmon
May 23, 2011 18:59 UTC

David Segal’s Haggler column this week concentrated on companies which use Mechanical Turk to plant fake reviews — both positive and negative — on Yelp. “This is very sneaky,” he writes, “and it’s a continuing problem for Yelp, which is locked in a “Spy vs. Spy”-style contest with fake reviewers.”

But Panos Ipeirotis has found a much more interesting way of using Mechanical Turk to game Yelp; it may or may not be sneaky, but it does seem to give companies a significant advantage — enough that Zappos seems to have spent roughly half a million dollars on it. It’s worth noting that both Zappos and Mechanical Turk are owned by Amazon, so if Yelp has an issue with this, it’s going to be fighting a very large opponent.

The insight here is that the kind of companies Segal is writing about are looking at Yelp in a pretty naive way: good reviews are good, bad reviews are bad. But in fact it’s more subtle than that. In a recent paper, Ipeirotis looked at a long list of variables in hotel reviews, to see which ones were good predictors of customers actually booking those hotels. The statistically-significant variables were these:

statsig.tiff

Top of the list — the thing you really want if you want your hotel to get booked — is “beach.” But hotels can’t do much about their proximity to the beach. What they can do is address the second-most important variable: readability. Just having well-written reviews, it turns out, is much more important than having good reviews: the rating given in the review was much less significant, as were aspects of the review relating to cleanliness, check-in, service, and the like. And the Value rating on reviews actually had a significantly negative correlation: the better value reviewers said a hotel was, the less likely it was to be booked.

This holds true for other products, too, as Ipeirotis found in another paper:

Demand for a hotel increases if the reviews on TripAdvisor and Travelocity are well-written, without spelling errors; this holds no matter if the review is positive or negative. In our TKDE paper “Estimating the Helpfulness and Economic Impact of Product Reviews: Mining Text and Reviewer Characteristics”, we observed similar trends for products sold and reviewed on Amazon.com.

So Zappo’s, instead of getting people to write good reviews, just got them to fix reviews which already existed — deal with spelling errors, correct grammar, that kind of thing. And anecdotally (Ipeirotis got to talking to someone over drinks at WWW India), Zappo’s saw a “substantial” improvement as a result of its investment in cleaning up such things.

Is it fair for Zappo’s to give itself an advantage by doing its reviewers a favor and making them seem more literate than they actually are? I’m not sure. But I’m thinking that I should start correcting spelling and grammar mistakes in my comments section. It’ll only serve to improve what people think of it — and of my blog more generally. Even if those people are very rude about me.

(H/T Hanson)

COMMENT

That’s interesting…. I mean especially for some industries like hotels for examples online reviews are literally what drives consumers…so I get it how some companies can get desperate for a positive review..!! Here is an interesting article I found on the subject: http://growingsocialmedia.com/improve-on line-customer-reviews/

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Hidden bank fee of the day, wholesale FX edition

Felix Salmon
May 23, 2011 16:31 UTC

The WSJ has done a great public service today with its analysis of BNY Mellon’s forex pricing, nicely summed up in this chart:

barchart.jpg

Note the grey bars here, which are particularly egregious: a significant percentage of the time, BNY was giving its clients prices which were bad to the point at which they were physically impossible: no trades were actually done in the interbank market at that price that day.

This is about as cut-and-dried as things get. BNY Mellon’s clients put in FX orders, the bank executed those orders and reported back a price. Only it lied to its clients about the price it was getting, padding its own profits while so doing. This is doubly evil: not only did the bank lie, but it lied while serving as a fiduciary to its clients*, with an affirmative duty to give them “best execution.”

Watch the bank undercut a genuinely good point with an outright lie:

The spokesman says the bank offers “attractive, favorable rates” to pension funds like Los Angeles’s, which he says are not necessarily entitled to the interbank rate—the rate at which BNY Mellon trades. Many of the Los Angeles fund’s trades are relatively small ones, often of less than $100,000, he says. If executed in the international wire-transfer market, he said, the trades would cost the fund 2 percentage points above the interbank rate—a lot more than trading through BNY Mellon.

“Any suggestion that a price within (or even close to) the interbank range is an ‘unfavorable’ rate for these small trades reflects a fundamental misunderstanding of the foreign-exchange markets,” the bank said. The bank says it is transparent about the rates at which it executes client trades.

The fact is that small funds like the Los Angeles pension fund simply don’t have the wherewithal to get interbank pricing on their own. If you look at the total amount of money that the fund paid BNY Mellon for forex services, I daresay it’s quite reasonable compared to the alternatives. But one thing it’s not is transparent. BNY Mellon did not give its clients “the rates at which it executes client trades” — it gave them fake rates instead.

In fact, it’s far from clear that BNY Mellon actually “executed client trades” in any real sense at all. The obvious thing to do, if you’re a big money-center bank getting loads of order flow from thousands of clients around the country and the world, is to simply accept all orders and net them out internally, giving the sellers of dollars a rate at the top end of the daily interbank range, and the buyers of dollars a rate at the bottom end. That’s entirely consistent with what the WSJ is reporting, and it guarantees BNY Mellon a profit of the spread in between the two numbers.

If BNY Mellon did that transparently, it would probably be fine. But it doesn’t, and that’s the real problem here. It seems that even at the wholesale level, banks are much happier hiding their fees and profit sources than being transparent about them. Now BNY Mellon and other banks like State Street getting into trouble for its actions with state attorneys general and the SEC, maybe they’ll learn that honesty, in the long term, is a much better policy than trying to get one over on clients for whom you’re meant to be a fiduciary.

*Update: My colleague Cate Long says that BNY did not have a fiduciary duty.

COMMENT

Orannge County, anyone?

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Ben Stein Watch, penny-stock edition

Felix Salmon
May 23, 2011 13:23 UTC

In 2004, Ben Stein wrote a thin book called How to Ruin Your Financial Life, a collection of short sarcastic chapters giving extremely bad advice. Chapter 32 is entitled “Invest in Penny Stocks”, and it aims directly at the purveyors of “advice” about the same:

If you buy GE at $25 and it goes down by $.50, you’ve lost 2 percent, but if you buy XYZ at $.50 and it goes down by $.50, you’ve lost 100 percent.

This will never happen to you, though, because you’re only buying really top-quality penny stocks, the GEs and GMs of the penny stocks — only they haven’t been discovered yet.

Plus, you’re only buying after you’ve gotten really hot tips, and when you know for sure that you’re going to watch that stock zoom into the stratosphere.

Let’s put aside for the time being Stein’s decision to cite GM as being the kind of wonderful stock which goes up and up in value, because now Stein has endorsed Accredited Members Inc., “a leading publisher of micro cap investment research”:

Stein firmly believes micro caps have a place in every investor’s portfolio and that the kind of in-depth research AMI brings to its readers can mean the difference between success and failure in investing in the micro cap space. “AMI does the kind of research that can result in triumph and avoid tragedy in the micro cap world. An informed investor is the best kind of investor,” said Stein, “and in the micro cap and nano cap world, AMI is an important path to being informed.”

Later this year, Stein is publishing “What Would Ben Stein Do: Applying the Wisdom of a Modern-Day Prophet to Tackle the Challenges of Work and Life“. Yes, he really does refer to himself as a “modern-day prophet”, probably on the strength of his farsighted views on things like the GM share price. It’s going to be fascinating to see what the book says about selling out all your stated beliefs if someone comes along with a big enough check. Or what to do if you follow a modern-day prophet who gives wildly contradictory advice to his acolytes.

COMMENT

This post may scare some investors off, but if you are doing any day trading. Penny stocks are a must in this economy.

http://sandiego-movers.co

Posted by SanDiegoMoving | Report as abusive

Counterparties

Felix Salmon
May 23, 2011 07:38 UTC

Business Insider now doing 2,380 posts per week — Covestor

“City Hall admits to the mistake, and adds that there are no plans to bring porta-potties to the 9/11 memorial site” — Gothamist

“Why all the fuss? It’s merely a bit of hanky-panky with the help,” said Jean-François Kahn, the crusading editor of the left-wing Marianne weekly — Telegraph

Apple makes huge inroads in enterprise as corporate Mac sales surge 66% — Apple Insider

Bill Gates on Charles Kenny — WSJ

DSK’s armed guards cost him $200k/month — NYT

Personally, I’d rather just take a short nap — Lifehacker

Princess Beatrice’s Royal Wedding hat sells for $132,000 on eBay — NYDN

The nice people at the New Yorker have unlocked Nick Lemann’s 1999 take-down of McKinsey — TNY

A Week on Foursquare — WSJ

Gwen Robinson on the tragicomedy of Tepco — FT

COMMENT

HAH! OK that is hilarious! I really thought there was some new technology so that cookies could add ads!

(being that is the new technology being introduced for phones I figured imbedding it in a video might also be possible… crap I hope I didn’t give someone any ideas!)

Posted by hsvkitty | Report as abusive

The LinkedIn IPO debate

Felix Salmon
May 23, 2011 06:57 UTC

In the blue corner, we have Joe Nocera and Henry Blodget (twice). In the red corner, there’s The Epicurean Dealmaker (twice), with The Analyst as cornerman. The debate centers on the fact that the shares LinkedIn sold Thursday are worth hundreds of millions of dollars more than LinkedIn received from its bankers. To Nocera and Blodget, the conclusion is clear: LinkedIn’s bankers screwed the company out of that money, giving it instead to their favored buy-side clients.

There’s no doubt that investment bankers deliberately underprice IPOs. Blodget explains why:

If underwriters aimed to price each IPO exactly at fair-market value, there would be no incentive for institutions to take the risk of buying the stock before the shares started trading. Instead, they’d just wait to see where the stock traded and then make their buying decision then.

In the case of an oversubscribed IPO like LinkedIn, this isn’t completely convincing — getting a large allocation of shares at once is preferable to having to taking your chances with respect to being able to cobble together a significant position in the secondary market. After all, as TED says, the banks “want to weight the initial buyers in the deal toward investors who intend to not only hold the stock after it frees to trade but also add to their positions in the aftermarket”.

But the bankers don’t only want to place stock with high-quality long-term investors; they also want to achieve one of the main purposes of going public in the first place, which is price discovery. For that, you need a substantial volume of buyers — and sellers — all day every day for years and decades to come.

In other words, it’s the market which sets the price of the stock; it’s the job of the bankers to bring the company to market. And the bankers only have room for error in one direction. They can underprice the IPO; in fact, they have to underprice the IPO by some amount. But they can’t set the price too high.

Now the view of Nocera and Blodget is that the bankers can or should have a very good idea where the shares are going to end up trading, and that therefore if they end up underpricing the IPO by as much as we saw on Thursday, that’s unprofessional at best and downright theft at worst. Nocera says that the LinkedIn bankers “absolutely must have known” that the IPO was going to double in price; Blodget says that “Wall Street underwriters are paid massive amounts of money to estimate fair-market value, so they deserve to be held accountable when they blow it.”

I agree with Blodget’s premise here, but I come to a different conclusion. The whopping 7% fee that banks charge for an IPO is indeed a very large sum of money; if markets were remotely efficient, that fee would be much smaller, closer to the kind of fees normally seen on bond issuances, which can be less than 0.2%. Or, you can consider the 7% fee to be the cost of a guarantee that the company will get analyst coverage from the lead managers for the foreseeable future, rather than the price of market expertise which costs much less in other contexts.

In any event, I disagree with Blodget and Nocera that the banks knew what was going to happen when LinkedIn went public, and generously gifted hundreds of millions of dollars to their clients rather than giving 93% of that sum to LinkedIn and keeping the rest for themselves.

For one thing, if the large 7% fee does anything, it aligns the banks’ interests with the issuer’s. If the banks felt they could make millions more dollars for themselves just by raising the offering price, it’s reasonable to assume that they would have done so. I’m sure that the institutions which were granted IPO access are grateful to the banks for the money they made, but that gratitude isn’t worth a ten-figure sum to the ECM divisions of the banks in question.

But there’s an even easier way to prove that the banks didn’t know what was going to happen on IPO day. Which bank, after all, is the greediest and most knowledgeable of them all? Goldman Sachs. And Goldman was one of the few investors which sold its entire position at the IPO price of $45 per share. If Wall Street knew that LinkedIn was going to soar into triple digits on day one, you can be quite sure that Goldman would have held on to most if not all of those shares.

This, then, looks much more like a cock-up than a conspiracy. If the banks knew that they could get the IPO away at $80 per share and still see a 15% pop, they would surely have done so. But they didn’t know that, because LinkedIn was the first social-networking company to go public, and therefore no one — on either the buy side or the sell side — really had a clue where the public markets would end up valuing it.

And indeed it’s not entirely clear that the banks could have gotten the IPO away at $80 per share. The way that the LinkedIn IPO worked, the shares were issued at $45 to investors who were happy to hold them at that level; those investors then started selling when the first-day pop reached insane proportions. At $80 per share, however, very few of those investors would have been happy to hold on to the stock for the long term — which means they wouldn’t have put in bids in the first place. The banks might well have had serious difficulty even allocating the shares in the first place, and would have been risking a busted IPO.

What’s more — and this is a point which, weirdly, neither TED nor The Analyst have made — bankers and investors actually had a very good idea what the market price for LinkedIn shares was. It was $35 per share. LinkedIn was the fourth-most-traded stock on SecondMarket, with an auction every month from April 2010 through March 2011. In January there was a significant pop to $34 per share, and then it stayed there: in February the auction cleared at $35, and in March it was the same amount.

Yes, the LinkedIn prices were arrived at with only a small number of buyers and sellers, but they were real market prices in an anonymized market; pricing well above the SecondMarket level was always going to be dangerous. The bookbuilding process is vague and error-prone compared to the hard numbers being generated on a monthly basis on private markets, and so bankers were naturally going to trust SecondMarket as a very important datapoint in their pricing decisions. If LinkedIn had priced well below the SecondMarket price and then popped up to exactly that level, then it would have been easy to criticize the bankers. But instead it priced at a 30% premium to the highest-ever SecondMarket price — which was pretty aggressive, I think.

The SecondMarket story also shows that auctions often don’t work very well. There’s a 50-page paper here explaining all the reasons why that might be, especially when it comes to initial public offerings. But this is an important point: the Noceras and Blodgets of this world are very quiet on the question of whether there’s a better way of doing things than the one we’ve got right now.

Auctions have been tried, in many markets and jurisdictions around the world, and they’ve always failed; attempts to improve them have been unsuccessful, largely because it’s pretty much impossible for underwriters to distinguish between investors who have done their homework and know exactly how much they want to pay, on the one hand, and free-riders who add a lot of noise to proceedings, on the other, who trust in the former group to get the pricing right. On top of that, the mathematics of the winner’s curse means that bidders have to be extremely sensitive to the number of other bidders in the auction — and that is a number they’re unlikely to know.

And yet I’m not completely on board with the people who think that everything’s fine. Consider the point is made by The Analyst, that the only people complaining, here, seem to be kibitzers in the press. The bankers, the sellers, and the buyers are all happy — so what’s not to love? Here I think Nocera and Blodget are on stronger ground, because of the slightly invidious way in which IPOs are set up.

Essentially, there are two types of stock sale, generally known as primary and secondary, although “secondary”, in particular, can have different meanings. What I’m talking about here is the distinction between primary offerings, where a company sells shares in itself; and secondary offerings, where shareholders sell stock to each other. Rights issues are primary offerings, even if they’re not IPOs, while a founder selling stock in the market would be considered a secondary offering, even though such activities are generally done very quietly.

The LinkedIn IPO was, like most IPOs, mainly a primary offering — LinkedIn itself sold most of the shares, and received most of the proceeds. Insofar as those shares were underpriced, LinkedIn was the victim. Now LinkedIn is owned by many shareholders, who can be considered victims proportionally to the number of shares that they own. If I own 1% of LinkedIn, and the company left $200 million on the table, then $2 million of that money can be considered mine.

But the fact is that if I own 1% of LinkedIn, and I just saw the company getting valued on the stock market at a valuation of $9 billion or so, then I’m just ecstatic that my stake is worth $90 million, and that I haven’t sold any shares below that level. The main interest that I have in an IPO like this is as a price-discovery mechanism, rather than as a cash-raising mechanism. As TED says, LinkedIn has no particular need for any cash at all, let alone $300 million; if it had an extra $200 million in the bank, earning some fraction of 1% per annum, that wouldn’t increase the value of my stake by any measurable amount, because it wouldn’t affect the share price at all.

In that sense, the extra $200 million, while having a huge amount of value to the lucky investors who got to buy in at the IPO price, is actually worth very little to LinkedIn’s shareholders. If markets were wondrously efficient, that $200 million in cash would be reflected in a share price being $2 higher. In reality, the people buying the shares at this level really don’t care how much money LinkedIn has in the bank — especially now that it has a much stronger acquisition currency, should it want to start buying other companies, in its own stock.

As a result, almost none of the “losers”, here, bar LinkedIn’s corporate treasurer, really cares about that money. LinkedIn’s shareholders care about the share price, and the amount of money that LinkedIn has is irrelevant to the share price. LinkedIn’s managers and executives care about the fundamental business, not about trying to manage a cash pile which was already very large and is now significantly larger. The only real losers are the investors in Goldman Sachs’s fund — I suspect they’re rightly very angry about the company’s decision to divest itself of its entire stake at $45 per share.

Meanwhile, the big winners — the funds given access to the IPO — are ecstatic. But those funds did nothing, really, to deserve their windfall. Early-stage investors in the company were taking big risks and locking up their money for years; the people who got IPO allocations were taking no risk at all and locking up their money for, oh, a few minutes.

It would be wonderful if there were a better, fairer way of running IPOs, which didn’t give Wall Street banks the power to make millions of dollars overnight for their well-connected friends. But many attempts have been made to find such a way, and none of them have really caught on.

And here’s where SecondMarket could come in handy. Companies wanting to go public could simply lift most of the restrictions on who can buy and sell company stock on SecondMarket, SharesPost, and other private exchanges — including any restrictions limiting the number of shareholders to less than 500. At that point, under SEC rules, the company would be making a clear statement that it intended to have a fully-fledged listing the following year. It could file an S1, and maybe release some shares of its own onto the private markets just to improve liquidity and price discovery.

Then, a few months later, the company would officially sign up with Nasdaq or the NYSE, and let its shares be listed, possibly in conjunction with another tranche of newly-issued shares coming to market at the same time. Because a large number of shares had already been trading in a quasi-public market for months, there probably wouldn’t be nearly as much room for pricing error as there is now. There needn’t even be a big official IPO; that would be up to the company and its bankers.

Many companies, of course, love seeing their name splashed across the Corinthian columns of the NYSE, and having their executives ring some bell or other to celebrate their listing. All that pomp and ceremony is worth something — as is the press coverage which comes with it. A fairer way of going public would necessarily mean that IPOs would become much less momentous events. Which is why I suspect that we’ll stick with the old-fashioned way for the time being. Even if it means dumping hundreds of millions of dollars into the laps of investors who really don’t deserve it.

COMMENT

Felix,
You have such repeated, insistent, conviction that “price discovery” is the justification for many things financial but it always seems as though you treat this as something obvious and in no need of any explication. One day, please, could you spend a bit of time telling us what you are really thinking when you invoke this concept?
E.g. Do you think there is an objectively “correct” (or economically useful/efficient) price being “discovered” somehow? (If so, how do you reconcile this with e.g. such high volatility in the public markets as we have seen over the last two years, or the periodic huge disconnect between private and public valuations?) Or do you just mean “a price near where there is substantial two-sided liquidity”? (In which case, don’t you think you over-praise its significance … I’m thinking in particular of various of your CDO posts).
In this post you say: “But the bankers … also want to achieve one of the main purposes of going public in the first place, which is price discovery?”
Do they really consciously _want_ this? I perhaps see it if it means merely “create a liquid market”, but wanting something beyond this? (Cynically: if their bonus isn’t tied to something, can a banker really _want_ something?)
And about a hypothetical insider already owning some of the company you say “The main interest that I have in an IPO like this is as a price-discovery mechanism…”. Surely no! My main interest is the IPO creating a liquid venue where I can sell my stake at a high-price when I want to. The higher the better. I’d be pretty sad if the market “discovered” a $1 price per share, and being told what a surprising discovery this was would not mollify me. Again, unless you mean something extremely shallow
by the term “price discovery”.

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