Private is now the New New-Private not the Newish Public
The recent transition of a slew of high profile tech companies from private to publicly listed corporations has reinstated the valuation premium that public companies hold over private ones. Spotify, Lyft, Pinterest, Zoom and soon to be listed Uber clearly show that public markets still dominate private ones when it comes to valuation.
The Private-is-the-New-Public mantra advanced the view that raising capital had become easier in the private markets than in the public ones, therefore obfuscating the need to list. Since access to capital was previously perceived to be the fundamental advantage of the public markets, listed companies should have traded at a premium. The rise of Venture Capital and Private Equity created the ability for private companies to raise capital on similar or better terms than the public markets. This should have arbitraged that public-listing premium away. Accordingly, newly listed privates should trade at the same price as before listing, or at least at the IPO price set by the brokers leading the deal…
Apparently not. Spotify, Lyft, Pinterest and Zoom each listed at 12%, 15%, 30% and 72% premium to their pre-listing prices. Lyft subsequently declined below its pre-listing price but it still had its first public day in the sun and was welcomed heartily.
Critics of the private markets argued that going public would expose the over-optimistic expectations of the fancy Venture Capital and Private Equity firms to the full scrutiny of institutional investors, in turn marking down their irrational exuberance. That is, the public markets would see through the cult-like blue-sky beliefs and bring valuations back down to earth. Perennially loss-making unicorns would face the reality of the need for profits and dividends; failure to do so would see prices slashed…
Apparently not. Even in the pre-market roadshows to institutional investors, each of the newly listed companies priced their offers at or above the top of the range suggested by the brokers.
The most interesting result of the recent listings is that being public still commands a premium. Access to capital cannot be that reason. Two possible explanations are either (i) access to liquidity accounts for the additional premium or (ii) the VC’s and PE’s expectations were too pessimistic.
Liquidity is precious to investors who cannot influence decision making – the ability to exit a position if the investor doesn’t like what he sees is much easier in the public domain than when there is no secondary market. Back of the envelope calculations can easily justify a 15 to 30% liquidity premium for a listed corporation with a 0.5% to 1% reduction in the required risk-premium.
Pessimistic VC’s and PE’s? There is an element of truth in this explanation as well. We are all taught that the value of a company is the discounted sum of all future cash flows. Traditional ‘value’ investors like Warren Buffett are more comfortable dealing with positive cash flows today and extrapolating these forward. ‘Growth’ investors tolerate extended periods of early losses in order to harvest fantastically rich cash flows in the future. Exactly how those riches will be generated and how much they will be is difficult science, so a smart VC/PE investor risking their own cash would surely prefer to underestimate their magnitude rather than overestimate. Growth investors are only really competing with Value investors for the same deals, so if the likes of Buffett don’t even consider investing in firms that post losses early on, then the VC/PE can effectively buy these companies at a price-point where the competitors drop out.
Irrespective of the reason, the clear message from the unicorn-parade is that being public still commands a premium. Founders and shareholders in unlisted companies should pay close attention to this fact. Opting to remain private may appeal to a founder’s romantic notion of non-conformist disruptor but it’s still going to cost everyone money. Private may have become more sophisticated and Newish, but Private is not the New-Public.
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Last Thursday evening, First Degree hosted a Launch Party for our manager platform. Everyone was having such a pleasant time that we decided against puncturing the enjoyment with a boring speech…
…for those of you who are curious about what I would have said, here it is!
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The Great Wall of China took several thousand years to build and was primarily a method for stopping Mongolian invaders from expanding into China. As a piece of military technology it dominated all-comers however it was rendered entirely useless with the advent of the flying machine. The 20th Century was not a good one for the Chinese military defenses…Walls work until someone finds a way to bypass them completely.
So it is astonishing that the political agenda in Europe and the US is currently fixated on walls.
First, Europe. The pantomime that is Brexit has been derailed by the wall that may have to be built in Ireland to keep out cheap imports from a trade-liberated UK crossing into Europe. “Fancy a pair of these fine Italian shoes or these Chinese ones fresh in from Northern Ireland this morning at a quarter of the price?” The reality is that this is the least of the worries for the EU who stand to have their service sectors decimated by liberal UK policies in the Finance, Legal and even Medical sectors. The City of London can easily attract companies and investors by simply cutting trading taxes or liberalising listing rules. No wall can stop this arbitrage.
Second, the US. The US Democrats have cut off funding the Government until President Trump abandons his promise to build a Wall along the Mexican border. If you had have asked Donald Trump “What do you think about shutting down the Government?” before he became President he would have said “Great idea!”. Not much has changed since becoming President. The irony of this tale is that the Democrats are the BIG GOVERNMENT believers and the shutdown is primarily at odds with both their philosophy and their constituency. Trump on the other hand, is in a win-win position and I suspect he would rather keep the Government shutdown than build his wall anyway!
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Private v Public is the new Active v Passive …plus Our US Election Prediction Special
One of the early contributions of Modern Finance was questioning the wisdom of active investment management. The empirical evidence indicated that active managers underperform passive strategies. While a finer analysis of the data subsequently demonstrated that some active managers are able to consistently outperform static benchmarks, the general principle that passive outperforms active remains, particularly for the high fee retail portfolios that the average man in the street is able to access. Curiously, it took 40 years for passive investments to assume their rightful role as the core of an investment portfolio(1).
The contemporaneous equivalent of the active v passive debate is the current infatuation with private asset markets. Private assets cover a range of investments such as venture capital, private equity, unlisted equity, partnerships, private lending, private placements, private real estate etc etc. Private assets all have the common feature that they are not listed on a recognised exchange which means that they are not publicly traded. This means that private assets are difficult to buy and sell and they are often described as ‘illiquid’.
The private v public debate centres on whether the expected rate of return on private assets is attractive enough relative to publicly quoted assets to induce investors to sacrifice liquidity. So far there appears to be a substantial premium to be earned in some private markets while others are dubious. For instance, early stage Tech-VC has generated long run risk premia of about 20% per annum compared with public equity premia of around 6%. On the other hand, while private equity appears to share a premium over public equity in gross performance terms, a lot of that gets eaten up in fees to the PE managers who undertake the investments. The bottom line is that private assets do offer superior returns versus their public counterparts but accessing these opportunities is difficult if you are a small investor.
While private assets make sense from a risk premium standpoint, their drawbacks are brutal. Investors are asked to lockup their capital for 10 years or more, information about the underlying investments is scant, investor protection is minimal compared with public markets, disclosure is optional, managers are gatekeepers, secondary sales are difficult to execute, regulators are at worst hostile and at best adopt a caveat emptor attitude. Lumped together, these drawbacks are the root cause of private asset illiquidity and therefore impede the public capital pool from crossing over into the lush private space…solve these problems and private asset markets will become more mainstream thereby challenging the dominance of the public markets.
The key to unlocking liquidity in the private space is understanding that the illiquidity stems from a confluence of factors rather than a single cause. Simply creating a token that sits on some cyber-exchange will not create liquidity since the other problems remain. For instance, the information asymmetries between sellers (who are often insiders) and buyers (who have no rights to ensure disclosure at any level on the actual investments) effectively drives the bid price well below fair value. If a buyer is scared of getting stitched up then he will bid low. Similarly, regulators need to accept that private markets are here to stay and, if the regulator is going to influence outcomes, then they need to ease the path to the public trading of private securities.
Solving the liquidity problem would take 3 simultaneous initiatives to my mind,
(i) Investors demand and entrepreneurs commit to high rates of continuing disclosure from private companies
(ii) Ease of price discovery and secondary transfer of private assets in some open marketplace
(iii) Regulatory tolerance of open markets with softer disclosure standards
Of these conditions, item (i) is the most important and suggests that private companies should voluntarily act like a public company when it comes to keeping markets informed. Entrepreneurs cite the relatively low level of continuing disclosure as a benefit of remaining private, thereby allowing them to focus on the business, but this is rubbish. Investors reward higher levels of disclosure with additional capital and higher valuations both before ipo and during the process of going public.
Just as ETF’s provide public vehicles which bring passive investing to the masses, sooner or later a public vehicle will bring private to the masses. Exactly what that looks like will make someone very rich.
US ELECTION PREDICTION SPECIAL
Long-term readers of this blog will be familiar with my theory that the great majority of swing voters in elections only decide who they will vote for when they are physically in the ballot room with pencil in hand. These voters are motivated by “Money and Mischief” – money in terms of which party or candidate offers them the best prospects and mischief in terms of pissing people off. So what is my prediction for next week’s US mid-term elections?
It is not fashionable to be a Republican in America. While the vocal left-leaning media fume at everything Trump says and does, it behoves the right-leaning Republican voter to simply sit quietly during dinner party debates or football afternoons with their Democrat friends. But the US economy is booming, the US President is ACTUALLY TRYING TO DELIVER ON HIS PROMISES and nobody seems to like Trump – publicly anyway.
So next Tuesday when the voters reach the polling booth and actually make their decision, the “Money and Mischief ” vote goes firmly to the Republicans. My prediction is an increased majority for the Republicans in both the Senate and the House – that will piss CNN/NYT/Washington Post/etc/etc off!
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(1) The first studies showing active managers underperforming passive benchmarks emerged in the 1970s but it wasn’t until the last decade that passive has become central. The reason for this is the emergence of Exchange Traded Funds (ETFs) that make buying a passive portfolio easily accessible to the average invest. The lesson here is that new investment ideas will only be embraced once the investment vehicle is publicly traded.
Brexit: non-market breakdown…
Here’s a riddle. If the solution to market-breakdown is regulation, what is the solution to non-market breakdown?
If ever there was a demonstration of the inability of Government to plan, decide and execute a simple instruction it is Brexit. The UK referendum instructed the Government to leave the EU cartel. The rights and obligations that European and UK governments, corporations and citizens under the cartel agreement were therefore to be abandoned. Whatever fills the void and however the economic relations between the EU and UK proceed in the future is to be determined…but by whom?
Not surprisingly, the GOVERNMENTS of both the UK and the EU think that their role is to construct an alternative legislative framework to replace the existing cartel. This is rubbish and they have misunderstood entirely the economic forces that decided the referendum. When a cartel breaks down, which cartels tend to do, the economic solution is not to try and patch it up. Cartels are bad for many and only good for some. The competitive pressures that chip away at the cartel’s stability, have at their basis a better solution.
The proper role for Government is to facilitate this better, more competitive solution by discarding the protected waste and facilitating the more open, freer trading environment that Brexit stands for. Neither the EU nor the UK Governments understand this basic fact. These institutions operate non-market bureaucracies that are incapable of relinquishing control. Worse they think that the cartel is fundamentally good, so if one rule is abandoned then it must be replaced with another rule to achieve the same thing.
One ‘sticking point’ in the negotiations, for instance, is whether Ireland and Northern Ireland should have a hard or soft border? This is really dumb, completely irrelevant and anti-competitive. Market forces don’t care about imaginary borders. Market forces just want to do business.
The Brexit negotiations are being undertaken by non-market people from non-market institutions. The World is witnessing arguably the greatest example of Non-Market Breakdown ever in economic history.
So what is the answer to the riddle? The Market, of course.
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PoW, PoS or what for the Blockchain?
“You can’t always get what you want, but if you try real hard, you can get what you need.” The Rolling Stones
The Blockchain might want to be able to function autonomously and anonymously, but it can’t always get what it wants.
The distributed ledger Blockchain technology is a decentralised method for recording ownership and transactions. The main reasons why Blockchain is believed to be superior to central registries are (i) the central administrator has monopoly power and (ii) single entry ledgers are more vulnerable to attack and fraud. This latter concern means that if a single entry in the ledger determines title then changing that entry will go undetected, whereas multiple entries in a distributed ledger like Blockchain must all be altered simultaneously to give effect to a fraud.
So, is the Blockchain impenetrable? The simple answer is No. In the event of a discrepancy across the ledger records, Blockchain invokes a ‘51% rule’ which says that the ‘true’ block is the block which occurs in the majority of the nodes. It is conceivable that if an organisation obtained 51% control of the nodes, then that entity could simply substitute a completely different set of blocks in the chain with consequential theft of ownership claims.
To combat this small but very real risk of fraud, the Blockchain uses a number of methods to ensure that the number of nodes are large and/or the risk of attempting a 51% fraud is too costly. The Proof of Work (PoW) protocol incentivises miners to search for compensation from the chain by solving ‘hash problems'. Anybody can join the PoW enterprise therefore ensuring a large set of unrelated nodes in the chain. Free entry to mine makes it difficult to stack the number of nodes in your favour – at least for economically important Blockchains such as Bitcoin. The Proof of Stake (PoS) protocol requires each node owner to back their honesty with their ownership stake in the chain. That stake is lost in the event of an aberrant block record in the chain so that if an entity wants to control 51% of the nodes they need to own 51% of the underlying assets. The consequent risk of loss can be enormous if they start tinkering with the record and get found out.
PoW and PoS methods have their weaknesses. PoW can be costly and slow. It is estimated that the energy cost spent mining for Bitcoin exceeds that of the entire consumption of Ireland while the Bitcoin block can only cope with 20 transactions per second compared with 15,000 transactions on Visa’s credit card network. PoS has greater capacity but fewer and fewer participants in the ledger are prepared to risk their stake as their ownership increases. The 51% rule relates to the number of nodes that are staked, so there is the potential to hijack a chain that happens to operate with only small stakes at hand.
The fact that the Blockchain is open to any member of the public and that they can remain anonymous is both an attribute and a weakness. Crooks are members of the public and they can operate just as anonymously as anyone else which affords them the cover that the physical world does not. The 51% rule in the Blockchain seems like a kitchen-sink solution to the risk of fraud, but it doesn’t stop a coordinated fraudulent attack on its integrity. So what can the physical world teach the Blockchain?
First, crime and opportunistic behavior is a social reality that can be minimised but not eradicated. There is an optimal amount of crime and the digital world should accept this. Second, reputation in the physical world is often used as a form of bonding or guarantee that a particular enterprise is safe. Some institutions deliberately operate with full public openess in order to lend their credibility to a function and other institutions actually host data platforms with security guarantees. In general, these institutions earn a fee for the reputation that they extend to the platform.
Which of the following structures would you trust more in the event of a discrepancy in a Blockchain: a democratic 51% voting rule of an anonymous set of ledger nodes or the secure records mirrored by a publicly announced group of software giants, audit firms and banks? Adopting some physical world practices might deliver the security guarantees that the Blockchain needs.
 For instance, the Depository Trust Corporation is a centralised warehouse for all US Equity Securities.
 Hash problems are unique mappings from one number to another number. Solving the problem uses random search algorithm that is computationally intensive.
 For example, a chain might only be supported by nodes representing 1% of the underlying asset base. Therefore buying and staking 1.05% of the asset base would give the hacker control of the chain.
The US-China trade war ‘Punch and Judy show’ is about to end
The US- China trade war is a short-term phenomena that will correct itself despite the warnings of some. The pessimists cite the classic Prisoner’s Dilemma model as the reason a trade war will have long-term consequences. This is wrong…
In the Prisoners Dilemma, two felons are confined separately and interrogated. They are offered the choice of snitching on their fellow culprit with the reward being freedom or clamming up and risking that their accomplice snitches. The equilibrium in the game is the (snitch,snitch) pair where they both fess-up and they both go to jail. The optimal strategy, on the other hand, is the (clam,clam) pair which ensures that they both go free.(1)
Despite its romantic left-wing appeal(2), it is a little known fact that the Prisoners Dilemma actually breaks down in a world where the fuzz can re-interrogate a prisoner – the so called ‘repeated game’. In this more realistic setting, snitching on your mate does not allow you to walk free – the police just pick you up again and you, too, go to jail. So the optimal strategy in the repeated game is to (clam,clam) thus ensuring that both felons remain free.
The reality is that trade wars are repeated games with the optimal strategy being the Free Trade choice. The US sanctions China and China responds tit-for-tat. This goes on for a few rounds, makes headlines, but eventually the sanctions are abandoned and we all live happily ever after. If the optimal strategy is Free Trade, why would the US impose sanctions and why would China respond? In the case of the US, there is always a saddle-point in mixed strategies and it may be advantageous to test your friend and opponent’s resolve. In the case of China’s response, the tit-for-tat sanctioning is a method for proving China’s credible threat point. But once the Punch and Judy show is over, it is in the interest of all parties to return to the Free Trade position as soon as possible.
(1) This was a major discovery in economic theory since, prior to John Nash’s Nobel prize winning insight, it had always been held that equilibrium strategies were simultaneously optimal and vice versa. Nash showed that the equilibrium could be sub-optimal
(2) Governments and other Left Wing entities use the Prisoner’s Dilemma to justify almost everything
Pragmatism and compromise in Brexit
“In the referendum on 23 June 2016 – the largest ever democratic exercise in the United Kingdom – the British people voted to leave the European Union…
…But to do so requires pragmatism and compromise on both sides.”
UK PM Theresa May in the foreword to the White Paper on the Future of the UK’s relationship with the EU, July 12 2018.
TWO years after the UK voted to exit the European Union, they are still there. How can this be? It seems that the same non-market forces that created the EU cartel have taken control of the Brexit thing.
Were it left to market forces to guide the exit my guess is that,
1. The exit would have been completed by now; and
2. Profitable trade links would remain and the bureaucracy ditched
But it’s not up to the market to decide what to keep and what to cut. The clearly visible hands of the non-market appointed negotiators have taken a simple problem and complicated it. Theresa May’s statement above is classic professional politician inertia and the entire document is poetry as opposed to science, but I particularly like the reference to ‘…pragmatism and compromise…’ for the following reason:
Free trade entails loading up a container with stuff and sending it to somewhere to people who want it. Finding customers and delivering a product at a price which satisfies each party to the transaction – buyer and seller – is the ultimate expression of ‘…pragmatism and compromise…’. Ironically, Mrs May hit the nail on the head – leave it to the market! – but she neither understands it nor did she mean it.
Surviving the Value Quicksand
Value investing refers to buying stocks at less than their intrinsic value. Warren Buffett is considered an extremely successful value investor. While Buffett continues to perform well, many of his value investing counterparts have struggled over the last five years as technology stocks, in particular, have attracted investment capital. Value Guru David Einhorn, for instance, has underperformed the S&P 500 by nearly 50%. The Russell growth index has outperformed the Value index by 38% over the last five years.
I first encountered value investing when I began working at JPMorgan Investment Management. I was intrigued by the method that they adopted, the so-called ‘Dividend Discount Model’ or present-value calculation. JPMIM employed a large number of equity analysts to forecast the dividend profile for a company which was then equated with the company’s current market price to get the implied discount rate. This ‘dividend discount rate’ (DDR) was central to the value philosophy since an increase in a company’s stock price would cause the DDR to fall (assuming the analyst dividend forecasts remained constant) thereby making the long-run rate of return lower. DDR’s should rotate from high (cheap) to low (expensive) as prices moved lower to higher. This ‘rotation mechanism’ is logically attractive and my first job at JPMIM was to understand whether the DDR actually ‘rotated’ the way people believed it should from a quantitative perspective. It didn’t…
One only had to look at the data to realise that the DDR did not mean-revert since many of the critters would just hang around the same level for years indicating the stock was forever-cheap or forever-expensive. Moreover, different analysts displayed different forecast biases meaning one set of DDRs were systematically higher than another set. A few weeks studying the dataset led me to the conclusion that value investing can ‘get stuck’ when the assumptions determining the level of the DDR are wrong. Getting stuck happens when you hear comments like ‘I’ve never found a cheap tech stock’ or ‘why hasn’t the market realised that this stock is a screaming buy’. In its most brutal form, getting stuck is when Guru’s like David Einhorn lose all their assets and their reputation is ruined. Getting stuck is like sinking in quicksand…
The solution to this DDR-level problem, to me, was and still is, simple. Rather than focus on levels, it is better to focus on changes. It is trite time-series practice that, if you suspect that a variable has an unstable or inestimable mean, you can eliminate the problem by simply differencing it away. DDRs, like share prices, can meander aimlessly for months and years until new information hits which then jump…so it is the change in the DDR that carries information as opposed to the level.
So how does this differencing idea work? A neat result from statistics is that if you think that a stock should trade at 10 times earnings, then the change in the stock price should also be 10 times the change in earnings. The ’10 times’ is a parameter that you can estimate using either levels or changes and it should be the same. If it turns out that this parameter estimate is wildly different when using levels v changes then you have a problem in your valuation process. Put another way, if for some reason your pessimism never makes a tech stock look cheap, no one is going to question the value-based wisdom of buying tech stocks that have just gone down by 25% – they may not be cheap but they just got a whole lot cheaper!
From Communism to Militaryism to Money Worship
A diplomat is a man who thinks twice before saying nothing” – WInston Churchill
“He would be there, he would be running his country, his country would be very rich.” – Donald Trump 17 May 2018 on his vision for Kim Dong-Un’s role in a future North Korea
Kim Il-Sung established the modern North Korea in 1948 as a Communist-Agrarian state modeled on Maoist China. When China’s reformists jettisoned Communist ideals, North Korea quietly removed all constitutional references to Communism under Kim Jong-Il in 2009 replacing them with a commitment to “Songun” or “Military first”, so adopting military rule as the supreme source of authority. Kim Dong-Un, the grandson of Kim Il-Sung and son of Kim Jong-Il, seems poised to re-orient the North Korean state once again, only this time toward Trump-ism which is a form of Money Worship…
If this astounding political transformation transpires, the history books will falsely portray Trump as a masterful diplomat and Kim Dong-Un as a courageous reformer. Why falsely?
Winston Churchill’s description of a diplomat does not apply to Trump. When confronted with the potential summit-stopper over Mr Kim’s post-cold war role in the World, Mr Trump could have side-stepped the issue with indecipherable blather. Instead he promised Mr Kim that the US would not undermine his power, instead creating the way for him and his Generals to become oligarchs. Summit-On!
Kim-the-Courageous will be another false historical narrative. The story will be that Kim Don-Un had always intended to bring North Korea in from the coldd but had to purge the Military first to assert his power. The purge was, indeed, brutal. But the trigger that pushed the youngest Kim of his dynasty towards Money Worship was the message he received from the greatest Money Worshippers of all – China. Lobbing missiles over Japan was unacceptable, so get with the program, get rich or get out!