Public Markets and Hedge-Fund Closings
For over 70 years, the U.S. capital markets have been the envy of the world. Our markets have allowed our businesses to grow and create jobs. Our markets have provided a broad cross-section of America the opportunity to invest in that growth, including through pension funds and other retirement assets. In recent years, our markets have faced growing competition from abroad. U.S.-listed IPOs by non-U.S. companies have slowed dramatically. More significantly, it is clear that our public capital markets are less attractive to business than in the past. As a result, investment opportunities for Main Street investors are more limited.
My Bloomberg Gadfly colleague Lisa Abramowicz is skeptical:
He appears to peg this pessimistic view to a decline in the number of publicly traded companies and in particular a drop in IPOs, especially U.S.-listed IPOs by non-U.S. companies. But that's an extremely narrow perspective. The need to go public isn't as great as it has been in the past, in large part because of how robust private markets and debt financings have become.
That is right, but I don't think it's Clayton's point. His concern is not that companies can't find investors, but rather that investors can't find companies. The central story of American financial markets is that they allow middle-class investors to benefit from the world's economic growth by buying equity in vibrant growing companies. If the vibrant growing companies are all funding themselves elsewhere, then middle-class public investors will miss out on that key engine of growth.
This strikes me as a bipartisan complaint, and also as basically true. Michael Mauboussin, Dan Callahan and Darius Majd at Credit Suisse had a note out this week on "The Incredible Shrinking Universe of Stocks":
Listed companies today are on average larger, older, and more profitable than they were 20 years ago. Further, they operate in industries that are generally more concentrated. The overall size and maturity of listed companies means they are more likely to pay out cash to shareholders in the form of dividends and share buybacks than companies were in the past. We speculate that the maturation of listed companies has also contributed to informational efficiency in the stock market. Gaining edge in older and well established businesses is likely more difficult than it is in young businesses with uncertain outlooks. In turn, the greater efficiency may be one of the catalysts for the shift that investors are making from active to indexed or rule-based strategies.
If you invest in that sort of public stock market, full of mature predictable profitable companies in capital-return mode, you are not generally funding the growth of promising new companies. The purpose of the U.S. public stock market, in 2017, is not to help companies raise money to grow, but rather to help companies return money to shareholders. The growth money comes from private investors. Who are, generically, not "Main Street" investors, though these days plenty of mutual funds and pensions end up investing in private companies too.
If that is the problem -- that companies are staying private longer, and therefore middle-class investors are missing out on exposure to America's economic dynamism -- then what is the cause? There is a standard boring answer, which is that regulation is killing the desire to go public. This seems to be Clayton's answer. “We have to reduce the burdens of becoming a public company so that it’s more attractive,” he said in response to one senator's question. The Sarbanes-Oxley Act, more extensive disclosure requirements, constant shareholder lawsuits, etc., have made it less attractive to be a public company. That's probably partly true? But as Mauboussin et al. point out, "the shrinkage in the population of listed companies started well before" Sarbanes-Oxley. It also feels a bit like a cop-out answer, like we can reverse the decline in public companies just by eliminating some unnecessary paperwork.
A more interesting answer is that public markets haven't really gotten worse; instead, private markets have gotten better. After all, public markets have always been way more burdensome than private ones. What entrepreneur would ever want to go public, and bother with the expense of lawyers, the work and embarrassment of public disclosure, and the annoyance of a bunch of strangers buying shares in your company and thinking that you work for them now? Any sensible business would stay private forever, and most sensible businesses always have. But historically, the businesses that wanted to get big had to go public. You might not like dealing with public shareholders, but you had no choice, because they had all the money.
Now that's not true! You can raise limitless oceans of money in the private markets, and so companies like Uber Technologies Inc. do. Most of the other benefits of being public -- global name recognition, acquisition currency, employee liquidity -- are also available to hot tech unicorns these days, so the initial public offering is less necessary. Some of this is about legal and technological innovation in the private markets. A lot of it is about the concentration of investment capital in the hands of people -- both large fund managers and rich individuals -- who are allowed and inclined to invest in private markets. If the economic engine of the stock market is the aggregated power of millions of middle-class individual investors, then the only way to access them is to go public. But if you can raise all the money you want from rich people who don't make pesky disclosure or governance demands, then you don't need the middle class.
If your diagnosis is that private markets have gotten so good that they've taken over the business of funding growing companies, then you have to think comprehensively about why companies would prefer to remain private. One reason is disclosure: It's always more attractive to have control over what information you disclose to whom than it is to have to make public standard audited comprehensive disclosure on a fixed schedule. Another reason is control: Private companies can generally set up whatever governance structure the founders and investors agree on, while public companies tend to have a generic package of expected governance and shareholder-protection rights dictated by SEC rules, stock exchange listing requirements and public-market tradition.
If you want public markets to compete with the growing clout of private markets, just rolling back recent regulation might not be enough. You need to think about a much more fundamental rollback, and question some of the basic expectations of shareholder rights that have been established for the last half-century or more.
And that's already kind of happening. The obvious story is Snap Inc., which went public with non-voting shares. That has always been legal, but it had never been done. Now it has been done. An SEC that really wanted more companies to go public might try to push in that direction. There are all sorts of regulations -- everything from political-contribution-disclosure rules to 13D rules about activist stake accumulation to stock-exchange rules about which corporate actions require a shareholder vote -- that help set the balance of power between shareholders and managers. Striking the balance more in favor of managers might make public markets more attractive to entrepreneurs. But the tradeoff is giving up some of the rights that we always thought were essential for shareholders. If you want more middle-class people to participate in the economic benefits of growing companies, you might have to give them less control over those companies.
Eric Mindich, whose eternal claim to fame might be that he was the youngest-ever partner at Goldman Sachs Group Inc., is shutting down his hedge fund, Eton Park Capital Management, due to "a mix of challenging market conditions and Eton Park’s poor performance." "Youngest Goldman Partner Now Middle-Aged Ex-Hedge Fund Manager," is Jon Shazar's perfect headline at Dealbreaker. (Also excellent: "Mr. Mindich started at Goldman the summer after he finished Scarsdale High School," notes the Wall Street Journal.)
It's a standard story. Times are tough these days for hedge funds, particularly the older-vintage, high-fee, human-run fundamental hedge funds that have had uninspiring recent performance. On the other hand, if you're running an older-vintage hedge fund (Eton Park started in 2004), you've had a lot of great times. If you got really rich off the hedge fund boom, I can't quite see why you'd want to stick around to slog through a hedge-fund bust. "We have made the very difficult decision to return your capital," Mindich wrote to his investors, "from a position of relative strength.”
Meanwhile, here's an idea:
Noviscient plans to start a fund that will charge investors no management fees and will absorb the first 5 percent of annual investment losses, moves almost unheard of in an industry known for levying the highest fees in the money management business.
Noviscient is a computer-driven Asian hedge-fund startup founded by Scott Treloar; it will also "charge 20 percent of gains for the first 10 percent of profits, splitting the spoils equally with investors after that." Generally investors should want a fee structure that encourages managers to take the level of risk that the investors want them to take. The classic hedge-fund fee structure -- 20 percent of profits, zero percent of losses -- encourages a fair amount of risk-taking, which makes sense if you think of hedge funds as relatively high-risk, high-return vehicles. Noviscient's plan -- paying 100 percent of the first 5 percent of losses, while getting 20 percent of the first 10 percent of gains -- would seem to encourage a certain conservatism. (Though the big step up at 10 percent profits cuts the other way.) Perhaps that's what investors want from hedge funds these days. My Bloomberg Gadfly colleague Christopher Langer is worried for Noviscient, though: "Mortgaging the house to attract investments can't be the solution either."
Former Name of the Year candidate Zeke Faux profiled likely future candidate Guy Gentile at Bloomberg Businessweek yesterday, with amazing results. Gentile is a former online brokerage owner who was arrested in connection with some alleged pump-and-dump scams and agreed to cooperate with the Federal Bureau of Investigation in exchange for leniency. But then he found it was just so much fun:
Working undercover made him feel like an action hero. It fed into his love of intrigue, according to his ex-wife, Karen Barker-Gentile. “He did actually assume a new personality in which he imagined himself to be an FBI agent,” she says. He began calling his operation Wall Street Underground and developed a signature move, giving each target a hug at their last meeting before the FBI moved in.
He was also pretty good at it, giving his targets just the nudge they needed to go from "shady stock promoter" to "guy explicitly planning crimes on tape." But then prosecutors told him that, despite all his good work, he'd have to plead guilty to a crime, at which point he naturally started a website, recorded a rap song ("The feds don't know who they got, bro/I'm going rogue") and "binge-watched Billions." He eventually beat the charges (statute of limitations!) and now seems to be doing well:
We decided to find someplace less broiling to talk. In his red SUV, he put on a techno version of the James Bond theme and puffed mint-infused smoke from a vape pen. A Make America Great Again hat lay on the dashboard. As we drove, he launched into his story.
Activist poison pills.
The "poison pill," or "shareholder rights plan," allows the board of directors of a company to unilaterally prevent someone from buying a lot of shares of that company. The original idea was that the pill let a board fend off coercive tender offers from 1980s corporate raiders. But that original idea was almost immediately followed by another idea, which was basically: Hey wait, this means that the board of directors can prevent anyone from acquiring the company, for any reason. I mean, the law is not technically quite that generous to boards -- they need to make pious noises about how a takeover offer undervalues the shares, and when it clearly doesn't the board usually ends up selling -- but in practice the pill is often a useful tool for managerial entrenchment.
Having solved the problem of hostile takeovers, the drafters of poison pills moved on to solve another big challenge to managerial entrenchment, activist shareholders. The basic trick is to build a poison pill that limits not only takeovers -- acquisitions of most or all of the stock -- but also any large stakes, preventing activists from getting too much influence. But there are other tricks. If your poison pill prevents activists from talking to each other, or to other shareholders, then that makes it much harder to run an activist campaign. This stuff seems hard to justify based on the original theory of the poison pill, which was about protecting shareholders from losing control of their company to a shady corporate raider. But, you know, activists are "short-term-focused," so it's not too hard for boards to justify cracking down on them as threats to shareholders' long-term interests.
Here's a blog post and related paper from New York University law professors Marcel Kahan and Edward Rock about "Anti-Activist Poison Pills." They take seriously the idea that "Under Delaware law, the validity of a pill hinges on whether the pill is a reasonable response to a cognizable threat," and draw from it some limits on anti-activist pills:
Importantly, the nature of the threat must justify the design features of the pill. Thus, for example, the threat of creeping control will generally not justify pills with a trigger threshold below 20%; and the threat posed to a fair election process requires a response that is evenhanded and does not favor one of the contestants. On our analysis, synthetic equity—which confers on an activist an economic interest but not voting rights—generally poses no cognizable threat and thus should not count towards the pill trigger because the cognizable threat posed by an activist derives from its power to vote its shares, and not from a pure economic stake. On the other hand, permitting an activist to accumulate an economic stake through synthetic equity is desirable as it enables the activist to benefit if the activism results in an increase in the value of the company and lends credibility to the claim that the activist is motivated to generate such an increase.
That seems right to me, though it also does not seem to be what courts or companies think. A Delaware court upheld Sotheby's anti-activist pill, which triggered at a 10 percent ownership threshold, and poison pills covering derivative ownership seem to be popular.
Hedge fund names.
Here's the best finance-paper abstract I've read in a while, from Juha Joenvaara and Cristian Ioan Tiu:
We document that investors allocate more flows to hedge funds whose names exhibit gravitas - defined as a combination of words from geopolitics and economics, or suggesting power. The economic effects are relatively large: averaging across our models, adding one more word with gravitas to the name of the average fund brings more than a quarter million dollars more in annual flows. We also document that having a name with gravitas is associated with abnormal negative performance: high name gravitas funds have lower returns, alphas, Sharpe ratios and manipulation-proof performance measures, higher volatilities and maximum drawdowns as well as higher probabilities of extinction than the funds with lower name gravitas. Although we find evidence that investors learn about the true investment abilities of their funds and respond less to gravitas as they do so, the chasing gravitas behavior survives all these controls. From the point of view of hedge fund managers, we document that funds with more name gravitas report to fewer databases, suggesting that giving the fund a "good" name serves as an alternative form of marketing.
People are worried about unicorns.
Theranos, the Blood Unicorn (Elasmotherium haimatos), is doing a ... sort of a rights offering, I guess?
Theranos Inc. plans to give additional shares to investors who pledge not to sue the battered blood-testing company or Elizabeth Holmes, its founder and chief executive, people familiar with the matter said.
The deal includes investors who participated in Theranos’s latest funding rounds, which ended in 2015 and brought in more than $600 million. Those investors could get about two additional shares for each share they bought, one of the people said.
The additional shares would come from Ms. Holmes’s personal stake in Theranos, some of the people said.
Would you take that deal? On the one hand, the fact that it's on offer suggests pretty strongly both that you have something to sue about and that the shares you're getting aren't worth very much. (Confirming that, Rupert Murdoch bought shares in 2015 for about $125 million and sold them back to Theranos recently for "a nominal amount" -- "One person familiar with the matter said the amount was just $1" -- to take a tax loss.) On the other hand, if you did sue, who would you sue? Elizabeth Holmes? Her wealth is mostly in Theranos shares, so that's all you'd really stand to win. Might as well take them now.
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