Private markets are the new public markets
Not that long ago, the stock market was a place where companies raised money to invest in their businesses. If you were a company and you needed money to build a factory, you could sell stock to investors. Investors would give you the money in the hopes that the factory would be profitable and you’d have more money later on, which you could give back to the shareholders in the form of dividends.
Now the stock market is a place where companies return money to shareholders. If you are a company and you have a factory, it probably makes money, and you use the money to buy back stock from your shareholders. Investors trade your stock with each other on the stock exchange in the hope that your factory will be profitable and you’ll buy back their stock. You don’t sell stock to raise money; you buy stock, to do something with your money.
Where did you get the factory? How do companies raise money, if not on the stock exchange? One simple answer is, you built the factory back in the olden days when you raised money on the stock market; now you already have the factory, so you don’t need money to build it and can buy back stock instead. More specifically, this answer might mean that public companies are older than they used to be: In the olden days lots of companies would go public and raise money and spend it on investments; now fewer companies raise money, and the ones that are still around from the olden days—and already mature and profitable and ready to return capital to shareholders—are relatively more important.
Another answer is that companies borrow the money to build the factories: Debt is cheap, and companies have a more aggressive view of optimal leverage levels than they used to, so they are happier borrowing more money and using less equity. (In practice, if you’ve already got the factory, this often means borrowing money to buy back stock.)
A third answer is that companies still finance themselves by selling stock, just not in the public markets: Companies can raise a lot more money privately than they used to, so they can build their factories before going public. It used to be that if you needed to raise a lot of money, the most efficient way to do that was to sell stock to public investors, the biggest and deepest pool of capital around. But now there is, you know, SoftBank: There are huge pools of late-stage venture-ish capital, and private fundraising can be faster and more efficient (just talk to one investor!) and potentially cheaper (unicorn bubbles!) than a public offering. You raise your money and build your business privately, and then you go public to get liquidity for the early investors who actually paid to build the business.
A fourth answer is that companies don’t build factories at all anymore, that factories are no longer how companies make money. The companies that go public these days make things like social media apps and online marketplaces and software-as-a-service, and they just have less need for capital from investors. In the extreme stylized case, a company consists of a founder having an idea that can instantly and costlessly turn into a steady stream of profits. The company goes public not because it needs a lot of money to turn the idea into profits, but because the founder needs a lot of money to buy yachts; the initial public offering is purely a liquidity event for insiders, not a fundraising event for the company.
All of this is extremely stylized and over-generalized but it does get at something real in modern markets. Public companies are older and larger than they used to be, stock buybacks are more important and stock offerings are less important, intangible investments are more important and tangible ones less, etc.
At Morgan Stanley, Michael Mauboussin and Dan Callahan have a fascinating long research note on “Public to Private Equity in the United States: A Long-Term Look.” I have been saying things like what I wrote above for a while now, but what I actually wrote above was mostly inspired by their argument. It is not a fair summary, they cover a lot more ground, and if you like this sort of stuff you should read it. It’s hard to excerpt, but here’s a good little fact:
Virtually none of the $1.3 trillion in value that Amazon built was in the private market. Three percent of the value created by Alphabet, which controls Google, was in the private market, and that percentage was about 17 percent for Facebook. And the implied value of Uber in the private market was more than 100 percent of the total value created, as the company’s market capitalization is below what its IPO price implied.
I also liked this passage, on the importance of intangible investment for the current state of public and private markets:
The mix of tangible and intangible investments has changed over the last 40 years. In the late 1970s tangible investments were nearly double those of intangible investments. Today, intangible investments are one-and-a-half times larger than tangible investments. A watershed change in the form of investment has occurred over a couple of generations.
This shift has a few implications for our discussion. To begin, companies need less capital because they need fewer physical assets. For example, sales per employee for Facebook, Inc. were nearly double those of Ford Motor Company in 2019. From 1956 to 1976 the number of public companies grew fivefold, as many companies needed to finance “their mass production and mass distribution.” Today, companies simply do not require as much capital as they once did. This, along with freer access to private capital, allows private companies to remain private longer.
Another implication is that the rate of change, which we can measure by longevity, appears to be speeding up. The idea is that if longevity is decreasing, the rate of change is increasing. About 1,500 companies went public during the 1970s, 3,000 in the 1980s, 3,900 in the 1990s, and 2,100 in the 2000s. Companies that had listed before 1970 had a 92 percent probability of surviving the next five years, and those listed in the 2000s had a probability of only 63 percent. The chance of survival has dropped in each successive decade. The main reason companies delist is that they are acquired. This contributes to the last implication.
In corporate America, the strong are getting stronger. This is giving rise to “superstar” firms. For example, the gap in return on invested capital between a U.S. company in the top 10 percent and the median has risen sharply in recent decades. Consolidation explains a large part of this. Measures of concentration, such as the Herfindahl-Hirschman Index, have shown a substantial increase for many industries since the mid-1990s. These include industries that rely on tangible assets.
When the proper conditions are in place, certain businesses exhibit increasing returns, which include very high market shares and economic profits. Increasing returns are pronounced in intangible-based businesses, and there has been a growing gap between the intangible spending of the large firms relative to small ones.
The shift from tangible to intangible assets has had a meaningful effect on the mix between public and private companies. That many young companies have less capital intensity means they don’t need to go public to raise capital. The mix of the companies that are public has shifted to more reliance on intangible investment, which in turn has led to a reduction in longevity. And the economics of information goods, combined with the concentration of traditional industries and the outsourcing of low-value-added activities, means that a handful of leading companies earn much higher economic rents than their competitors and businesses of the past.
In a world of intangible investment, small private companies don’t particularly need to go public to raise money to build factories. And large public companies (1) get bigger, because there are increasing returns to scale, (2) are very profitable, and (3) don’t need to invest their profits in capital-intensive projects, so they have a lot of money to return to shareholders.
The Kodak thing
Here is an incomplete list of things that went wrong around the Trump administration’s announcement that it will give Eastman Kodak Co. a $765 million loan to pivot to producing generic drug chemicals:
- The stock went up 25% on heavy volume the day before the deal was announced.
- It turns out that was because Kodak leaked the news to some journalists early and forgot to tell them it was embargoed, leading them to tweet it out and investors to see (and trade on) those tweets.
- Rather than rush out the official announcement after it leaked, Kodak called the journalists and told them to delete the tweets.
- The chief executive officer and a director bought Kodak stock about a month before the announcement, apparently while negotiations for the deal were ongoing.
- The company gave the CEO a bunch of stock options the day before the announcement, which immediately became worth tens of millions of dollars.
All of these things, I think, qualify as “not that bad.” I sort of defended the stock options (point 5) the other day: Sure, not best practices, I said, but if the CEO does a transformative deal then in some rough sense it’s fine for the board to reward him. I sort of shrugged off the early announcement (points 1-3) last week: Definitely not best practices, I said, maybe even securities fraud, but then everything is securities fraud and this seems like fairly mild securities fraud. The insider buying (point 4) is suspicious, but it is not clear when the negotiations got serious or how material they were when the insiders bought; it is sort of unavoidably suspicious whenever insiders of a company buy or sell its stock, and this is maybe above-average suspicious, but it’s not a smoking gun.
Still you shouldn’t have so many bad things! One or two lapses from best practices, you know, it happens, but five starts to feel sloppy. And so:
The Securities and Exchange Commission is investigating the circumstances around Eastman Kodak Co. ’s announcement of a $765 million government loan to make drugs at its U.S. factories, according to people familiar with the matter.
News of the loan last week caused Kodak’s shares to rise as high as $60, before falling to about $15 on Monday due to a dilution in the shares. Amid the heightened volatility, trading volume has surged. The price spike briefly produced a potential windfall for company executives who owned stock-option grants, some of which were granted on July 27, the day before the loan was officially announced. …
Among the areas being probed by regulators: how Kodak controlled disclosure of the loan, word of which began to emerge on July 27, causing Kodak’s stock price to rise 25% that day.
Yeah once you have a list of nonsense that that’s long, you gotta do an investigation. Also:
Senator Elizabeth Warren wants U.S. regulators to examine possible insider trading and disclosure violations involving Eastman Kodak Co. after the former film company’s shares soared when it announced a surprise foray into generic drugs with help from a $765 million government loan. …
“This is just the latest example of unusual trading activity involving a major Trump administration decision,” Warren, a Massachusetts Democrat, wrote.
(Here is the letter.) Also, speaking of not best practices:
At a White House briefing Tuesday night, President Trump distanced himself from the Kodak deal, saying he wasn’t involved.
“The concept of the deal was good, but I’ll let you know. We’ll do a little study on that … If there is any problem, we’ll let you know about it very quickly. But I wasn’t involved in it. It’s a big deal. It’s a way of bringing back a great area, too, in addition to pharmaceuticals. Kodak has been a great name but obviously pretty much in a different business. So we’ll see what that’s all about.”
I wrote yesterday that “historically when the president of the United States says something, that has represented a policy of his administration, but when President Trump says something, that just represents the crankish views of a guy who watches way too much television,” and here’s a perfect illustration. The policy of President Trump’s administration was to give Kodak a big loan to make drugs; you can tell because the administration put out a press release about it under the headline “President Donald J. Trump”—that’s his name—“Is Committed to Ending America’s Reliance on Foreign Countries for Vital Supplies.” But he is personally unaware of his own policies, and he apparently learned about this one from television and it made him cranky. “So we’ll see what that’s all about.”
It will be funny if, after they “do a little study on that,” he cancels the loan? (It’s still at a “Letter of Interest” stage, not final, and Kodak doesn’t have the money yet.) Kodak’s stock is down more than 50% from its high last Wednesday, after the deal was announced, but still up more than 500% from the previous Friday, before the deal was leaked. If the deal turns out to be a chimera, a lot of shareholders are going to be mad! But about what? There is still no press release on Kodak’s website about this deal, still no 8-K on the SEC website. The reason investors know about the deal—besides the early, deleted accidental announcements—is from the government’s announcement. If it turns out not to be true, will investors sue Kodak because the government’s press release was misleading?
We have talked a few times, in recent years, about a particular sort of article about hedge funds. In these articles, some hedge fund managers (or sometimes other fundamental asset managers) are quoted complaining that the markets don’t make sense anymore, that the patterns that they thought were fundamental have disappeared. “These ‘algos’ have taken all the rhythm out of the market, and have become extremely confusing to me,” is how Stanley Druckenmiller once put it on television. Here is the Financial Times in January 2019:
There has been recently a flurry of finger-pointing by humbled one-time masters of the universe, who argue that the swelling influence of computer-powered “quantitative”, or quant, investors and high-frequency traders is wreaking havoc on markets and rendering obsolete old-fashioned analysis and common sense.
And the Wall Street Journal in October:
Managers say the rise of quantitative and passive investing has distorted how stocks move and reduced the chances to profit. Quants can spot and eliminate certain mispricings of securities that once offered opportunities to stock pickers.
I tend to make fun of these complaints. They are bad complaints! What is good for hedge fund managers is not necessarily good for the world. If you manage a hedge fund, you want financial-asset prices to be wrong in predictable (to you) ways, so that you can buy underpriced assets and sell overpriced ones and make a lot of money. But from a social perspective it is better for asset prices to be right, so that capital is allocated to its best uses and so forth. I once wrote:
Look, you’re not supposed to be able to pick which stocks will go up! This is great news! Markets are more efficient! You don’t need to pay a person a billion dollars to make stock prices efficient; now a robot will do it for pennies! Everything is great!
You could sort of extend this into a metric of how well financial markets are functioning: The more hedge fund managers complain about how impossible and confusing markets are, the better those markets are performing. (And, usually, the worse the hedge fund managers are performing.) When hedge fund managers are fat and happy that means something is going wrong. We talked this January about the European Union’s Mifid II rules regulating stock research; specifically, we talked about how hedge funds like the rules because they have made markets less efficient. “Managers of hedge funds and mutual funds say the spotty coverage has led to buying opportunities for undervalued stocks,” reported the Wall Street Journal. In my book that is an argument against the rules, though I suppose you could take a Grossman-Stiglitz-ian contrary view.
So how well are financial markets functioning now? Here’s a troubling story from Bloomberg’s Sonali Basak:
One hedge fund manager is getting some inspiration from an unlikely source: the Robinhood crowd.
Adam Sender’s volatility hedge fund has climbed 30% this year — in part by betting on and against stocks that have been popular on the retail trading app. He notched gains by wagering around stocks including carmakers Hertz Global Holdings Inc., NIO Inc. and Tesla Inc. …
The day trading crowd has “created the late ‘90s type of environment I thrive on,” Sender, 51, said in an interview, referring to the tech bubble of the late 1990s.
See, when a hedge fund manager says “these markets are so weird, the algos make it impossible to make money,” that probably means the market is efficient. When he says “these markets are so weird, the Robinhood traders make it so easy to make money,” that probably means the market is inefficient.
Sender’s view is not universal, by the way, and “the HFRX Global Hedge Fund Index, an early indicator of industry performance, is roughly flat this year through July.” The Robinhood market doesn’t make sense to everyone! But I can believe that it’s not efficient.
Activism vs. anti-activism
Allison Bennington, a longstanding executive at activist hedge fund ValueAct, known for shaking up the boards of Microsoft, Rolls-Royce and Citigroup, is switching sides and joining boutique investment bank PJT Partners to help companies defend themselves against corporate raiders.
Ms Bennington is joining as a partner after a 17-year career at ValueAct to advise PJT’s clients on how to better prepare for and respond to activist campaigns. She will work closely with its merger and acquisition bankers and its investor relation advisory unit, PJT Camberview. She will also lead the firm’s environmental, social and governance advisory practice.
“I have been inside the mind of an activist,” Ms Bennington said in an interview. “I understand the activist types, the tools at its disposal, and I understand how an activist deploys those tools.”
Ms Bennington’s switch from corporate poacher to gamekeeper is a rare move for a Wall Street investment bank. The two sides are seen as incompatible by many company executives who demand extreme loyalty from their advisers.
I don’t understand why companies would demand extreme loyalty; effectiveness is what you want. Really it seems inefficient for her to leave an activist fund (albeit a “friendlier” activist fund) for a banking boutique. The move here is to lean into the conflict, to start a hedge-fund/advisory-boutique combo that does both (1) bitter, brutal activism and (2) corporate anti-activist advice. Then you show up at companies to pitch your advisory services. “We know how vicious and effective activists are, we are some of the most horrible activists ourselves, we do activist campaigns all the time, we’ll do them for any reason or for no reason at all, after we are through with a company it is just a charred wreck and its disgraced executives have nightmares for years. So we understand the mindset, is the point. Anyway great to meet you, we’d love to work with you, our fee is $20 million up front, let us know. Also say hi to your son for me, I hope he’s doing well in rehab.” I bet you’d get a lot of mandates!
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 It’s very bad to disclose information early to some preferred investors so they can trade early and give you kickbacks! (That is insider trading.) It’s moderately bad to disclose information early to some big investors so they can trade early and be favorably disposed to your company. (That is Regulation FD.) It’s quite mildly bad, improper but not evil, to disclose information early to some reporters by accident.
 If I were one of the Kodak insiders who bought stock in the month or so before the announcement, I might use this fact in my defense: *Even now*, Kodak seems to think that the deal isn’t official or material enough to require an 8-K filing; it is still preliminary negotiations, not a formal deal. Surely when they started negotiations a month or two ago it was so immaterial that insiders could still trade the stock.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.