Thursday, June 16, 2011

The Mock P. O. Craze

I want to trade mark the term "Mock PO".  It's just what you think: a fake IPO.  Remember, you read it here first.  LinkedIn and Pandora come to mind.  Sell a tiny sliver of a company to the public at an absurd price. The $64,000 Question: Why?

I've written before that private equity and venture capital firms ex ante expropriate their clients assets.  What about ex post?  Can investors suffer another round of pain?  Management fees transfer substantial value from investor to manager, but real manager value depends on expected performance fees.  If markets turn south, how do you make performance fees?  How do you cover the burn rate on the yacht?  An MPO may be the answer.

How does it work? 

Very limited public float (i.e. don't really sell much more than a sliver of the company) holds the price artificially high because of incredible demand for new companies in hot sectors.  (I'm not convinced of this argument, but the world seems to be buying it...the market seems to forget all the shares that could be sold...)  In simple terms, imagine you could sell 5% of the company at a $20 billion valuation, or 50% at $10 billion.   

Fund documents typically allow managers to distribute positions in-kind.  Again typically, investors perceive this as a last ditch move by managers for still private companies that cannot be sold, but nothing precludes distribution of public stock.  Finally, nothing precludes taking performance fees on in-kind distributions.  (To say nothing of catching up on losses or hurdle rates!)

So, the VC fund takes potentially very large performance fees on valuations that their investors can never realize because when the investors sell the stock, the "exclusivity premium" baked into the stock price falls to zero.  In the end, the investors hold the $10 billion valuation company...after the VC fund takes their performance fee on the $20 billion one.

Time will tell if the strategy works.  I certainly hope I'm wrong.