About the Recent Spate of Large IPOs

In the wake of the Twitter IPO announcement, Tyler Cowen asks if the return to public equities is now lower. His theory, about a wealthier world that causes successful companies to stay private for longer seems flawed but he brings up an interesting question.

It is worth thinking about what has changed recently where we now see many more mega IPOs.  In 1986, Microsoft had its IPO, raising $61 million dollars with  valuation of almost $800 million dollars. This would be $1.7 billion dollars in 2013 dollars. In 1993 Allstate had the biggest initial public offering ever up to that point by a US company. It sold $2.12 billion worth of stock at a price that gave it a valuation of $11.8 billion dollars or $19 billion in 2013 dollars. This large IPO was possible at the time because it was a spinoff from Sears.

More recently, Linked-in went public in 2011 for $4.5 billion and Facebook went public in 2012 for $90 billion. With Facebook now comfortably above its IPO price, Twitter is planning on going public with analysts estimating its IPO market capitalization between $10 and $20 billion dollars.

There are many differences between the world that spawned the Microsoft IPO and today’s markets, but the below might be the most important:

1. Sarbanes Oxley raises the cost of going public. When Sarbanes Oxley costs average over a million dollars the cost benefit analysis of going public doesn't make sense until a company has a significantly higher valuation/revenue stream than it would have needed in the past.

2. With many companies putting off going public a new financial ecosystem developed to fund these companies. Late stage VC firms like Andreessen Horowitz entered into the market. Not only do they have billions of dollars they need to deploy but they actively help the companies they invest in. This further raises the opportunity cost for companies thinking about going to the public markets.

3. A growing secondary market in shares of startups lets many founders and early employees diversify a significant amount of their new worth out of the company. When these employers feel financially secure this reduces the incentive for an immediate IPO.

4. With the internet and globalization, network effects are much more important and markets are much more likely to be winner take all. Once the winners are established their market capitalization will be significantly higher than companies in the past. This doesn't stop companies from going public sooner by itself, but it does mean that by the time the company feels that it is stable enough to be traded on the public markets its market capitalization will be much higher.

Given all of these factors, the higher market capitalization of IPOs makes a lot of sense. What this means for public equity returns is more complicated. 

The first factor prevents many companies from going public until they are much more successful. This includes companies that go on to be successes but there are also companies that end up as failures or frauds that would be detected by tougher accounting laws that public market investors are never exposed to. Small companies will also often sell themselves to larger companies rather than enter the public markets. Overall it is difficult to calculate the direct effect of this factor on public market returns. 

The factor that really penalizes public market investors is that a healthy secondary market means there are not as many situations where a company will go to market merely for the sake of allowing its management team to cash out. When there is demand for liquidity, the people on the side of the trade giving liquidity will on average make a higher return. The reduction of this factor could lower returns for public market investors in general. At the very least it should cause a reduction in the size premium. And from the chart below, we see that size was never a particularly attractive risk premium to be long in the first place.  Momentum, market return, value and even the risk free rate have outperformed the classical size risk premium factor.

Source: Ken French’s Data Library

The winner takes all (most) nature of many of markets today is both a blessing and a curse for public equity investors.  It isn’t always private companies like Facebook or Twitter who create new markets, as Apple investors from the early 2000s know very well. At the same time, other public companies, Microsoft is an example that comes to mind, will often spend billions of dollars trying to be the winner in a new market but fail miserably.  And if companies really are sustainable pseudo-monopolies, then public market investors have a chance of benefiting from investing in them even after IPOs.

When thinking about what impacts public market returns it is fun to think about things like the impact of mega IPOs will be but it is better to double check theory again the basic fundamentals. We currently have an equity market that is yielding over 6% while investment grade debt yields, depressed by quantitative easing and low rate expectations, are below 4%. Until the past few years, investors in bonds have been paid a premium over earnings yield because they are taking on inflation risk and their earnings will not go up. The last time this happened we have to go back to a time period when equities were viewed as a realm for uncouth gamblers and everyone knew that railroad bonds were the key way to keep their money safe.

 Source: Bloomberg, Barclays

Given the current valuation dynamics, it isn’t likely that the average return on publicly-held companies has moved lower. 

Naming the Decade

When talking about an event between 1980 and 1989 we call it the eighties. When talking about an event between 1990 and 1999 it is the nineties. But the one from 2000 to 2009 is confusing. Wikipedia was somewhat helpful.

Orthographically, the decade can be written as the "2000s" or the "'00s". Some people read "2000s" as "two-thousands", and thus simply refer to the decade as the "Two-Thousands", the "Twenty Hundreds", or the "Twenty-ohs". Some read it as the "00s" (pronounced "Ohs", "Oh Ohs", "Double Ohs" or "Ooze"), while others referred to it as the "Zeros". The single years within the decade are usually referred to as starting with an "Oh", such as "Oh-Seven" to refer to the year 2007. On January 1, 2000, the BBC listed the noughties (derived from "nought" a word used for zero in many English-speaking countries), as a potential moniker for the new decade. This has become a common name for the decade in the UK and Australia, as well as other Anglospheric countries.

Others have advocated the term "the aughts", a term widely used at the beginning of the 20th century for its first decade.

The "two-thousands" might have seemed good at first, but those using it probably forgot that it refers to the whole millennium and not just the first decade of that millennium. Two contenders make sense - the "Twenty-ohs" and the "aughts".  The first is accurate, if three syllables, and the second has historically been used, even if it sounds like you are being told what to do when someone brings up the decade. But one thing is clear - we can't let it be called "the noughties". That would just be awkward. 

At least this confusion won't happen in the teens. 

Copyright Extension and Star Trek

The current crop of writers doesn't really like the core fan base of Star Trek.  The director of the new films, J.J. Abrams, was too philosophical. And the feeling from the fans is largely mutual as the latest movie was voted the worst Star Trek movie ever at a recent convention. The head writer Bob Orsi had some words for these Star Trek fans who didn't like the explosion and action in the Star Trek movie that wasn't about Khan but was in fact about Khan:

 STID has infinetly more social commentary than Raiders in every Universe, and I say that with Harrison Ford being a friend. You lose credibility big time when you don’t honestly engage with the FUCKING WRITER OF THE MOVIE ASKING YOU AN HONEST QUESTION. You prove the cliche of shitty fans. And rude in the process. So, as Simon Pegg would say: FUCK OFF!”

This whole mess would be largely avoided if the Star Trek intellectual property was in the public domain. They'd still probably be making bad Star Trek movies, it just wouldn't be as offensive when there were other options. Big studios wouldn't be the only game in town when it comes to characters and a universe that has been part of people's lives for many years.

If the 1909 Copyright act was still in effect, Star Trek would be in the public domain after 56 years. The original series first aired in 1966, so by 2022 the basics of the original Star Trek universe free to anyone who might be able to do it justice. Under current law, it is in the hands of the current rights holders until at least 2061 and likely longer since copyrights get extended when Mickey Mouse gets close to the public domain due to Disney's lobbyists. 

But Star Trek fans should look on the bright side, if Star Trek ever does enter the public domain the debates over which material is canon will get even more confusing.

Pareto Assurance Contracts

Alex Tabarrok blogs about assurance contracts, an idea he originally wrote about in the 90's. An assurance contract helps get around the public goods problem.

In an assurance contract people pledge to fund a public good if and only if enough others pledge to fund the public good. 


What a dominant assurance contract adds is that the entrepreneur agreeing to produce the public good if k or more pledge also agrees that if fewer than k pledge he will pay a prize to those who did pledge.

Many companies have used the power of the internet combined with assurance contracts to create new businesses. Groupon assures businesses that if they engage in a promotion they will have a minimum number of customers, while Kickstarter and Indiegogo fund products or ideas that can be closer in nature to public goods because without the funding many of the projects they support wouldn't exist. The existence of a product in the market place that large groups of people would wish to purchase isn't the most common example of a public good, but it seems to qualify even if the good itself is a private good.

It is important to note that Kickstarter figured out a better way than dominant assurance contracts to fund their projects. Rather than forcing entrepreneurs to risk large payouts to potential funders (or arbitragers who can seek out projects certain to fail), the Kickstarter business model is to provide extra benefits to funders. They allow project creators to offer different levels of rewards, depending on the choice of the funder. The rewards can be capped, so only the first X amount of people to fund at a given level are given significant rewards while late coming crowdfunders will get slightly inferior rewards that are still better than what the general marketplace will get.

This is a solution where all sides benefit (assuming the people kickstarting the project didn't miscalculate their rewards), so perhaps the type of contracts used by Kickstarter and other crowd funding platforms should be called Pareto assurance contracts.

Things going on in the world

1. New Zealand is leading the way in IP law by banning software patents. If they were a larger country this would have more of an impact, but if this were a larger country the lawmakers probably would have been bribed to preserve the rent-seeking status quo for patent trolls.

2. Kim Jong Un's ex lover was executed for producing sex tapes. I'd say his wife Ri Sol Ju caught him watching the tapes. But a more likely version of the story is that she decided to flex her power to get rid of many of her former rivals. If the wife is that bloodthirsty then it suggests that the chances for long term North Korea liberalization are lower than they would be if the situation were different.

3. I can't believe that Soros dicussing his HLF purchases is insider trading, it sounds like outsider trading to me. It also sounds like Ackman is desperate to try to get revenge on an investor who bet against him and withdrew his money from Ackman's fund.  On the other hand, it looks like these Canadian directors got away with things they shouldn't have when they issued themselves options before announcing "spectacular" drill results.

4. The Justice department clarified its stance on how it is going to turn a blind eye towards recreational marijuana use in Washington and Colorado and that recreational use by adults (assuming they aren't driving or giving it to minors) isn't a priority in other states either. It's unclear why these changes didn't come four years earlier or why shutting down medical marijuana dispensaries in California was such a large priority, but it is a welcome change.

The Market's Exit Interview

On most days, CEOs can probably pretend that what is happening to the stock is beyond their control.  But some days the stock is all about them.

Today, Microsoft's stock price is reacting to the news that Steve Ballmer is going to retire within the next 12 months.  The market capitalization of MSFT is currently $285 billion. Yesterday it was about $270 billion. Microsoft's jump in stock price means that people think whoever gets picked to replace him will make Microsoft approximately $15 billion more valuable than it would have been if Ballmer remained at Microsoft indefinitely.

It could be worse, Microsoft is only up 5.8% at the moment. When Carly Fiorina left HP the shares rose 7.5%. And the leaving executives will own large amounts of the stock that is appreciating in value in response to their leaving. So this hit to their pride is balanced by a boost to their pocketbook and this is before whatever ridiculous severance they've negotiated for themselves is also taken into account.

Edit: It appears Ballmer doesn't have an additional retirement package, so he's going to have to content himself with the over $700 million he made on his stock holdings from the market's reaction to his impending retirement. 

Disclosure: I talk about a lot of stocks. It should be assumed that I might own any mentioned in my blog posts either directly or indirectly and I'm not trying to get the reader to buy or sell anything since they should do their own research.

Regarding Useless Ladders

Tim Harford had an interesting op-ed last week and it's now outside of the FT's pay-wall.  In the op-ed he looks at the reasons behind the increase in inequality.  It covers a lot of the same ground as Mankiw's paper, Defending the One Percent.  After reviewing the reasons why globalization and technology have caused winner take all markets to become the norm in many areas, the analysis turns to the increasing correlation of intergenerational wealth in America and the UK and how this amounts to the rich pulling the ladder up behind them.

He focuses mostly on the higher cost of status markers.  
"The well-off feel that they must strain to prevent their children from slipping down the income ladder. The poor see the best schools, colleges, even art clubs and ballet classes, disappearing behind a wall of fees or unaffordable housing."
In a wealthy society, the market for status does not get more efficient - more money is chasing the same number of spots and the signal of money being spent is often mistaken for quality. Take these competitions to their logical extreme and we end up with 400 dollar sessions designed to help 4 and 5 year olds get into the top preschools*. The solution to inequality is not to make it easier to attain the same status markers. Those status markers are functionally useless ladders. It has been attempted with education, and throwing more money into student aid and loans has helped drive education costs higher, saddling students with debt that is far in excess of what they can handle given their economic opportunities. 
No matter what you do, there are still a limited amount of spots at the top. Subsidizing university education for everyone just makes going to a top university or getting additional degrees in relevant fields more important. If everyone takes ballet classes, then ballet classes won't matter as a status marker anymore. The total costs to signaling go up, but the winners will be by and large the same people. The op-ed goes on to note how high inequality countries are self perpetuating.
The painful truth is that in the most unequal developed nations – the UK and the US – the intergenerational transmission of income is stronger. In more equal societies such as Denmark, the tendency of privilege to breed privilege is much lower.
The comparison of Denmark's lower intergenerational transmission of income to the US completely misses Denmark's significantly lower variation from both a genetic and cultural standpoint. 
The population of Denmark is so much more homogenous than that of the United States that bringing them into the discussion is basically a non-sequitur.  Not only is the US significantly more diverse, the United States has also been segregating itself along educational lines. In the US, universities have increasingly acted as genetic and cultural sorting mechanisms. In 2011, 71 percent of college graduates married other college graduates and it should be obvious that children of these couples face many advantages. The school districts they attend are better because of their involvement. Their children go on to outperform children from other backgrounds, reducing intergenerational wealth mobility. 
Expensive private schools and extracurricular activities do make life very difficult for the intelligentsia who are members of the upper middle class but who lack the income to support that membership for their children. But they aren't the heart of the problem - the concern is about creating opportunities for the least well off rather than making sure those who are well off are able to see their children fail. The heart of the problem lies in cultures ravaged by the war on drugs and in the broken school systems the war on drugs has helped create. The obvious solution is to stop the crazy war on drugs.  Otherwise, getting rid of crazy occupational licensing laws and other rent seeking structures in society, creating frameworks for apprenticeships and finding ways to match students with good teachers who have time to teach without the presence of disruptive students are all potential paths towards a much better future. These issues and many others come well before those looking at the big picture should start even worrying about the rising cost of ballet lessons and art classes.
*Unfortunately, this isn't really the logical extreme. Things will get much crazier.

Companies have been underpaying for bugs for a while

This Forbes article on the Zero-Day bug market is quite interesting. It highlights that there are people (mostly consisting of government intelligence organizations) willing to pay hundreds of thousands of dollars for specific exploits. Exploits in Adobe reader sell for between 5k and 30k, while IOS exploits sell for between 100k and 250k. The buyers? Western spy agencies. What about the companies themselves?

 Google typically offers a maximum of $3,133.70 for information about the most complex flaws in its software, a number that’s meant to spell out “elite” in hacker slang.

Perhaps there are good reasons for companies to refuse to participate in a market that revolves around exploiting their mistakes. And maybe the brokers who deal in these exploits aren't actually allowed to sell the exploits to them, for fear of being accused of blackmail.  Or maybe companies don't want to have to pay market rates for a problem they have identified and are resolving.

Still, there are ways around all of these problems. In the end this seems to be a subject that most companies are too prideful to treat properly. Something that used to be offered for free or quite cheap is getting expensive and companies are caught flatfooted. But some companies are finally starting to accept reality, according to a recent New York Times study of zero day exploits Microsoft recently raised its top bounty to $150,00. Facebook, when it is willing to make payouts, has made payments as high as $20,000.

Suppliers who used to provide these services for free are starting to realize they should be paid at the same time more buyers are entering the marketplace. Combine this with high profile bounty rejections and more hackers will figure out that there are usually other ways to monetize their findings. Given the supply and demand dynamics in this market it is unlikely that prices are going anywhere but up.

Facebook follows Paypal in trying to turn white hats black

A lot of companies have bounty programs. Sometimes they try to find silly reasons for refusing to pay out. Paypal didn't want to pay a programmer under 18 years old who found a bug. This is a bad idea because it encourages those who have found bugs to figure out other ways to make money with those bugs. Today, it's Facebook that has decided they also want to create perverse incentives for hackers.  Their security team ignored a bug report until the researcher used the bug to post on Zuckerberg's wall.

Joshua also informed Shreateh that he would not be receiving a bug reward for reporting the exploit because he violated the site's terms of service. "We do hope, however, that you continue to work with us to find vulnerabilities in the site," he wrote.

There are two interpretations of what is going on here. The first is that Facebook does not want to encourage people to embarrass the company or harass their CEO/Founder.  But adding to this is that the Facebook employees who are in charge of this program that decided to not listen to the researcher decided to not pay out the $500 due to their general embarrassment.

Either way, it should be noted that exploits that allow for spamming Facebook walls are worth significantly more than $500.  In terms of cost, $500 is a very small amount for Facebook and they are used to spending much more in order to keep employee morale high. By not even paying these relatively small payouts, Facebook is encouraging people who can find exploits to find other ways to monetize their findings. They are also decreasing the morale of their large free workforce. If Facebook is going to refuse to honor their pay outs unless people follow the rules exactly they should make the payout significantly larger.

For the individual involved in each case the publicity the media gives them is worth more than the payout they missed out on, but the opposite is the case for the companies involved.

The Politically Connected, Banks and the FCPA

I've already talked a little about the inherent disadvantages that US and other developed market economy based companies face due to the Foreign Corrupt Practices Act (FCPA). Companies that can't or won't bribe officials in corrupt economies will be at a large disadvantage compared to companies who will make these bribes. In order to win business they will have to be orders of magnitudes more efficient than their local competitors - which is an advantage that is hard to sustain for long periods of time.

I thought companies had an easy way around it - hire locally connected employees. The relationships these employees have are likely to be based on favors rather than explicit bribes. Hiring these connected people will open doors and prevent the developed market based companies from being shut out of deals or from being taken advantage of. A new story concerning JP Morgan in China highlights how this strategy is becoming a risk for the banks.

...with the U.S. Securities and Exchange Commission (SEC) investigating whether JPMorgan's Hong Kong office hired the children of China's state-owned company executives with the express purpose of winning underwriting business and other contracts...

The facts of the case aren't out yet. It might be the case that people within the relevant JP Morgan departments weren't careful enough to keep incriminating facts out of email and an angry employee became a whistleblower. But if the SEC is merely applying the same criteria to enforcing the FCPA as they do to insider trading (if the correlations look like insider trading they will go after you) companies will have a more difficult time working in emerging markets.

If developed market companies can expect a harder time competing in developing markets this is good news in the long run for developing market equities. Considering the underperformance of EM equities this year they need all of the help they can get.