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.

FDIC Proposes Rule To Pay Bankers More

FDIC announced today that a proposed rule clarifying the "Orderly Liquidation Authority" would allow the FDIC to claw back compensation from senior managers and directors found substantially responsible for the failure of a bank.

What's the problem?  In an attempt to bring greater responsibility to bank managers, regulators actually propose increasing their personal risk.  (That's what I'd call taking away compensation after the fact...you certainly aren't reducing their risk!)  So, by increasing executive risk, executives will respond by demanding higher expected compensation.

[If the individuals in question didn't respond this way, then, by definition, they are risk seeking, rather than risk averse.  We most definitely do not want to encourage risk seeking people to engage in bank management!!]

Moral Relativism and College Tuition

Apparently my sister's recent blog post caused a bit of a family panic.  That's nothing new, as any of her readers would know.  Our father, distressed by factual errors, reminded her that our parents did not give Brandeis a pile of cash so that Penelope would gain admission.  They gave it so she could graduate.  She thought his distinction irrelevant.

I disagree.  Allowing sub-standard students entry in exchange for cash helps the sub-standard individual, but hurts the other students.  Charging students to graduate benefits everyone. 

 Consider this: Compromising on admissions reduces the measurable qualities of the school: average SAT scores, numbers of valedictorians, high school GPAs, number of extracurricular activities.  The list goes on.  Compromising on graduation standards by charging students to receive degrees probably raises measurable qualities: per student spending, endowment per student, and, most importantly, graduation rates.

What's the difference between Brandeis saying "I'm sorry Ms. Trunk, you are short two courses to graduate, so we'll see you next semester, please see the bursar for your bill," and saying "Look, P, you had the college experience, you're short a couple of classes.  You can burn six months of your life and $25,000 on another semester, or you can pay $30,000 right now, and call it even."  I'd say not much.


There's even further benefits to the school.  Colleges already nearly perfectly price discriminate.  (When was the last time you turned over your income tax returns and statement of assets to allow the seller of a product to pick the price??)  However, tuition remains an important headline number for marketing puposes: It should be high, but not too high to scare people away.  Individualized "graduation fees" would allow a little back-end price discovery, presumably furthering the wealth redistribution goals of educational institutions. 

Schools could finely tune their pricing to further their various agendas: Want more English Lit majors?  Make the engineers pay huge fees upon graduation!  Need higher paid alumni without giving up the value of your trust fund babies?  Charge a fortune for that art history degree!

Why Don't Start Ups Have Debt?

This is not quite a stupid question. Start-ups have a future.  They have no present.  No earnings, no assets.  Maybe the management team has a track record.  Why would you lend to them?  Debt only has downside. Start-up investors take equity.  If they're taking the downside, they want the upside.

So, why do student loans exist?  Economically speaking, student loans look a lot like loans to start-ups.  They're a lousy proposition for the lender because you only have downside.  You can't take founders warrants in a career--slavery is illegal.  And the asset you finance, an education, remains with the borrower even if the borrower willfully defaults on the loan.

This story gives another tale that, on the surface might deserve sympathy, (call me heartless.)  The good doctor got herself $550k in the hole because she didn't "read the fine print" or keep track of the rules.  If you cannot borrow on sensible terms and you don't take the time to read the fine print then maybe this is exactly what is supposed to happen. Entrepreneurs evaluate their cost of capital and attempt to make good investment decisions.  This story signals really bad management and investment on the part of one individual.

I know, you say positive externalities (a better educated population means higher productivity, etc) mean we should subsidize education as a society.  This may be true, but we still need to address moral hazard and we need to efficiently allocate capital.  We shouldn't recklessly fund risky loans and let our sympathies after the fact worsen the situation.

What is the goal of corporate governance?

Jason Zweig, in the Intelligent Investor column in the Wall Street Journal writes about Lucian Bebchuk's research about CEO Pay Slice, (which you can find here.)

The most thought provoking comment in the paper is the following:

[CEO Pay Slice] is negatively correlated with the firm-specific variability of stock returns over time. This association could be due to a greater tendency of dominant CEOs to play it safe and avoid firm-specific volatility (which would impose risk-bearing costs on them but could be less costly to diversified investors).

Rarely does anyone take on the serious implications of this observation: CEOs and the Boards that oversee them must strike a balance between taking idiosyncratic risk that differentiates them from the rest of the marketplace and taking incremental diversifying risks that reduces firm specific volatility.

I served on the board of a public reinsurance company. Reinsurers take very risky bets by insuring, typically, catastrophic disasters. Catastrophic insurance has a particular type of risk I'll call short volatility: They collect insurance premiums and pay out very large claims. The claims are nowhere near normally distributed in the world of catastrophes. This means that writing "cat" reinsurance has very high returns on equity, although they aren't normally distributed. Also, cat reinsurers have ratings (A- or better, typically. See AM Best, for example.) This means they write protection on more risks than they can pay, because (re)insurance buyers accept a rating as evidence of ability to pay.

The first problem this raises for the Board is whether the board should be maximizing the expected return on equity of the company or maximizing the return to holding the stock of the company, or even maximizing the return on equity of the company subject to some limit on the risk of losing the rating and therefore destroying the enterprise value of the company.

At the time I served on the Board, I happened to also "control" more than 10% of the stock. However, that 10% of the stock was of little consequence to my firm's total risk. This gave me a serious conflict to address: As a Board member, what did I assume the shareholders of the company wanted me to do? I knew I was not necessarily a typical shareholder. Did I assume they held uncomfortably large blocks of stock, (which we all should view as irrational,) and therefore would want me to not risk the disaster of losing the rating? Was my goal to maximize the "value" of the rating, meaning the ability of the company to default on claims if something truly catastrophic happened, which is perfectly sensible if no one holds large positions in their own portfolio?

These are the interesting questions most boards, I suspect, spend too little time addressing.