Happy Meals and Glass-Steagall

Also quants, blockchain dating, insider trading, non-GAAP accounting and unicorn stock options.
Photographer: Gareth Cattermole/Getty Images

Programming note: Money Stuff will be off tomorrow, back on Monday.

A Happy Meal.

How do you raise money, if you're a public company? Well, you can borrow it, from banks or the bond market. This can be hard, though, if for instance you are an unrated tech company that is losing money: You may not have the cash flow or collateral to support a loan. So instead you can raise equity by selling stock. But this can be hard too, if for instance you went public at $24 per share less than three years ago and are now trading at $8.43. Stock investors have lost a lot of money with you, and are not going to be jazzed to give you more.

There's a third choice: You can sell convertible bonds. Convertible bonds are kind of like bonds and kind of like stock, but they are most like stock options, and they appeal to a different kind of investor. Bond investors want creditworthy companies, and stock investors want growing companies, but convertible arbitrage investors want volatile companies, because volatility increases the value of an option. The way convertible arbitrage works is that the investor buys the convertible and sells short some of the underlying stock. This hedges her investment so that she is more or less indifferent to the direction of stock price moves; she just wants the stock to move. She is a volatility investor; she's buying volatility. And an unrated tech company whose stock almost quadrupled after its initial public offering and then fell 90 percent from its peak has a lot of volatility to sell.

But there is a problem: If you're a company like that, there's a decent chance that a lot of people are already selling your stock short. To sell stock short, investors need to borrow it, and there is a market for stock lending, driven by supply and demand. If lots of people are already short, that means that it will be expensive and hard to find shares to borrow. Which means that convertible arbitrage investors will have trouble hedging their convertibles, which will make those convertibles hard to sell.

There is a solution that is very lovely, and GoPro, Inc., used it in the $150 million convertible deal that it announced yesterday, and I am going to tell you about it, but first I should give you a disclaimer. This is a thing that I used to do, or at least pitch, in my old life as a convertibles-and-derivatives banker at Goldman Sachs Group Inc., and I am very biased. These people are my people. (Maybe literally? The bankers on the GoPro deal are not yet public.) These are my derivatives. So when I tell you that all of this is lovely, you are entitled to have your doubts, and to think that I like it because I grew up with it and not because it is objectively beautiful.

Anyway, the solution is: You let the convertible arbitrageurs sell their stock short to the company through derivatives contracts. Mechanically, one of the banks underwriting the convertible sells GoPro some stock in a prepaid forward contract: GoPro gives the bank the money now, and the bank gives GoPro the stock in five years. Meanwhile, it is effectively short stock to the company. Then it does offsetting swaps with the convertible buyers, letting them get short the stock (without borrowing it). So they get cheap short exposure, which lets them hedge the convertible, which lets them buy the convertible.

One obvious downside is that the company needs to spend a chunk of the money from the convertible buying back stock, which means that it doesn't get the full $150 million from the convertible. (So this particular strategy is most popular for companies that really want to buy back stock and don't really need cash; Herbalife used it a few years ago, and we talked about it then. Incidentally this and related strategies are sometimes called "Happy Meal" convertibles, because they come with a bunch of toys I guess.) But even if GoPro is spending $80 million to buy back stock -- a number that I just made up -- then it's still getting $70 million from the convertible, $70 million that it might have more trouble raising in other markets. GoPro is effectively selling a convertible and buying back the stock-price risk, leaving investors with the volatility risk. But it's getting paid tens of millions of dollars for the volatility, which it couldn't sell otherwise.

Another downside is that GoPro is helping people short its stock, which is an awkward look. (There have been lawsuits over similar sorts of trades, on the theory that the banks who do them really want to help out shorts, not convertible arbitrageurs.) But this shouldn't trouble you too much, not only because the short sellers are convertible arbitrageurs (who are really long the company, over all), but also because they are shorting the stock to the company. So there won't be net selling pressure into the market; in fact, depending on the exact mechanics, this trade may cause the underwriters or convertible investors to buy stock in the market while the convertible is being priced, pushing the stock up.

You might take a look at the press release, which is not really written for human consumption. This stuff looks bad and hard and complicated and tricky. It's definitely financial engineering. Derivatives sure are involved. And yet it's a clear case of financial engineering solving a real problem: A real company, with a real business, that might have a hard time raising money in traditional stock or bond markets, can raise money by diligent application of financial magic. GoPro has volatility to sell, and its bankers came to it with a way to isolate that volatility, package it neatly, and sell it for millions of dollars that it can use to make waterproof cameras or whatever. GoPro has found a way to transform volatility into cameras. How can you deny that that's beautiful?

Glass ... Steagall?

Simplistically, you might expect Goldman Sachs Group Inc. to support a return of the Glass-Steagall Act, the old law that separated commercial banking from investment banking. Goldman was, for basically all of its history, an investment bank. It was a big and profitable one, but in the last few decades it saw commercial banks move into its territory in ways that were hard to compete with. The commercial banks just had so much money: They could get cheap money from depositors, and use that cheap money to lend to companies, and use those loans to pressure the companies into hiring them for mergers-and-acquisitions and underwriting assignments. Independent investment banks like Goldman had to compete on their wits; they had a much harder time flinging money at companies to win business.

Of course in 2017 none of that is quite as true any more: Goldman does more lending now, it actually has a retail banking business with deposits (disclosure: including mine!), and, most importantly, it is now a bank holding company with the same access to Federal Reserve liquidity as the big commercial banks. Undoing all of that would be a pain, and you don't exactly see Goldman going around lobbying for the return of Glass-Steagall. Still you might expect some old Goldman hands, who grew up at an independent investment bank that was always grumbling about unfair competition from commercial banks, to think quietly that Glass-Steagall was a pretty good idea.


In a private meeting with lawmakers, White House economic adviser Gary Cohn said he supports a policy that could radically reshape Wall Street’s biggest firms by separating their consumer-lending businesses from their investment banks, said people with direct knowledge of the matter.

Cohn, the ex-Goldman Sachs Group Inc. executive who is now advising President Donald Trump, said he generally favors banking going back to how it was when firms like Goldman focused on trading and underwriting securities, and companies such as Citigroup Inc. primarily issued loans, according to the people, who heard his comments.

The remarks surprised some senators and congressional aides who attended the Wednesday meeting, as they didn’t expect a former top Wall Street executive to speak favorably of proposals that would force banks to dramatically rethink how they do business.

I feel like there is a strong bipartisan consensus that we should talk a lot about breaking up the big banks, which means that it will never actually happen. But perhaps I'm wrong. Meanwhile here is Barney Frank on efforts to roll back the Dodd-Frank Act, and on bank regulation generally:

Wall Street had a major push on so that the overseas derivatives activities of American banks would not be regulated by our people, but by overseas regulators. And then came the London Whale, and the whale sunk that idea like Moby Dick sinking the Pequod.


I've been reading Hugh Kenner's "The Counterfeiters," which is terrific, and there's a passage about industrialization and 18th- and 19th-century automata that I particularly like:

There were automata long before Vaucanson – histories of the subject commence with Hero of Alexandria (first century A.D.). There were mechanical aids to computation before Babbage – Pascal designed a digital adding machine. But Hero and Pascal would not have called their artifacts simulators, but rather toys or tools, utilized by men who were metaphysically something other. The eighteenth and nineteenth centuries were less sure that man was other. To trace, in their automata, an advanced technology derived from looms and watches, enlightens us less than does consideration of their novel uncertainties about where, if indeed it existed, the boundary between man and simulacrum lay. If a man does nothing with his life but spin threads, then just how is a thread-spinning machine not a purified man?

One thing that I sometimes hear about quantitative investing is that it can't take over the world because someone will always need to actually make the on-the-ground capital allocation decisions, not "if stock X goes up should I buy stock Y?" but rather "if a private company asks me for money to build a factory, should I invest?" But here is an article about WorldQuant LLC, Igor Tulchinksy's widely distributed quant shop that runs $5 billion for Israel Englander's Millennium Management LLC:

Mr. Tulchinsky said the company has four million “alphas” to date and is aiming for 100 million. Each alpha at WorldQuant is an algorithm that seeks to profit by predicting some future change in the price of a stock, futures contract or other asset.

How many alphas can a human find? If the relevant skill set is analyzing facts in the world to find signals that predict the profitable allocation of capital, computers seem to have an edge. But their constraint is data, not analysis. WorldQuant is working on that too:

The “Alpha Factory” breaks up the process of investing into a quantitative trading assembly line. The inputs are data acquired by a special group that scours the globe for interesting and new data sets, including everything from detailed market pricing data to shipping statistics to footfall in stores captured by apps on smartphones.

The computers will be able to hold all that data in their minds much more easily than humans can, and, I suspect, will be at least as good at spotting predictive patterns in it. The limiting step is going to be getting the humans to go out and find the data. But the Alpha Factory has factory workers for that.

Blockchain blockchain blockchain blockchain.

Here's a story from a couple of weeks ago about an online dating site, but on the blockchain. What? Yes. Sure.

Citing a Ted Talk where Rachel Botsman spoke on 'The Currency of the New Economy Is Trust’, he added: “Trust is hard to gain. It’s earned. Matchpool’s currency is also trust and that trust is the cryptocurrency, Guppies.”

Every sentence is like that. Here's another one:

The beauty about a blockchain he asserted was that it “allows for peer to peer interaction” and for individual rules or contract creation “without a middleman micro-managing things.”

Also, it has a quieter beauty, but I very much enjoyed this tautology:

"Furthermore, it is expensive to open a dating site for a niche community, so the only sites that survived were the ones we hear about today."

Anyway if you meet your spouse over the blockchain and then get smart-contract divorced, please do let me know. Elsewhere: Should India have a property registry on the blockchain?

Billy Walters.

One thing that I love, but also find terrifying, about insider trading trials is how they hold up to suspicion every normal thing that stock traders do. So here is a story from the insider trading trial of Billy Walters:

His current broker, Rob Miller, called Mr. Walters a “very aggressive” and well-informed investor with a penchant for staking out big positions in certain stocks even when it seemed counterintuitive to do so.

“At times he would talk to me in gambler’s parlance,” Mr. Miller testified. “He would refer to his investments as bets.”

That's a defense witness, but imagine having to explain to a jury that sometimes you take big stock positions that "seemed counterintuitive," and call them "bets." Surely that is true of everyone who trades stocks for a living? 

Meanwhile, Miller also "acknowledged that as many as 80 percent of Walters’s investment ideas came from his friend" Carl Icahn. I don't know what's suspicious about that. If Carl Icahn was calling me with stock tips, I'd take them too.

People are worried about non-GAAP accounting.

The usual worry about non-GAAP accounting is that public companies, who are required to report their results under U.S. generally accepted accounting principles, also report non-GAAP numbers that somehow confuse investors. But here's a fun twist:

Audited GAAP financial statements facilitate capital allocation, helping companies divvy up their resources and invest wisely, decades of research suggests—but do private companies bother with audited GAAP statements when they’re not required to do so?

The short answer is: rarely. Research by University of Illinois’s Petro Lisowsky and Chicago Booth’s Michael Minnis demonstrates that almost two-thirds of medium-to-larger private companies choose not to produce audited GAAP statements. 

People are worried about unicorns.

There was that sad moment last year when Forbes revised its estimate of Elizabeth Holmes's net worth from $4.5 billion (based on Theranos Inc.'s $9 billion valuation in its last funding round) to zero. But it's worse than that:

Theranos Inc. founder Elizabeth Holmes, whose once-$5 billion stake in her blood-testing firm has shriveled amid regulatory and legal challenges, also owes her company about $25 million, people familiar with the matter said.

Bizarrely, she seems to have borrowed the money from Theranos to pay the exercise price on some stock options. Come on! That's not how this works! The way it works is, you start a company, and it gets a $9 billion valuation, and you take some money off the table by selling a little of your own stock. You don't borrow from the company to put even more money on the table! Ugh. Meanwhile:

“It subverts the entire premise of an option grant,” said Nell Minow, vice chair of ValueEdge Advisors, a corporate governance consulting firm, who said such grants are traditionally meant to encourage executives to produce results for their shareholders. The deal between Theranos and Ms. Holmes means “any downside is someone else’s risk,” Ms. Minow said.

No wait that's not how this works either. Having options means that "any downside is someone else's risk." That's just what an option is. Exercising the options means that the downside is now your risk. Borrowing money to exercise the options means that the downside is your risk, and could bankrupt you. Anyway "the company has the ability to release Ms. Holmes from the debt or cancel the shares." Every lawsuit filed over Theranos is going to be amazing.

Elsewhere, if your unicorn dies, maybe you should go to business school. And "Uber has said it is considering revising its statement of values."

Things happen.

Fed Is Expected to Pare Investment Holdings, Officials Signal. Wells Fargo’s Aggressive Sales Tactics Hit Small Firms. And here is another article about Wells Fargo and small businesses. Deutsche Bank Said Near Full Takeup for $8.5 Billion Offer. Europe’s CoCos Provide a Lesson on Uncertainty. Fed funds-linked swaps outstrip Libor for first time. 15 Years Later, Billions in Pre-Euro Currencies Remain Unredeemed. Kraft's Failed Bid Jolts Unilever Chief Into Protective Revamp. Investors Are Building Their Own Green-Power Lines. Valeant Tumbles Below $10 on Struggle to Sell Assets, Raise Cash. DOL Fiduciary Rule: Officially Delayed for Now, with More to Come. What’s the Maker of Post-it Notes Doing in the Ankle Monitor Business? Your work friends probably hate you. Eleven Madison Park is the best restaurant in the world. "A fundraising plan to hold a mock crucifixion of members of the public in Manchester city centre has been cancelled after Church of England clergy raised concerns it was blasphemous and unsafe." The trains from New Jersey are broken. The public bathrooms in Bryant Park are really fancy. "Ask a random group of people what their favorite method for bringing small amounts of liquid to their mouth for drinking is, and nine out of ten of them will say 'cups.'"

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    Matt Levine at mlevine51@bloomberg.net

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