Felix Salmon

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.


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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Hilton’s LBO unwinds

Felix Salmon
Sep 16, 2009 18:46 UTC

The LBO of Hilton hotels made no sense even at the time: I described it as crazy, adding that the lenders (including Bear Stearns, bless ‘em) were “taking equity-like risk” for pretty modest returns. So it comes as no surprise to learn that Blackstone, the buyer, has not only written down its investment by half, but is also looking to restructure Hilton’s debt.

The interesting thing here is the way that Blackstone is planning to do this: it essentially wants to convert Hilton’s outstanding loans into bonds. Which might come as some relief to the US taxpayer: we own a whopping $4 billion of Hilton debt inherited as part of the Bear Stearns bailout. If the bond markets are frothy enough to show appetite for Hilton debt right now, I’d happily sell it to them.

Update: See also the way that Warner Music Group turned $1.1 billion of loans into bonds. Although, as Vipal Monga notes, a lot of the time “refinancing loans doesn’t eliminate the debt, it just replaces lower-priced loans with more expensive bonds, increasing the interest burden on the companies”.


The restructuring is quite logical.

Example: (I made up the dollar amounts and haircut percentage)
1. Convert $100m in loans into $80m in bonds;
2. The government takes a 20% haircut;
3. The new lenders take less risk;
4. Despite having their equity wiped out in the original deal, the “owners” end up with new equity and keep the properties.

Everyone wins – except Uncle Sam.

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