January 3, 2020
Recommendation — The recent campaign by leading venture capital investors to allow direct listings of portfolio companies on national stock exchanges concurrent with, or without, an initial public offering (IPO), or private offering, or company or selling-shareholder shares should be permitted with one important caveat: all private companies should be required to register securities under the Securities Exchange Act of 1934 once the valuation of the enterprise first reaches $250 million. The current thresholds for public company reporting adopted under the Jumpstart Our Business Startups Act (JOBS Act) in 2012 have led to many large companies staying private for longer and a surge in capital flowing from public to private markets. The steady demise of public capital formation is synonymous with trends in other news and information-related businesses disrupted by social media platforms — belatedly recognized as social discord platforms. Once information about the financial condition of private companies held in institutional investment portfolios has been exposed to the light of day for an appropriate period of time, companies should be free to choose whatever form of capital-raising or exchange listing they determine is best.
Google IPO — The most vocal advocates of direct listings rest their case almost entirely on spurious claims of a sole academic that Wall Street banks consistently underprice IPOs. Some of the same individuals also did so when they influenced Google to choose an auction IPO in 2004. At the time, Googles auction IPO was not considered a success, not because of any Wall Street disinformation campaign as has been opined, but because of a lack of confidence in the auction process to determine the appropriate fundamental value of the company's shares. The very nature of the IPO process, and any liquidity event, requires new and independent buyers to agree to transact with sellers (or the company) at a specific price determined using their skill as (active) investment management professionals. The initial indicated pricing range for the Google auction IPO was $108 to $135 per share (not split-adjusted). The shares were ultimately priced, after receiving information from selected active public investment managers, at $85 per share, and then traded up 18% on the first day.
The IPO Process — Beginning in the 1990s, following deregulation of equity markets, the US-style of book-building IPO was widely adopted the world over as a superior method of capital formation and to undertake public market privatizations as compared to auction IPOs, helping US investment banks rise in global league tables. Since then, regulatory changes, demutualization of stock exchanges, passive investing and electronic trading have led to the collapse of trading commissions and the business lines, including equity research, that supported IPO underwriters in their role as honest brokers. Disruption of the (active) investment management businesses also came swiftly as a result other industry changes including the acquisition of the New York Stock Exchange (NYSE) by the InterContinental Exchange (ICE) and iShares purchase by BlackRock which led to an explosion in the number of exchange traded funds (ETFs) and other listed derivatives. Many market participants, including a prominent private market investor in a recent fireside chat with the SEC Chairman, claim end investors have been the major beneficiaries of these industry changes. However, actual evidence is mixed. High frequency trading has come to dominate market-making. Traditional active investment managers have found market prices now rarely conform with their insight. Widespread indexing concentrates holdings in the largest capitalization companies.
The Rise of Private Capital — The shift from public to private capital formation has concentrated attractive investment opportunities and, more importantly, valuable information. Claims of value creation by private market investors too often evaporate upon closer scrutiny yet the asset class attracts increasingly large commitments from investors. Much of the appeal of private market investing no doubt lies in the absence of volatility in reported values that comes with public market investing in exchange traded securities. Stewards of capital may (rationally) accept the unreasonable fee structures of such investments (with inevitable impact on realized returns — potentially shirking fiduciary responsibilities) in return for holding down their own jobs unchallenged, and for longer, when investment performance is consistently self-reported as above average yet unverifiable — just as with all Ponzi schemes before them. While private investments may mitigate career risk for certain professionals, the risk of private companies staying private for longer than the original expected life of the private investment fund has increased dramatically and may create significant headaches for successors. Given a lack of receptivity in the public markets for organized public offerings, funds may resort to large scale distributions of shares, if they are exchange listed, or simply seek to extend the fund life — leaving invested capital frozen. The wholesale secondary liquidation of private investment fund interests (of venture capital and private equity) is a growth area for certain exchanges and law firms but fund partners likely will realize steep discounts without public investor interest.
Price vs. Value — Proponents of direct listings claim they are not anti-bankers, but rather that they are pro-algorithm and want to leverage technology to make access to IPOs fair and efficient. There is a lot to unpack here. First, with respect to widespread dissemination of information, proponents of direct listings propose that (unregulated) social media platforms and investment news forums should be harnessed to spread information to new investors. Undoubtedly this is true, but the devil is in the details. In spite of the various shortcomings of sell-side firm equity research, it is hard to imagine unregulated information from all and sundry is likely to be considered a viable solution. The first step is to create a level-playing field for all in terms of company reporting. Although it is rarely mentioned as a factor, Spotifys direct listing was facilitated by company having regularly filed for some years publicly-available audited financials and other information as a private company with regulators in its home jurisdiction of Luxembourg. Second, pricing in the secondary markets (Day 2) is fundamentally different from the initial pricing in new issue (sometimes referred to as primary) markets (Day 1). Comparing the two is an apples-to-oranges comparison the difference between determining an informed absolute valuation in the absence of prior information and relative valuation exercise of determining todays price compared to yesterdays. One might say, algorithms know the price of everything and the value of nothing. Finally, venture capital firms have chosen to internalize some of the investor search and various other functions (traditionally performed by investment bankers) in-house and with the CFOs at their portfolio companies — yes to avoid fees — but primarily because they can capture for themselves the economic advantage of the information asymmetry they have as insiders over new investors by cutting out the honest broker. The incentive fee structure of venture capital fund compensation makes each liquidity event at a portfolio company potentially a life-changing one and warrants regulatory attention to ensure full and fair disclosure.
Cross-Over Investors — Late-stage private companies and venture capital firms perhaps believed they had co-opted many large public institutional investors (that is, mutual funds and hedge funds) that would ordinarily be independent price-setting institutions in a traditional IPO by allowing them to invest in late-stage financing rounds. However, the primary rationale for these investors to come into the late-stage rounds instead of waiting for the IPO was simply to invest at a more attractive price (that is, to average the cost of their purchases) and gather intelligence on how emerging technologies may affect public company investments. For many cross-over investors, late-stage investments were a one-way bet — tiny compared to the scale of the public equity portfolios. The former lawyer responsible for private investments at one of the largest mutual fund companies, once indicated he had purchased shares in some 300 different companies. When queried on how many he had sold, the number was less than a handful. With such a track record he was recently able to leave the firm and start his own fund. In recent years, foreign government-backed and sovereign wealth funds (SWFs) also became popular sources of capital for many late-stage pre-IPO companies and private investment funds. Given their size and scale many SWFs pursue passive indexing strategies for their public equity investments. Just how high private investment fund managers are willing to jump for potential fund allocations from foreign SWFs is quite eye opening. Recent IPO market performance suggests that if private market investors need Main Street retail investors to validate their desired stepped-up valuation, they are in for a rude awakening. It will take considerably more than the much-maligned IPO pop to attract retail investors back to the IPO market. The direct listings reality distortion field does not extend far beyond Sand Hill Road.
Demise of Public Capital Formation — Today, the leadership of the US Securities and Exchange Commission (SEC) is seemingly beholden to New York and Silicon Valley law firms and their private capital-focused clients. Contrary to public statements and the SECs mission, the interests of Main Street public market investors are not prioritized and claims of US capital markets being the best in the world no longer ring true. The public market underwriting infrastructure at most traditional equity-focused investment banks has been slowly dismantled over the past two decades as deposit-taking institutions with the ability to deliver low-cost leverage capture an ever-larger portion of the capital-raising fee pie. The few surviving equity brokers (the lead left banks) have been restrained in their public comments about the direct listings drive. The closed-door campaign rallies organized by the ringmaster advocates of direct listings have instead invited best-selling authors to share the microphone, alongside paid law firms, and called in favors from former Wall Street analysts (previously barred for life from the securities industry) in order to amplify their message. IPO mandates aside, the banks do not want to jeopardize potential access to fundraising by leading private investment funds as it may be one of the few differentiators as they seek to evolve their own business models and provide fee-based wealth management services. What they are not going to do, however, is let Silicon Valley venture capitalists dump their cash-consuming and failed IPOs on retail clients — at least not without the potential for a fee or commission. Even the most famous Wall Street firms have only so much of their reputations they can afford to ruin. Decades of neglect risk turning the public equity markets, the crown jewel of a capitalist market economy, into the pump-and-dump world of the pink sheets and ICOs.
Investor Protection — Some of the claims of the direct listing advocates are so outlandish — that it is inexperienced venture capitalists who are the patsies who are fleeced at the proverbial IPO table sitting opposite experienced investment bankers and public market investors — it begs the question, what makes a billionaire venture capitalist so cynical about the traditional IPO process? Closer inspection of the portfolio company investments of the agitators reveals some clues of possible ulterior motives. It transpires that so-called gig and sharing economy investments dominate. While such companies have many positive aspects, they also have a dark side: the commoditization of labor, stripping millions of workers of employee rights and benefits and consumers of various regulatory protections. Such companies have often sought to achieve scale and the winner-takes-all network benefits by relentlessly burning capital to acquire customers and employee-contractors to their platforms. The early venture capital backers have already reached far and wide, at home and abroad, to tap new sources. The cynical attempt to promote direct listings as a way to provide access to Main Street retail investors and make markets more efficient is nothing of the sort: it is an attempt to bypass the independent skilled investment banking and investment management professionals when establishing the initial market value of the company. Ultimately, the goal of these venture capitalists may be to facilitate the wealth transfer from ordinary Main Street investors to themselves. The target? The large pools of uninvested savings (the dumb money) sitting in the near zero interest bearing accounts at the nations discount brokers. Some of the new generation of designated market makers and other high frequency trading firms already have cut deals with the discount brokers to provide their accounts with access to the public markets with the pretense of best execution. Venture capitalists are probably licking their chops at the prospect of unlocking a thundering herd with social media clickbait that will make the recent explosion in the number of initial coin offerings (ICOs) look like a drop in the bucket in comparison. Will Chuck be able to resist his noisy neighbors and protect his own legacy? So far, so good but only he has the scars from the 1997 foray into IPOs.
The Last Hope — In spite of the public relations marketing from Day 2 players — the stock exchanges and the designated market makers — inflating the value of their contributions to the IPO process, the lack of trust and transparency combined with asymmetric information will always make Day 1 pricing a challenge. Transactions in non-registered shares almost always are initiated by employees or insiders who, by definition, have access to information not available to potential investors. As the sums at stake have grown exponentially, and the influence of the principals has spread dramatically, the private capital market requires much greater scrutiny. Regulators can no longer justify turning a blind eye. Given advances in technology and the ease of disseminating transaction details and company information, it would seem to be in the public interest to upgrade the quality wholly-inadequate Form D disclosures. Moreover, as private company shares are now included in many public mutual funds, they must be marked to an estimate of market value and self-reported values are not credible. The IPO process is clearly not without flaws. So too, the Series A, B, C, D and every other financing round before the IPO has flaws. Far too often, it is actually startup entrepreneurs and employees who are the patsies fleeced by the private company investors (and their lawyers) with complicated financing terms, company policies, and boardroom shenanigans that make IPOs and life at a public company look decidedly plain vanilla. Understandably, trust in financial markets and institutions remains low and can only be restored by commitments to strong ethics, accountability and integrity on behalf of all market participants and with high-quality information, as opposed to quantity, and facts rather than fiction. Many recent IPOs have contributed little in this regard. It takes time and critical scrutiny for information to be assimilated into markets and prices. The answer is not to lower the bar for accredited investors in private markets. Making markets effective is much more complicated and requires improving transparency and extending the availability of reliable quality information from the public markets to all areas of private markets.