Why private equity investing is the way to go, while ‘the stock market is for suckers’

25 Feb

Below is a great education on why Wall Street’s public stock scheme is no longer in vogue, & why venture capitalists are using private equity funding to get great returns. 

‘The stock market is for suckers’

by Jason Kirby of Macleans.ca

Facebook decided to "unfriend" Wall Street & the public investing model, opting to partner with Goldman Sachs to outsmart the system instead. Justin Sullivan/GETTY IMAGES

Were it not for the source and recipients of the email—From: Goldman Sachs, To: Our most outrageously rich clients—it would have read like one of those Nigerian investment scams that slip through spam filters now and then. “When you have a chance I wanted to find a time to discuss a highly confidential and time-sensitive investment opportunity,” the secretive missive began. But this was clearly no shady dispatch from Lagos. What investment bank Goldman Sachs offered by way of the emails, sent out to thousands of its most valuable high-net-worth clients in early January, was the chance for them to buy a piece of the hottest company in America: Facebook.

Since the social networking site infused itself into every facet of our lives, investors have anticipated the day when the company would take its place in capitalist folklore beside Microsoft, Netscape, Apple and Google. Everything seemed to be in place—the phenomenal growth, chief geek Mark Zuckerberg’s rapid ascent to Bill Gates-ian prominence, The Movie!! It all suggested we were about to witness one of those rare moments when the spark of innovation meets the greatest wealth-creation machine the world has ever known: the American stock market.

Only that’s not how things have unfolded. In its email to clients, Goldman wasn’t talking about a public stock offering for Facebook. Instead, the bank, along with a Russian investment firm, injected US$500 million into Facebook’s coffers by way of a purely private transaction. Goldman, in turn, set up a fund through which wealthy clients could own those Facebook shares themselves, for a minimum of US$2 million. Based on that valuation, Facebook emerged a colossus worth more than US$50 billion.

Since the deal first made headlines, Goldman has had to backtrack somewhat, due to “intense media coverage.” Regulators were cool to the optics of rich Americans gaining access to hot companies when their less wealthy countrymen were shut out. So last week the investment bank made membership to its Facebook fund more exclusive still. Now only rich foreigners will be invited in.

The stealth arrangement is just the latest sign something is very wrong with Wall Street. The stock market has become dangerously disconnected from its primary function of uniting growing businesses with large numbers of long-term investors. Part of that disconnect can be seen in the growth of a so-called “second market” for private companies­—like Facebook—off limits to all but the wealthy. But there’s more. Markets have come to be dominated by myopic short-term thinking. The vast bulk of trades now involve no humans at all, but rather sophisticated computer programs that swap stocks at lightning speed; many believe so-called high-frequency trading was one of the causes of the flash crash last year that exposed how fragile the whole game has become. And as more Americans have tied their savings to the market, regulators have sought to protect them with layers of rules and red tape that critics say is driving away public companies.

Now there are signs some institutional investors, such as pension funds, are giving up on equities and buying alternative assets like bridges and toll roads instead. No wonder American companies like Facebook are avoiding the hoi polloi of traditional stock markets in favour of raising capital from private, rich investors. “The idea of the stock market was to help businesses raise capital, and to provide people, individuals, with a chance to invest their savings and participate in that growth and have enough money to retire,” says Peter Cohan, president of Peter S. Cohan and Associates, a venture capital and management consulting firm in Marlborough, Mass. “But in the last decade the whole thing seems to have fallen apart.” Where the market once helped investors and companies, now it’s failing both.

In Canada it may seem academic to fret about the faulty mechanics of the U.S. stock market. Yet we should be very much concerned that it’s not working properly. Many Canadian investors put their money into U.S.-listed stocks, and as America’s largest trading partner, we also benefit when that country’s economy is functioning properly.

Perhaps billionaire Mark Cuban, who made his money off the Internet bubble of the late 1990s and now owns the Dallas Mavericks basketball team, has put it best on his blog and in interviews. “The stock market,” he says, “is for suckers.”

Facebook’s decision to shirk public stockholders in favour of rich, private ones has only driven home that point further, and sparked a debate about how America’s rising corporate stars are financing their growth.

Facebook is far from alone in choosing to “unfriend” the stock market. Despite rumours that some high-profile stock offerings could be coming down the pipeline—including social networking company LinkedIn and bargain-shopping site Groupon—the U.S. IPO market has been in decline since the mid-1990s. According to figures compiled by Jay Ritter, a professor of finance at the University of Florida, last year 96 operating companies went public on the major U.S. exchanges. True, that was a rebound from the depths of 2008, when just 21 companies went public. But in the mid-1990s, even before the tech bubble, 400 to 500 IPOs a year was common.

Why does it matter whether companies go public? Because that has historically been the best way for smaller businesses to boost themselves to the top of their industries. Instead, with fewer new companies coming to market, the number of U.S. stocks is growing worryingly thin, leaving regular investors with fewer options to choose from. In a report last fall, the New York Times noted there were 7,500 companies listed on the NYSE, Nasdaq and American Stock Exchange in 1997. Today there are fewer than 4,100. “In the 1990s going public was a badge of honour,” says Cohan. “Now companies look at it and say, ‘If we can avoid it, we will.’ ”

To do that, companies are increasingly relying on private investors, depriving the investing masses of access to exciting new businesses. Private investors are not new to Wall Street. Since the early 1980s, private equity funds have regularly gone shopping for unloved public companies with the goal of fixing them up and then taking them public again. Venture capitalists have also injected untold billions into upstart tech companies with the hope of cashing out with IPOs.

What sets the deal between Goldman Sachs and Facebook apart from previous private financings was the way it targeted large numbers of wealthy individuals while flouting rules intended to stop private companies from doing just that. The SEC bars unlisted companies from accumulating more than 500 shareholders. Anything above that limit means they must disclose financial information, something Facebook is loath to do. So Goldman set itself up as a single Facebook shareholder, while its clients go along for the ride. What’s more, under SEC rules investors must be “sophisticated”—or rich—to buy private company shares, with a net worth of US$1 million or annual earnings of US$200,000 in each of the past two years. Put another way, wealthy people are considered inherently smarter than the rest of us when investing.

The Goldman Sachs financing isn’t the only way private money is allowing Facebook and other companies to avoid the markets. Virtual online exchanges are springing up, where investors in private companies can sell their shares. One of the key reasons companies go public, aside from raising money to fund their growth, is to give venture capitalists and employees who already own shares a way to unlock their money. Two of the largest firms in the burgeoning private company market are SecondMarket and SharesPost, which both launched their private company services within the last two years. As a result, existing shareholders now have a venue to sell their stakes, and companies are feeling far less pressure to go public. In addition to Facebook, shares in scores of private companies now trade on these alternative exchanges, including Twitter, Craigslist, Zipcar and Digg. Not all are Internet companies, though. There are also clean technology and semiconductor businesses benefiting from the shadow market. Nyppex, a New York-based advisory company that specializes in secondary markets, estimates that roughly $4.9 billion worth of private company stock was traded last year, more than double the year before, and it’s expected to continue growing rapidly. Once again, regular investors can forget about participating, though—these alternative markets are also off-limits to all but the rich.

There’s a much darker side to all this stealth trading in private company shares, argues Cuban. “We are seeing people who are trying to game the system,” Cuban told Maclean’s in an email interview. “The expectation is that [a company] will go public at a significant premium and the secondary market is a way to ‘get in on the IPO’ at a lower cost.” After all, for rich investors who snap up Facebook shares by way of the Goldman Sachs deal or through SharesPost and SecondMarket, the ultimate way to profit will be for Facebook to go public. By then, though, the value of the shares will have been bid up, and much of the company’s best growth may be behind it. The very real risk is public stock market investors could be left with an overpriced heap.

For now it seems many private companies seem intent on staying that way. One reason for that, some believe, are increasingly onerous rules that accompany a stock listing. For instance, Andrew Lo, a professor with the Massachusetts Institute of Technology’s Laboratory for Financial Engineering, points to the impact of the Sarbanes-Oxley Act, the sweeping rules passed in the wake of the dot-com crash and Enron scandal. Critics say the legislation does little to prevent frauds, but has driven up the costs for companies that go public. “There are enormous costs to being on the public market, thanks to Sarbanes-Oxley and other regulatory changes,” says Lo. “It’s become a lot more expensive to be a public company. So now you can access capital through hedge funds and private equity firms without the costs of going to the stock market.”

It’s important to remember why regulators have felt compelled to layer on so many rules. Over the last 40 years there’s been a radical reshaping of the investment world as retail investors rushed into the market. Since the late 1970s American investors have gone from having less than US$100 billion (adjusted for inflation) tied up in equity mutual funds to a staggering US$12.6 trillion in 2007. Where in 1980 fewer than six per cent of households invested, now roughly half do. Analysts have hailed this as the “democratization of finance.” As more people took control of their own retirements, it was generally seen as a good thing for American society. But with last decade’s back-to-back crashes, leaving the market where it was 11 years ago, that also means the pain was democratized, too. Panicked politicians reacted by passing new laws. Now it seems the very rules established to keep regular investors safe may actually shut them out from participating in the growth of many of America’s fastest-growing companies.

But there’s even more to the market dysfunction hurting investors and companies.

In 2004, at the age of 92, the late Sir John Templeton, a pioneer in the world of mutual funds, issued a stark warning to investors. “The stock market is broken,” he said in an interview. He went on to predict the housing bubble would spark the sort of terrible market crash we witnessed four years later. But Templeton saw a bigger problem than just the bubble then emerging. Stock markets are now dangerously short-sighted. “Mass media, especially TV today, is so short-term that few in its audience grasp the lasting damage and corrective impact which will continue to linger from the greatest financial crash in world history,” he said. In the wake of that very crash, short-term thinking is as much a problem as ever before.

The stats behind investors’ amputated attention spans are astonishing, and reveal the damage caused to the wider economy. According to the New York Stock Exchange, in the 1960s the holding period for stocks was eight years. By 1990 it had fallen to two years and today the average stock is held for just nine months. As investors have shortened their time horizons, companies have been focused on each next quarter’s financial results at the expense of the next decade, say experts. Last spring, the U.S. Senate banking committee held hearings to examine the plague of short-term thinking in capital markets. Some astonishing revelations emerged. In a survey of 400 chief financial officers, 80 per cent said they’d cut research and development spending to goose short-term performance. To make matters worse, when companies do beat expectations, executives are lavished with huge paycheques and millions of stock options that dilute existing shareholders even further.

One reason investor time horizons have shrunk so dramatically is that hedge funds have been taking massive gambles using borrowed money, says Cohan. “One of the biggest sources of volatility is hedge funds betting on very short-term movements,” he says. “That whole dynamic is not really conducive to long-term investing, or the long-term management of companies.”

The same can be said for much of what goes on in the stock market these days. At precisely 2:45 on May 6, 2010, U.S. indices plunged nine per cent, temporarily wiping out US$1 trillion of market value, before recovering several minutes later. For many regular investors, it was their first painful introduction to the volatile world of high-frequency trading. HFT firms earn billions betting on stocks as they move up and down by fractions of a penny. A typical high-frequency trader owns a stock for just nine seconds. The problem is, should markets drop abruptly, the complex computer algorithms used by HFT firms can make matters worse.

The same goes for the rise of another Wall Street creation, exchange-traded funds—mutual funds that trade as stocks. While ETFs are pitched as a safe, low-cost way to invest, critics say the nearly US$1-trillion segment poses a systemic risk to investors in the event of another flash crash, since the inevitable rush by ETF managers to sell their holdings will drive markets down further.

For those in the burgeoning secondary market for private company shares, like SecondMarket, this all points to increased demand for their services. “There are problems in the public markets that are not going away,” says Mark Murphy, a spokesman for SecondMarket. “If they can avoid having to deal with high-frequency trading, short-term thinking and Sarbanes-Oxley, private company CEOs are saying they’d rather stay private and build something long-term.”

What’s the solution to all this then? In the eyes of some, we must tempt investors to hold their shares longer. U.S. legislators have looked at measures such as bigger tax breaks on capital gains for longer-term investors. Meanwhile, Lo at MIT offers the radical proposal—license retail investors to educate and protect them. “In the same way there was democratization in travel when the car was invented, at some point they put in mechanisms to protect people from each other, like stop signs, traffic lights and certification for drivers,” he says. “We had a tremendous period of financial innovation; now it’s time to figure out what protections we need to impose to make the investing highways more safe. Maybe people should pass tests to show we can manage our retirement well.”

In the meantime, the market will remain a dangerous place, not just for companies, but especially for regular investors. Which is why Cuban stresses to investors that they should avoid what Wall Street is selling. “There should be warning labels with every stock purchase,” he told Maclean’s. “Dear Sir or Madam . . . Before you place this order, please press the button that says ‘I know the person on the other side of the trade probably has spent far more time and money to understand this stock than I have and I am okay with that.’ ” Or, as he wrote on his blog last fall, “The stock market is still for suckers . . . you should put your money in the bank.”

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: