Felix Salmon

I spent most of this morning at SecondMarket, having a long conversation with Adam Oliveri, the person in charge of their private company market. That’s the part of the company which gets the most attention: it’s where stock in companies like Twitter and Facebook change hands, for instance. I learned a huge amount while I was there, and have now changed my mind on whether Facebook is going to go public: I finally understand exactly why companies need to do an IPO once they have more than 500 shareholders.

Once the 500-shareholder limit is breached, companies have to start reporting detailed financial information to the SEC. Which isn’t in and of itself a compelling reason to go public — lots of private companies with public debt file that information, after all. But there’s something else which gets triggered when you have more than 500 shareholders: you have to register your equity securities with the SEC. And at that point, your shares can be traded by anybody at all in the public over-the-counter markets, even if you haven’t had an IPO.

It’s conceivable that companies could continue to encrust their shares with various contractual restrictions which prevented shareholders from trading their shares in the OTC markets, even after those shares were formally registered with the SEC. But in practice, it’s almost impossible for companies to prevent OTC trading in their publicly-registered securities. And when a stock trades in the OTC markets, that trade is registered and printed in public. At that point, with a company’s stock being traded by anyone at all, at any time, at a public price, on the basis of public information filed with the SEC, the company is to all intents and purposes public already. So it might as well just make it official by having an IPO.

Now that Facebook has said that it passed the 500-shareholder limit this year, then, it’s pretty certain to go public in 2012. (Kara Swisher thinks it might be even earlier than that: I have a bet with her that it won’t happen before September 21 of this year. If it does, I need to go to San Francsico and buy her dinner, but if it’s still private at this point she needs to come to New York and take me out.)

SecondMarket actually has two platforms for trading private-company stock. The main one is Adam’s private company market, which is about two years old at this point, and has seen equity in 50 different growth stocks change hands. It’s pretty much restricted to growth stocks: none of those 50 companies has ever paid a dividend, and they’re overwhelmingly in the technology space.

For other companies, SecondMarket has set up a much more nascent market, which kicked off in January with those trades in Pimco stock. It’s also designed to help trade stock in partnerships (like McKinsey, say), or maybe even large, established private companies like Mars or Cargill. But mostly it seems that SecondMarket has its eyes on companies like Pimco which are subsidiaries of larger companies but which still use their own equity as a recruitment and compensation tool. Reddit is one company which might try to price stock on SecondMarket, as a way of helping it attract talent and grow while still remaining a part of Conde Nast.

Adam also helped answer my question of why SecondMarket is taking off now. Look at the three companies which really got this market started: Facebook, LinkedIn, and eHarmony. They’re all highly visible companies, with metrics that can be measured externally with quite a lot of specificity by companies like ITG Investment Research. It’s also much easier these days to find such companies’ articles of incorporation and the like online — and of course huge amounts of information about these firms is published by the fast-growing blogosphere. So while the amount of information that would-be investors have is surely lower than if there was a formal SEC-registered prospectus, the rise of the internet has made it much easier to do reasonably good diligence on how much a company might be worth. And that’s especially true when the company is young enough that its revenues don’t matter very much.

On top of that, webby companies like these are generally pretty capital-efficient: there’s very little risk that existing shareholders will be unpleasantly diluted by some big upcoming capital-raising round. It’s no coincidence that SecondMarket hasn’t seen trading in green-tech or biotech startups, which are much more capital-intensive.

And then there’s the big picture, which is simply that we’re seeing fewer IPOs of small companies, and that most companies when they do IPO are more like 8-10 years old rather than 3-4 years old. At that point, you’re likely to have had a reasonable amount of turnover in terms of employees, and early employees who have long since left the company are reasonably going to want a way to cash in their equity stakes. That demand for liquidity — along with long-term employees who have a lot of paper wealth but still live relatively frugally and who would like to monetize some of their stake — is what helped get SecondMarket’s equity business started.

Letting employees sell some of their vested stock doesn’t disalign incentives — quite the opposite, in many cases. After all, venture-capital owners of fast-growing tech startups are looking for high-risk home-runs and have diversified portfolios. Employees, by contrast, are always going to be more risk-averse, and letting them cash out in the growth phase can give them enough money to be willing to take the kind of risks their VC paymasters want to see.

It’s also worth clearing up some of the misconceptions in Dennis Berman’s column today on SecondMarket and SharesPost. For instance:

Many in Silicon Valley and Washington regard SharesPost and rival SecondMarket as small saviors of American capitalism. These markets give young companies and their employees new ways to raise capital or sell private stock without the arduous financial and legal disclosure of fully public companies.

This is partly true, but I’m pretty sure that neither SharesPost nor SecondMarket has ever let a company raise capital using their platform. I asked SecondMarket about this today, and in principle they’re open to exploring the idea in future, but for the time being they’re concentrating on simple transfers of shares, rather than the capital-raising issuance of new equity.

Berman continues:

SEC boss Mary Schapiro seems conflicted about these new markets’ purpose. The agency is investigating potential abuses in these secondary markets, including conflicts of interest and insider trading.

There’s no hyperlink here, so I have no idea what Berman thinks he’s talking about. It’s conceivable, I suppose, that he has an SEC source feeding him secret information about an internal SEC investigation that nobody else knows about. But if he did, one imagines he’d write a news story about that, rather than mentioning it in passing in a column which leads with the death of his grandmother 20 years ago. Certainly I’ve seen nothing to indicate that the SEC is investigating SharesPost or SecondMarket for potential abuses including insider trading; this seems to me to be both inflammatory and false.

After quoting Ben Horowitz as someone who is skeptical about such markets (but not mentioning that Horowitz spent $80 million buying shares of Twitter on SecondMarket in the secondary market), Berman comes out with this:

For a market to work best, investors need to be comfortable that they can trade at will.

This manages to completely miss the point of SecondMarket and SharesPost. They’re emphatically not trading vehicles: they’re designed to facilitate one-off transactions. In the two-year history of SecondMarket’s private-companies market, the company has seen maybe half a dozen instances of what you might call tertiary trades: someone who bought at one point and then sold later, once the price had gone up. SecondMarket gives an opportunity to invest in private equity, and private equity by its nature is illiquid. In fact, that’s why many investors like it: they want to capture the illiquidity premium, happy holding on to their stake for many years and knowing that they have an asset which isn’t highly correlated with public markets.

Going forwards, of course, SecondMarket would love it if the 500-shareholder restriction was relaxed. When the rule was introduced in 1964 it was pretty arbitrary, but it was set at a level which wasn’t particularly onerous: the 500-shareholder limit was very rarely triggered before a company went public. After all, in those days you could go public when you were still small; today, that’s much harder. Today, the 500-shareholder limit is a real constraint on how companies do business, how they compensate their employees, and how they structure themselves internally. Is there any good fundamental reason to change the way you incentivize and compensate employees just because you’re hiring lots of people? Of course not — but that’s the effect the rule has.

So while I worry about the public-policy effects of having fewer public companies, I also see no reason for the SEC to keep this rule at its anachronistic 1964 level. On the other hand, I think it might make sense for the SEC to regulate SharesPost and SecondMarket more explicitly than it does at present, rather than having them operate in the shadow of exemptions which were written long before they were founded. If the SEC set clear rules for how private exchanges like this could operate, then that might open the way to bring the rules for companies listing on public exchanges into the 21st Century.

Update: SecondMarket’s Mark Murphy emails to say that Horowitz’s secondary-market acquisition of Twitter shares did not take place through SecondMarket.

Clare Baldwin and Sarah Lynch are unambiguous: “As US regulators review rules on shares issued by private companies,” they write, “they must not make it too easy for hot Internet companies such as Facebook or Twitter to avoid the scrutiny that goes along with an initial public offering.”

They’re talking, of course, about the letter which SEC chairman Mary Schapiro sent to Darrell Issa on Wednesday. It’s a long and pretty boring document, and it’s certainly not as revolutionary as some of the press coverage would make you think. Jean Eaglesham, who broke the news without printing the letter, set the tone of the subsequent discussion by saying that the SEC review “could remake the way American start-ups raise capital,” “would upend the normal path for fledgling companies to raise funds,” and “could shut out many ordinary investors from one of the fastest-growing market sectors.”

But it’s hard to see anything in the letter which really supports Eaglesham’s reading. Mostly the letter is dry and legalistic, and in fact it takes pains to say that “the Commission seeks to minimize the costs of being a public company in the United States and provide a regulatory environment that encourages companies considering going public.” The part of the letter which talks about revisiting the 500-shareholder rule makes it clear that any change is overdue in any case, given how the rule isn’t having its intended effect:

All of this seems much more like a common-sense view of a rule which hasn’t really been updated since it was enacted in 1964, and much less like a revolutionary attempt to kill the IPO market by making it particularly attractive to stay private. Certainly there doesn’t seem to be any point in forcing companies to give out options, or phantom stock, or stock appreciation rights, or other such weird and wonderful inventions, just as a means of getting around a rule which has been around for half a century and is showing its age.

And it’s easy to overstate what exactly goes on in places like SecondMarket:

The SEC is wrestling with the needs of private companies to raise capital against the investing public’s need to make informed decisions.

The issue has jumped into the spotlight as Wall Street banks and electronic markets offer investors a chance to buy and actively trade stakes in hot Internet companies such as Facebook, Twitter, Groupon and Zynga before they go public.

Investors are indeed being offered the chance to buy stakes in companies like Facebook — although Facebook is sui generis and is much more of an outlier than it is typical. But as far as I know, no one is actively trading any of these properties. The auctions come up irregularly, they often require shareholders to hold on to their stock for a period of years, and the trading costs are very high — on the order of 5% per trade. Meanwhile, Goldman’s attempt to come up with a private exchange where shares could be actively traded has fizzled embarrassingly, and never attracted any hot internet companies.

As Jason Zweig says, there’s a good reason retail investors are barred from investing in private placements: they are very risky and dangerous things. But global high net worth individuals are increasingly interested in buying in to such placements, and the SEC has no real reason to stop them from doing so. I’m not a fan of this development. But that doesn’t mean I think the SEC should keep its rulebook in 1964, just because doing so might allow companies to prosper in private hands a bit longer.

Jean Eaglesham has a big piece of news today: yes, the SEC is looking into the private share dealings in Facebook. But not necessarily with any kind of enforcement in mind. Instead, it’s thinking about raising the 500-shareholder limit which marks the point at which companies need to start making public filings.

A move in this direction would be a huge ratification of private markets by the SEC, which was created to protect investors. I guess that one way of protecting investors is to ensure that they never get an opportunity to invest in the first place:

The move could potentially delay or derail IPOs by tech companies that want to grow but would rather avoid having to disclose vast amounts of information. It could also shut out many ordinary investors from one of the fastest-growing market sectors, since shares in private companies are generally available only to investors whose individual net worth is at least $1 million. And at a time when investors are seeking more market transparency, it would lessen the amount of publicly available data about those companies.

The point here is that there is literally an opportunity cost to such a move, which is almost impossible to calculate. How much diversification (in the technical sense) and diversity (in the more colloquial sense) are the public markets going to miss out on if important, fast-growing companies stay private rather than going public?

But I have to admit I don’t understand this:

The possible changes come amid concerns about a dearth of U.S. stock listings, which politicians on both sides of the aisle worry could hurt American competitiveness with the rest of the world.

I don’t know which politicians Eaglesham is talking about (Tim Geithner, perhaps?), but in what sense are stock listings a sign of international competitiveness? There might be a vague correlation there, but I can’t see much in the way of causation. Indeed, there’s a strong case to be made that US companies can be more competitive internationally if they’re free to concentrate on running themselves as best they can, and don’t need to use up precious management cycles dealing with analysts and journalists and people second-guessing all of their actions on the basis of how their share price is moving that day.

The sourcing on the story is about as annoying as it possibly can be: Eaglesham says that the SEC review was “disclosed in a letter to a lawmaker,” without saying who did the disclosing, posting a copy of the letter, naming the lawmaker in question, or even explaining how the letter came to be written. This kind of coyness does nothing to advance the public interest; instead it looks like little more than a petty way of jealously guarding Eaglesham’s Capitol Hill source so that her competitors can’t find the same letter. Come on, WSJ, your job is to make news public, not keep it to yourself.

Eaglesham’s story comes in the wake of two very different takes on the prospects facing private markets. Evelyn Rusli has the bullish view from Silicon Valley, where entrepreneurs are turning down millions of dollars in funding and indeed are cashing out long before any IPO.

“By taking money off the table, you’re expunging a big source of risk, allowing you to focus on the interests of the company you’re building instead of your own,” said Andrew Mason, the 30-year-old founder and chief executive of Groupon. He said he was able to sell some of his shares in D.S.T. Global’s initial Groupon investment, a $135 million round last April.

Meanwhile, Gregory Zuckerman has the more bearish view from Wall Street, where Goldman Sachs’s attempts to put together a private stock exchange called GSTrUE have gone absolutely nowhere.

Goldman has largely stopped working on GSTRuE, merging it into the Portal Alliance, a fledgling network developed by Nasdaq, Goldman and Wall Street firms to act as a single market. That effort hasn’t attracted any new listings, either.

“When everyone ran for the door in the crisis it changed people’s desire to invest in things that aren’t listed” on an exchange, says Anton V. Schutz, manager of Burnham Financial Funds, who says he no longer buys issues that aren’t listed. “Even deeper markets than this haven’t come back after the crisis.”

Why was GSTRuE a failure while SecondMarket and SharesPost are much bigger successes? I suspect that the answer might have something to do with the fact that GSTRuE was set up to mimic a public exchange, with a common set of rules for every company looking to list and every investor looking to trade. The auction sites, by contrast, are happy approaching every deal on a case-by-case basis, structuring auctions to exactly the specifications of the company in question. And, of course, there’s also the fact that there’s a Web 2.0 bubble right now, while GSTRuE launched mainly with asset-management firms which are much less hot.

In any case, it looks very much now that all the current shareholders in SecondMarket were quite right to hold on to their shares rather than sell them on SecondMarket. (There have never been any SecondMarket trades in itself, because no one wanted to sell.) Today’s news has surely increased the value of the company substantially, and you can probably add SecondMarket founder Barry Silbert to the list of people who is politely telling would-be investors that sorry, he has no use for their money right now.

I got some predictably super-smart reactions to my questions about private equity markets at the Kauffman Bloggers Forum today.

Matt Yglesias said he couldn’t see what the fuss was all about: the SEC was created to protect small individual investors from having access to super-risky companies that disclose highly limited amounts of information, and that’s exactly what it’s done. It’s a good point, especially in the context of another idea, from Steve Waldman, which was echoed in the comments to my post by absinthe.

It’s the concept of the winner’s curse: that it’s maybe no coincidence that the Russian clients of Goldman Sachs who are falling over each other to bid ever-higher prices for Facebook shares are much the same people as the Russians paying $100 million for trophy Picassos, or Los Altos mansions.

The theory here is that Goldman Sachs, SecondMarket and the like have identified a group of buyers who are willing and able to pay through the nose for assets which are rare and special and which few other people can have. So long as companies like Facebook and Zynga meet those criteria, the winners in any auction for their shares are likely to be cursed — or, to put it another way, the final auction price is likely to significantly overvalue the company.

Looked at in this way, the market in private equity is less an opportunity for plutocrats to get excess returns, and more an opportunity for intermediaries to extract large profits by selling them overpriced equity in overhyped tech stocks.

As for the timing of all this, Virginia Postrel said that maybe all it took was one or two companies going this route successfully, and then everybody — both management and investors — wanted to join in the fun. A catalytic event is by its nature unpredictable, but once the idea got out that there was a lot of money and attractiveness in private markets, it became self-fulfilling. It’s important not to use Facebook as an example of what can happen when companies go the private route — especially since recent news implies that it might go public early next year. It really is sui generis. But Facebook can still be an important catalyst, inspiring many others to take a serious look at alternatives to expensive and stressful public markets.

On which subject, many of the bloggers in Kansas City were convinced that Sarbox really is an important reason why public markets have become less attractive. The year 2001, in this view, saw not only the 9/11 attacks, which gave birth to the security theater of the TSA; it also saw the Enron scandal, which gave birth to the regulatory theater of Sarbox.

Finally, Tyler Cowen had a good point: now that the rich are getting richer, it’s easy to see how there might be no need for companies to tap the power of millions of small investors any more. If you can get all the equity capital you need from a handful of plutocrats instead, that’s surely a preferable route to go down. In this view, the rise of private equity markets is correlated to the rise of the international plutarchy. Which makes sense to me.

Update: Here’s the talk, for those of you who want to see the questions as well as the answers:

About the same time that “junk bonds” became “high yield” and shortly after “third world” became “emerging markets,” the finance industry quietly engineered another rebranding: “leveraged buyouts” became “private equity.”

So as Andrew Ross Sorkin notes today, the idea of a private-equity shop without debt is fundamentally at odds with the genesis of the industry. This is private equity done the old-fashioned way, where “old-fashioned” means “unprecedented.” But in Brazil, it makes perfect sense: rates there are simply too high to be able to make LBOs profitable, and meanwhile there are lots of efficiencies to be found turning smallish family-owned companies into much larger professionally-run operations.

Brazil is particularly suited to this model, as it has a lot of family-owned companies, and it also has a large elite professional class which is more than capable of taking them on and running them efficiently.

Sorkin is a bit credulous when he wonders at how Brazilian private-equity shops can “make such huge profits,” citing returns of “more than 20 percent annually.” The fact is that many of these family-owned companies, if they’d simply waited two or three years and gone the IPO route instead, would have seen bigger returns than that on the amount of money that they actually sold for. The IPO market in Brazil has been white-hot for a while now, barely taking a breather for the global financial crisis to come and go. Brazilian private-equity shops fund themselves with 100% equity not just because debt is expensive, but also because equity is extremely cheap.

That said, it does make a certain amount of sense for a deep-pocketed investor to buy a good but small franchise and spend the money needed to get it big and efficient enough to IPO effectively: private-equity firms are probably a good way of shepherding companies to the promised land of an IPO, or some other big exit. Effectively, private equity in Brazil is behaving more like US venture capital than it is like US private equity. Except it’s more interested in old family-owned companies than in young technology start-ups.

All of this is a welcome development, in a world with enormous systemic risks associated with debt finance. Private equity might not be as good as public equity, from a public-policy point of view. But it’s still better than debt.

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.

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.

John Abell asks a very good question about a privately-traded Facebook:

Aren’t all the people investing at this moment assuming that a $50 billion valuation is a bargain? What will drive a higher valuation — let’s limit it to the Goldman Sachs Golddiggers — that makes the investment savvy?

Can a relatively illiquid market (one open to only ultra-high net worth individuals) do that? Or are these new investors buying at what they hope will be pre-IPO bargain prices? Would they otherwise, i.e., would they put up $2 million to get a upside potential based solely on privately-reported earnings?

For the answer, it’s worth looking to Justin Fox. Yes, public markets are much more liquid and transparent than private markets. But, as accounting firm Grant Thornton says,

Generally speaking, economists and regulators have maintained that competition, and reduced transaction costs are of great benefit to consumers — but only to a point. When it comes to investments, higher front-end or transaction costs and tax structures that penalize speculative (short-term) behavior can disincent speculative behavior and incent investment (buy-and-hold) behavior that may be essential to avoiding boom-and-bust cycles and maintaining the infrastructure necessary to support a healthy investment culture. As markets become frictionless (i.e., when there is little cost to entering into a transaction), it becomes easier for massive numbers of investors to engage in speculative activity.

Goldman is requiring that investors in Facebook commit to holding their shares for an indefinite period of time: the bank does seem to be making a good-faith effort to find long-term investors rather than people looking to flip their shares the minute there’s an IPO. And for those people, the speed and efficiency of public markets, where the average stock is held for just 22 seconds, looks much more like a bug than a feature. It means that stocks become highly correlated with each other, and that the value of a stake in Facebook becomes much more a function of the performance of the stock market as a whole than it is a reflection of the value of Facebook.

Goldman’s clients are looking for uncorrelated investments, and Facebook will become much more correlated to other stocks the minute it becomes public. That’s why the clients will be happy with Facebook remaining privately-traded. After all, private markets have already bid the value of Facebook up to $50 billion: there’s no reason why they can’t bid it higher still.

The NYT is reporting that Goldman Sachs only made its $450 million investment in Facebook after its in-house private equity fund, Goldman Sachs Capital Partners, passed on the deal.

Many people — including the NYT — have been talking a lot in recent days about the “ancillary business” that Goldman is likely to get as a result of this investment, including fees from any future IPO and wealth-management fees for looking after Mark Zuckerberg’s fortune. There’s no formal agreement about any such things, I’m sure, but the general understanding seems to be that if Goldman scratches Facebook’s back by raising a couple of billion dollars for it now, then Facebook will scratch Goldman’s back in future with various lucrative bits of investment-banking business.

Goldman, it seems, would have loved to get all those fees without having to put its own money into the deal — and then when GSCP said no, it ponied up the requisite cash itself.

But that means something important: that from the point of view of Facebook, Goldman’s client, there’s really no difference between Goldman investing and GSCP investing — whether the money was borrowed from the Federal Reserve or invested by rich clients. Goldman Sachs and GSCP are two faces of the same company and either way Goldman is likely to end up with those ancillary fees.

That, in turn, makes a mockery of all the talk about Chinese Walls between banks’ sell-side and buy-side operations, or the idea that speculative trading is fine, the Volcker Rule notwithstanding, just so long as it takes place in the asset-management arm rather than the bank itself. (Ask Bear Stearns just how insulated a parent bank is from losses at a subsidiary fund.)

If an investment from a bank’s asset-management operation gives that bank all of the relationship-based upside of a principal investment by the bank itself, then it’s clearly silly to think of those investment subsidiaries as being divorced from the investment-banking business. It’s something regulators should think hard about, as they put together clear rules and guidelines about what kind of activity is acceptable where.

At the bottom of the NYT‘s long and fascinating account of the feud between Andrew Cuomo and Steve Rattner, there’s a startling kicker:

After earning millions from managing Mr. Bloomberg’s fortune, Mr. Rattner now advises the billionaire mayor without pay, as the terms of his S.E.C. settlement require, reducing a onetime Wall Street titan to a volunteer.

This is news, I think, and fascinating, to boot. In its press release, the SEC said only that Rattner had “consented to the entry of a Commission order that will bar him from associating with any investment adviser or broker-dealer with the right to reapply after two years”; when Dan Primack called Bloomberg for comment, he was told that “Mr Rattner is a friend whose advice the Mayor has and will continue to rely on.”

Why is Rattner working without pay for Bloomberg? A few possibilities present themselves:

• Bloomberg is somehow paying Rattner under the table, or in kind, or with some kind of nod-and-a-wink understanding that Rattner will somehow be able to invoice for services rendered at some point in the future, a bit like Mike Milken managing to charge $50 million in M&A advisory fees even after he was barred from the securities industry for life.
• Rattner is hopeful that he’ll be able to charge for his investment-advisory services once he’s able to reapply in two years; obviously it’s worth staying in charge of Bloomberg’s multi-billion-dollar portfolio for a couple of years unpaid if you get to start charging for managing it in the foreseeable future.
• Rattner loves the idea that he’s found a loophole in the SEC agreement he made, and can continue to manage Bloomberg’s money for him even though it would seem that the SEC agreement prevented him from doing that.

I suspect that the real reason, though, is hinted at a bit earlier in the NYT story, when it says that Bloomberg is Rattner’s “most coveted and prestigious client,” and that Rattner’s relationship with the mayor “has conferred credibility and stature on Mr. Rattner despite the legal pall that hangs over him.” Rattner needs a rabbi to protect him, and Bloomberg is the best possible rabbi he could have, with the possible exception of Barack Obama himself.

Earlier in the piece, there’s this:

The attorney general was known to be especially galled that in February 2009, in the midst of the investigation, Mr. Rattner had accepted the high-level post in the White House, overseeing a task force reorganizing the American automobile industry, and later announced he would write a book about the experience.

Cuomo clearly thinks that Rattner was hoping to protect himself with Obama’s coattails, and generally bolster his reputation as much as possible through public service. When that didn’t work, Rattner turned from Obama to Bloomberg for protection. I wonder how much that’s worth to him—how much Rattner would be prepared to pay in order to retain his connection to Bloomberg.

Andrew Ross Sorkin loves private equity.

Sorkin finally get around to responding to Malcolm Gladwell today, and he’s unimpressed. Here’s how he frames the question:

Can financiers ever do anything beyond financial engineering?

With General Motors planning an initial public offering for Thursday that values the once-left-for-dead company at more than $50 billion, the answer to that question is more than theoretical.

How did G.M. become one of the greatest turnaround stories, at the moment at least, in history?

You can guess where Sorkin ends up. While Gladwell gives a lot of credit for GM’s current health to Rick Wagoner, Sorkin dismisses Wagoner as the CEO under whom GM went bankrupt. Instead, he says, “the GM turnaround is ultimately an act of financial engineering”—the financial engineering that Steve Rattner takes lots of credit for in his book, and which Sorkin is happy to ratify as one of the greatest turnarounds in history.

The financial engineering at GM was difficult and impressive. But in principle it’s neither difficult nor praiseworthy to take an insolvent company, put it through bankruptcy, and let it emerge under the ownership of its former creditors and people who provided DIP funding.

Bankruptcy, in theory and in practice, is essentially just a change of ownership. It’s not easy, and it carries non-negligible costs; Rattner did a good job of minimizing those costs and therefore maximizing the value of the post-bankruptcy GM. But you don’t need PE honchos to orchestrate a bankruptcy filing and rid a company of its liabilities. And the main thing that Rattner did with GM was to lubricate the process with something over $50 billion in US taxpayer money, most of which went to pay off GM’s creditors, and much of which is unlikely to ever be repaid.

Rattner deserves praise for what he did. But so does Wagoner, and so do all the workers who have worked and who continue to work to actually make the cars that GM sells. The financial engineering might have been a necessary part of the turnaround process. But it wasn’t remotely sufficient.

Politico’s Chris Frates has a good story today on the magnitude of buy-side lobbying efforts:

The Private Equity Council and the Managed Funds Association paid lobbyists more than $7.3 million last year and almost $2 million in the first three months of this year…

In 2009, the financial industry hired 940 former federal employees, including at least 70 former members of Congress, to peddle influence, according to a recent Public Citizen report…

As one Democratic financial industry lobbyist put it, “When the A-Team leaves the Hill and they go back to the Hill to lobby, you don’t stand a chance.”

The buy side lobbyists alone have hired three former members of Congress and many more former Hill staffers, including two senior Chuck Schumer aides.

The lobbying seems to have worked, in that very little proposed financial-reform legislation really touches the buy side. And one of the problems here is that if the reforms have the effect — as I hope they will — of shrinking Wall Street’s investment banks, then there’s a good chance that such activities will simply resurface elsewhere, in what you might call a “shadow investment banking” system of large hedge funds like Citadel.

I’d be a fan, then, of a leverage cap on hedge funds and private-equity shops, which are structured so similarly to hedge funds that we’ve got to avoid the hedgies simply reclassifying themselves as PE just to get around regulations.

I’d also like to see some way of aggregating the intelligence of any hedge funds which see and bet on systemic risks. The systemic risk regulator, whoever it turns out to be, doesn’t have anything like the profit motive of hedge funds when it comes to identifying exactly where the risks might be, and I don’t think that a formal reporting requirement to the SEC will do the job. I’d rather see human contact: although it’s hard to force hedge fund managers to be honest about their positions, a lot of them are in fact happy to talk to a non-competitor in confidence if they think there’s willingness to listen.

One lesson of the financial crisis is that prime brokers actually did a good job of managing the risks within hedge funds: they seem to have learned their lesson from LTCM. But of course those managed risks were largely bilateral: no one was netting them out, or looking at large-scale correlations across firms. I’d like to see some such mechanism in the financial reform bill, although it’s not going to happen. Just because the buy side wasn’t a huge cause of this last crisis, doesn’t mean it won’t be a major part of the next one.

William Cohan has a long profile of Chris Flowers in Fortune, and the big-picture takeaway is that Flowers’s career trajectory is something of an arc — or even an Alpine peak. Flowers started off at warp speed, becoming the youngest-ever partner of Goldman Sachs at age 31; after leaving during the nasty Corzine-Paulson fight (Flowers was a Corzine loyalist) he used his Goldman connections to make the most legendary private-equity investment of all time, buying Long Term Credit in Japan for $1.1 billion, renaming it Shinsei, and selling it four years later for $10 billion.

Since then, it’s all been downhill for Flowers, and Cohan spares him none of the gruesome details: the extra billions pumped into Shinsei and lost; the disastrous European investments, including $1.5 billion for 24.9% of Hypo Real Estate; the second and third funds which are being marked at zero in the secondary market; the Sallie Mae fiasco; the fairness opinion Flowers provided to Ken Lewis, saying that he was paying a perfectly reasonable price for Merrill Lynch. Even his marriage has fallen apart.

Weirdly, Flowers doesn’t seem to have lost a large percentage of his own fortune in all this. Cohan says Flowers is still worth about $1.5 billion — more than he made from the Shinsei deal — which raises the question of what all that money is invested in. A large chunk of it, I’m sure, is Goldman stock; the rest is not clear. Flowers’s investors are very angry at him, and Cohan implies that it’s because he’s lost a lot of their money. That’s probably half of it — but the other half is that Flowers doesn’t seem to have lost all that much himself.

Warner Chilcott is paying $3.1 billion to buy the drugs business of Procter & Gamble. How much of that is its own money, and how much is debt? In the wake of the blowup of so many leveraged loans, one might expect the proportion of the sale price funded by banks to be low. After all, the banks don’t seem to be very keen to lend to anybody these days. But in fact, the banks are providing not half, not 75%, not even 95% of the total — they’re putting up a whopping 129% of the acquisition price.

Yep, Warner Chilcott not only has to put no money down to buy this asset, it also gets an extra $900 million to refinance existing debt. And there’s quite a lot of that, as you might expect from the fact that Warner Chilcott is owned by a who’s-who of the private-equity world, including Bain Capital and Thomas H Lee Partners.

This is being spun as good news. Marketplace’s Jeff Tyler interviewed Ken MacFadyen, the editor of Mergers & Acquisitions Journal:

MacFadyen sees the deal as a heartening harbinger for the banking industry.

MacFadyen: That’s a good sign to see that the lenders are active again.

Me, I’m not so heartened. I’d much rather see the banks’ money going into the real economy, where it can do some good, rather than being used to further lever up a company which was invented by private equity types and domiciled in the tax haven of Ireland.

The leads on this deal are JP Morgan Chase, Bank of America, Credit Suisse, Citigroup, Barclays, and Morgan Stanley. Remember those names, especially if and when any of them starts complaining about how little money they have to lend. Evidently they have no shortage of money if the borrower is one of their old friends in private equity.

Update: Angus Robertson has an excerpt from a Fitch report, under the headline “Investors Swarming Back Into Leveraged Finance Markets”. ‘Nuff said.

Aaron Patrick’s WSJ article on EMI tells us little we don’t already know about the state of the famous record label, and indeed soft-pedals the famous “fruit and flowers” expenses so much that many readers will have no idea what he’s talking about. (It’s industry code for cocaine and other illegal expenses.)

What is interesting, however, is what’s going on at the top of the company: after installing himself as CEO, owner Guy Hands then replaced himself last September with Elio Leoni-Sceti, who is now telling Patrick that “it’s a natural part of the business that it moves on from ownership to ownership over the course of a long term”.

EMI Music has failed three covenant tests on its $950 million loan from Citigroup, which could, therefore, were it so inclined, foreclose on the loan and auction off the business. The quote from Leoni-Sceti sounds to me as though he’s wholly cognisant of that possibility, and not particularly scared of it, especially if (as is entirely possible) he remains CEO under the new ownership.

The acquisition of EMI by Terra Firma was one of the highest-profile private-equity acquisitions of the boom, along with Cerberus buying Chrysler. The latter went to zero; there’s no reason why the former shouldn’t do the same.