Wednesday, March 21, 2012

Size Matters

Don't believe the lies women tell you, boy, you need this
“It’s not the meat, it’s the motion.”

— Possibly apocryphal motto ascribed to certain Ivy League Lightweight Rowing Programs1

Felix Salmon and Pascal-Emmanuel Gobry have commenced an interesting tennis match with dueling blog posts recently. At stake is what is allegedly wrong with the market for initial public offerings in this country and what should be done to fix it. Apparently the whole brouhaha was triggered by some ludicrously-entitled piece of bipartisan bullshit evacuated by Congress known as the JOBS Act, the fundamental purpose of which seems to be to lower the barriers for smaller companies to access capital in the financial markets. Felix offered up the opening serve, Pascal returned serve here, and Felix has pelted the ball back over the net this evening.

Now I—as a mercenary intermediary in the capital markets whose livelihood and enjoyment of exotic delights unknown to ordinary humans depends in part on the introduction of persons in need of filthy lucre to those in uneasy possession of too much of the same—clearly have a dog in this fight. Interestingly enough, however, I freely admit that I couldn’t give a rat’s ass whether this piece of campaign-finance-inspired legislative pandering passes or not. Number one, it won’t affect my business in the least, and number two, it won’t really make a damn bit of difference to increasing the availability of financing for businesses which can contribute meaningfully to the economic growth of this economy. I mean, if you want to pretend that Kickstarter—that crowdsourced cesspit of Mickey-Rooney-like “Hey, fellows, let’s put on a show!” garage band nonsense—can make a material difference to the unemployment figures or economic growth trajectory of a thirteen trillion dollar domestic economy, be my guest. And after you’re through playing with yourself, I have an attractive bridge of historical significance to sell you.

Having witnessed the evolution of the equity capital markets over a two-decade period (longer than the conscious lifespan of most of the callow strivers populating the crowdsourced finance ecosystem), I do have a perspective and opinion which some might find illuminating. It boils down to this: neither Felix nor Pascal addresses the root source of the current dilemma. Public financial markets—and the institutional investors who dominate them2—have become too large to be an effective source of late-stage growth equity capital for most companies. The “round lot” (sorry, minimum size) for an effective IPO nowadays is at least $75 million dollars. But very few fast-growing companies ever need that much money to grow their business. Let’s face it: most startup companies with indisputably fabulous business models have no opportunity or intention of becoming the colossal world-beaters which Pascal identifies in his post. Furthermore, few insiders (management and original equity backers, whether VCs or otherwise) want to sell all of their holdings in these companies on an IPO, even if the underwriters allow them. After all, they usually believe in the story, and they want to continue their ride on the rocket ship. If the company doesn’t have a good use for the money, and pre-IPO shareholders don’t want to sell any meaningful portion of their stake, where the hell are the shares for the IPO going to come from? Exactly: they’re not.

* * *

Part of the problem lies with the current structure of the investment banking industry. Too many potential underwriters are just too large to consider run-of-the-mill, pissant IPOs to be worth their time and attention. To paraphrase 1980s supermodel Linda Evangelista, bulge bracket banks like Goldman Sachs, JP Morgan, and Bank of America Merrill Lynch just won’t get out of bed in the morning for less than a $300 million offering. They can’t even pay their defense counsels’ retainers with the commissions earned from such business. And for various reasons, smaller investment banks which could make a decent living off such fare are relatively few and far between.

But the real problem lies with the primary audience for IPOs, institutional equity investors themselves. Over the past few decades, the public equity markets have evolved from a relatively staid and selective backwater, a playground for pension funds, insurance companies, and the idiot sons of wealthy men, into a gigantic global pool of capital, driven and supported by huge amounts of money from literally everybody. Equity markets have become tremendously democratized, both directly with the individual participation of non-wealthy punters and indirectly with the huge reallocation of pension fund and pooled institutional capital into publicly traded stocks. I will leave it to an enterprising PhD student to research the data, but I suspect the aggregate amount of equity market capitalization as a percentage of GDP has swelled tremendously over the past three decades. Equities have gone mainstream, and as they did, the size of equity markets ballooned.

As they have done, the minimum size investment which your average institutional investor in public equities can entertain has ballooned, too. I remember a senior equity capital markets banker (IPO shill, to you) telling me a story years ago about how a friend of his had joined one of these institutional behemoths as a portfolio manager at the same time he joined the sell side. His friend explained that when he started managing equities in the 1980s, he had a total portfolio of around $100 million dollars. To devote sufficient time and attention to each of his positions, this PM limited his portfolio to no more than 100 individual companies (which, frankly, was pretty energetic and ambitious). By the 1990s, good luck, skill, and a rising tide had swollen his portfolio to $10 billion in size, but he still adhered to his limit of no more than 100 portfolio company investments. In other words, his average investment in an individual company’s shares had grown from $1 million to $100 million. Each. And he was neither unusually successful nor particularly large.

You can quickly see, Dear Readers, that such a portfolio manager must think long and hard whether he wants to spend the time and energy investing in, following, and adding to a position in a company in which he will be limited to no more than a 10% portion of the initial public offering.3 Especially if his initial investment in a $75 or $100 million IPO is 10% or less of his ideal average size portfolio holding. This also explains, indirectly, why investment banks have grown to a size where it is not economically efficient or profitable for them to underwrite IPOs of less than $75 million in size: as middlemen, we have followed the money, and our buy side clients, after bigger game.

* * *

Now whether this so-called JOBS Act is a sensible alternative to the current jury rigged system of angel investors, venture capitalists, and private investors in late stage growth equity capital which has grown up to fill this widening structural gap in the capital markets is above my pay grade. As I said above, I suspect it will have very little effect on mainstream, Wall Street underwritten IPO business at all. But I must agree with Matt Levine of Dealbreaker when he observes that

either the SEC registration process is necessary to protect investors, in which case it’s especially necessary for smaller newer companies, or it’s not, in which case it’s no more necessary for large companies than for small ones.

It is a little disconcerting to me that bipartisan knuckleheads in Congress seem intent on reducing regulation, protection, and oversight in retail finance at the same time they are putting other parts of my industry into testicle clamps. But I suppose political campaigns just don’t pay for themselves.

In any event, you may rest assured that one perennial truth about entrepreneurial business funding markets will never change, no matter what changes to the legislative and regulatory environment may occur:

The retail investor will always get screwed.

1 Quibble, cavil, and plead all you want, Gentlemen, I am here to tell you—after decades of personal experience—that size does indeed matter. Any woman who tells you otherwise is protecting your feelings. And probably looking for her next boyfriend/husband, besides.
2 Yes, yes, retail investors make up a portion of the public equity markets too. But hear this: no-one in my business ever asks the opinion of Aunt Millie or Uncle Joe about the proper price of an initial public offering. No underwriter in my industry, now or ever, has relied upon the retail demand of a bunch of ignorant, emotion-addled, staggeringly poor (relatively) individual investors to drive the size, pricing, and ultimate success of an IPO in the US markets. At best, retail investors are fleas on the asses of lumbering institutional investors like Fidelity, Vanguard, and myriad public pension funds which put in orders for hundreds of millions of dollars of stock. At best, retail investors comprise 15 to 20 % of the total demand of an IPO. Frankly, my dears, you could all simultaneously get hit by buses crossing the street the day before the offering, and it wouldn’t make a damn bit of difference to us or the issuer. Sorry to break it to you like this, but when it comes to initial public offerings, retail investors are irrelevant.
3 IPO underwriters like to limit “anchor” or lead investors to no more than 10% of the initial offering size. The hope is that they will want to add to their position in aftermarket trading, thereby providing ongoing buy-side support to the shares. IPO offering books are usually anchored by no more than 3 to 5 such 10% holders.

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