12 April —  Over the New Year’s weekend this year is was announced that Facebook has raised $500 million from Goldman Sachs and DST (the Russian investment fund) — with more investment coming — in a deal that valued the company at $50 billion.  The deal maked Facebook now worth more than companies like e-Bay, Yahoo and Times Warner.  For the story from the New York Times’ Dealbook click here. 

More interesting was the news that Goldman created a “special purpose vehicle” to allow its high-net worth clients to invest in Facebook.  As the Dealbook post states “While the S.E.C. requires companies with more than 499 investors to disclose their financial results to the public, Goldman’s proposed special purpose vehicle may be able get around such a rule because it would be managed by Goldman and considered just one investor, even though it could conceivably be pooling investments from thousands of clients.  It is unclear whether the S.E.C. will look favorably upon the arrangement.” Goldman later limited the offering to non-U.S. investors but the S.E.C. is still investigating the transaction.

For Goldman it was a win/win/win because it will start earning a return on its investment long before it sells its stake: (1) its first source of  income was the millions of dollars in fees it charged Facebook and the wealthy private clients who wanted to participate in a $1.5bn fund; (2) it can charge fees to manage the fund; and (3) it could make tens of millions of dollars if it is chosen to underwrite Facebook’s initial public offering, which could come next year.   The IPO is not a slam dunk and the myriad law suits over Facebook’s origins has escalated  (click here) which could hold up an IPO.  And Goldman’s arrangement of the private investment is not a guarantee of an IPO mandate and rival Wall Street firms will mount a campaign to land the IPO deal.

So more light on the thriving secondary market for shares in private Internet companies … and the S.E.C. investigation of that market.  Disclosure:  I bought Facebook shares in that secondary market.

The market for private company stock has been growing at a rapid pace in recent years, thanks in large part to the vast appetite for shares in technology companies such as Facebook, Twitter and Zynga.  Given the deep pockets of private money to be tapped while private companies’ revenue models continue to evolve, investors looking for growth potential in technology businesses can bet more than in the public markets.   But it also highlights three points made by all sides in the debate to explain this surge:  (1) the U.S. markets for many years were the largest and most liquid but are now in decline. The number of IPOs had dropped since the 1990s; (2) the number of shares traded on U.S. exchanges peaked in 1997; and (3) fast growing companies now seem to try and delay an IPO as long as possible.  To get a feel for the details and nuances behind these arguments read the exchange between Representative Darrel Issa, Chairman of the House Committee on Oversight and Government Reform, and S.E.C. Chairman Mary Shapiro.  You can access two summaries here and here.

The rapid growth of this market (and its somewhat opaque nature) has understandable drawn the scrutiny of the S.E.C. which launched a preliminary investigation into the secondary market for private company stock (a series of letters went out to various market participants inquiring about “pre-IPO pooled investment funds”).   According to a variety of media reports, the focus of the SEC investigation is two pronged:  (1) how these private companies are valued, and thus how shares are priced, and (2) are these attempts to skirt the public disclosure rules. 

Existing SEC rules mandate that buyers and sellers of equities have equal access to information about a traded security. But because the buyers of private company stock rarely have access to a company’s books, there is inherent information asymmetry between investors eager to get a piece of a pre-IPO company, and the companies themselves. 

Clearly there is going to be a disconnect between what is going on in the secondary market and what’s going on with the company.  I doubt these transactions are a good representation of the value of a company’s stock.  But it is a great way to participate on the upside if you can afford the bet.  And it is a bet.  In the case of Facebook, does the Goldman Sachs deal “validate” an upcoming IPO?  This disconnect certainly has not stopped the market for private company stock from growing.   Nyppex, an investment group, estimates $2.4bn worth of private stock traded hands last year in the US, and says that figure could grow by 50 per cent this year.   And there are now scores of boutique analysts producing reports on the companies that are most actively privately traded for investors and participants in the private market.  Note:  in most cases, when investors are seriously interested in buying shares, they sign a non-disclosure agreement and are then privy to material non-public information about the company. 

But more intriguing, a new company has won SEC approval to serve as an online exchange for shares in private companies such as Facebook.  Xpert Financial will be the first electronic exchange with formal approval from the SEC to deal in private company stock.  It will allow companies to make primary offerings of stock to new investors, and facilitate secondary market transactions.  Analysts say that by offering equity to investors directly through an electronic exchange, private companies will be able to bypass traditional venture capital financing.  By automating trades on the secondary market, the company could bring order to what has been a disorganized and loosely regulated market.

It’s still a question whether all this new money will pressure Facebook to go public (hotly discussed in the securities blogs).  Many pundits note that the popularity of shares of Microsoft and Google in the private market ultimately pressured them to pursue initial public offerings.   At LeWeb2010 last year (click here) many suggested (despite Zuckerberg’s protestations to the contrary) that Facebook’s board has positioned a public offering in 2012.  Given the new developments in the “Facebook origin” litigations, we’ll see. 

As a result, Facebook has been able to bring in important strategic allies, including Goldman, Microsoft and Russian internet investor DST, while fuelling its rapid expansion (more firepower to steal away valuable employees, develop new products and possibly pursue acquisitions,  providing an outlet for early investors and employees who want to cash in some of the paper profits on their shares) without being a publicly traded company.  For the S.E.C. the question is whether this new money — without being a publicly traded company — is all within the rules.

But the private money is expected to flow.   Twitter was being valued at $4.1bn by a new investment fund set up by Felix Investments.   The investment firm has formed a group called Pipio Associates specifically to invest in the micro-blogging site (it’s a  Series C round).   The move comes less than a month after Twitter raised $200m in a round led by Kleiner Perkins Caufield & Byers.  That funding round valued the site at $3.7bn and was the largest investment round in the tech sector in 2010.  Groupon recently closed a financing which included T Rowe Price and Fidelity, $500m of an expected $950m.

But be wary of the numbers being bandied about.  While it appears that Facebook and Twitter are increasingly encroaching on Google, $2bn will not go very far.  Google was prepared to spend as much as $6bn to acquire Groupon, and Facebook can’t compete in that sort of a bidding war without the massive capital provided by an IPO.  Even if Facebook’s shares are worth an extraordinary amount to a limited number of private holders, it will not be easy to use them as currency in a takeover.  This is not an everyday liquid market and an agreed upon valuation for the company.  An IPO must come, if only for the investors.  And Zuckerberg knows that.  If he doesn’t, I am sure his investors will remind him.

1 February 2011 – Every year, courtesy of my accountants (and client) Deloitte Touche I receive a one-day pass to attend Davos.   I pay my own travel/lodging and for my security pass but entrance fees and “imbibements” are covered my dear, dear .. did I mention wonderful? … friends at Deloitte.   I do not go every year (it always hits right before LegalTech in New York which is a legal technology event I try to attend).  But this year I attended because there was particular focus on one area I follow very closely:  data, the new asset class.

Ah, such a wonder.  Globalization’s elite converging in the Swiss mountain resort of Davos.  And a much cheerier bunch than a year ago.  As my hosts proclaimed, 48% of the CEOs they polled were “very confident” of growth in the next 12 months, up from 31% a year ago.  “CEOs have emerged from the bunker mentality of surviving the recession”.  They determined to take advantage of better global economic conditions and increased customer demands.”

I attended one of the “overview” sessions … every year has a theme and this year’s theme was the “new reality” as the world’s economies rebuild in the wake of the global financial crisis … on the world economy.  But my focus was on the data sessions (I did catch a glimpse of Sergey Brin but missed his panel).  The points of these sessions were this:

We are moving/having moved towards a “Web of the world” in which mobile communications, social technologies and sensors are connecting people, the Internet and the physical world into one interconnected network.  Data records are collected on who we are, who we know, where we are, where we have been and where we plan to go.  Mining and analysing this data give us the ability to understand and even predict where humans focus their attention opportunity will resemble a living entity and will require new ways of adapting and responding.  This personal data – digital data created by and about people – is generating a new wave of opportunity for economic and societal value creation. The types, quantity and value of personal data being collected are vast: our profiles and demographic data from bank accounts to medical records to employment data. Our Web searches and sites visited, including our likes and dislikes and purchase histories. Our tweets, texts, emails, phone calls, photos and videos as well as the coordinates of our real-world locations. The list continues to grow.

All manner of firms collect and use this data to support individualized service-delivery business models that can be monetized.  Governments employ personal data to provide critical public services more efficiently and effectively.  Researchers accelerate the development of new drugs and treatment protocols. End users benefit from free, personalized consumer experiences such as Internet search, social networking or buying recommendations.

And that is just the beginning.  Increasing the control that individuals have over the manner in which their personal data is collected, managed and shared will spur a host of new services and applications.   As some described it at Davos, personal data will be the new “oil” – a valuable resource of the 21st century.  Personal data is the new oil of the Internet and the new currency of the digital world.  It will emerge as a new asset class touching all aspects of society.

At its core, personal data represents a post-industrial opportunity. It has unprecedented complexity, velocity and global reach. Utilising a ubiquitous communications infrastructure, the personal data opportunity will emerge in a world where nearly everyone and everything are connected in real time. That will require a highly reliable, secure and available infrastructure at its core and robust innovation at the edge.  Stakeholders will need to embrace the uncertainty, ambiguity and risk of an emerging ecosystem. 

As personal data increasingly becomes a critical source of innovation and value, business boundaries are being redrawn.  Profit pools, too, are shifting towards companies that automate and mine the vast amounts of data we continue to generate.   Far from certain, however, is how much value will ultimately be created, and who will gain from it.  The underlying regulatory, business and technological issues are highly complex, interdependent and ever changing.

The rapid rate of technological change and commercialization in using personal data is undermining end user confidence and trust.  Tensions are rising. Concerns about the misuse of personal data continue to grow.  Also mounting is a general public unease about what “they” know about us.  Fundamental questions about privacy, property, global governance, human rights – essentially around who should benefit from the products and services built upon personal data – are major uncertainties shaping the opportunity.

Yes, a tremendous amount of issues and information covered.  I was able to cram in 4 sessions in all.  Let me end with some interesting graphics presented at several sessions, and a quick word on “Blue Button:

Much has been written about health records and data privacy, one of the key concerns.  At Davos I learned about the U.S. Department of Health & Human Services “Blue Button” initiative for how to handle such personal data and I was very much impressed.

It’s a Web-based feature that allows patients easily to down load all their historical health information from one secure location and then share it with healthcare providers, caregivers and others they trust – something that wasn’t possible before.
 
The service is innovative in many ways.  First, it allows Medicare beneficiaries to access their medical histories from various databases and compile sources into one place (e.g., test results, emergency contact
information, family health history, military health history and other health-related information).

Second, the service provides the information in a very convenient and transportable format (ASCII text file). That allows it to be shared seamlessly with virtually any healthcare or insurance provider.

Finally, Blue Button fully empowers the end user: patients are given control over how their information is shared and distributed.  That allows them to be more proactive about – and have more insight into the medical treatments that they need.

12 September 2010 – For the curious but uninitiated, we thought this very brief primer prepared by our colleagues at the Financial Times would help you understand bank capital, Basel III and all that.

What is bank capital?   It is the funds – traditionally a mix of equity and debt – that banks have to hold in reserve to support their business. Bank capital has been in the spotlight since the financial crisis began.

How is it measured?  The two capital ratios that banks routinely cite are the tier one capital ratio and a subset of that – the core tier one capital ratio, also called the equity tier one ratio. Tier one is essentially top-notch capital, with core tier one a subset comprising the best of the best. There is also tier two capital, consisting largely of subordinated debt, but that is gradually becoming irrelevant for regulatory purposes.

The Basel Committee on Banking Supervision, whose Basel III rules form the basis for global bank regulation, is focused on the core tier one ratio, which, like the Americans, it refers to as the equity tier one ratio. It essentially will consist of only equity and retained profits.

How are the ratios calculated?  A bank’s capital is measured against its risk-weighted assets – essentially a bank’s total assets recalculated to a smaller number to reflect the relatively low-risk nature of some. The average bank today probably has a core tier one ratio of about 7 or 8 per cent, compared with a regulatory minimum of 2 per cent, and a tier one ratio of 9 or 10 per cent, compared with a 4 per cent minimum.

So the new requirement for a 7 per cent core tier one ratio will be a breeze for most banks?  Well, it certainly won’t be as much of a stretch as many banks originally feared. But for banks that are only marginally above it, or expect to be by the end of 2018 when the phase-in period ends, there could be issues. That is because both elements of the ratio are being toughened – what qualifies as core tier one capital is being narrowed to exclude lower-quality instruments. Previously accepted forms of top-notch capital, such as deferred tax assets, are being phased out. The weightings applied to banks’ assets will rise in many cases, amplifying the ratio’s denominator.

This is all a result of the financial crisis, right?  Right. In the financial crisis many highly geared banks with a lot of non-equity (such as hybrid debt) in their capital structures were left looking very weak because losses burnt through their relatively thin equity cushions quickly.

For that reason, investors have increasingly been interested in how strong banks’ core tier one ratios are. To an extent, regulators are just catching up with the market.

Copyright The Financial Times Limited 2010

23 May 2010 — According to the economist Friedrich von Hayek, the development of welfare socialism after the Second World War undermined freedom and would lead Western democracies inexorably to some form of state-run serfdom.

Hayek had the sign and the destination right, but was wrong about the mechanism. Unregulated finance, the ideology of unfettered free markets, and state capture by corporate interests are what ended up undermining democracy both in North America and in Europe. All industrialised countries are at risk, but it’s the eurozone – with its vulnerable structures – that points most clearly to our potentially unpleasant collective futures.

As a result of the continuing euro crisis, the European Central Bank (ECB) now finds itself buying up the debt of all the weaker eurozone governments, making it the – perhaps unwittingly – feudal boss of Europe. In the coming years, the ECB and the European Union will dictate policy. The policy elite who run these structures – along with their allies in the private sector – are your new overlords.

It is arguable who exactly are the peasants, the vassals and the lords under this model – and what services will end up being exchanged, but there is no question we are seeing a sea change in the post-war system of property, power and prosperity across Western Europe, just as Hayek feared. An overwhelming debt burden will bring down even the proudest people.

The ECB-EU approach will not return countries to reasonable levels of growth – the debt overhang is simply too large. The southern and western periphery of the eurozone cannot grow out of their debts under these arrangements and so will stumble from stabilisation programme to stabilisation programme – as did Latin America in the 1980s. This is bound to lead to hostile politics, social unrest and more economic crises.

The International Monetary Fund will do just what the EU and ECB asks to keep the charade in place. The old days when all member countries got presents from the eurozone are long gone; now it is all instructions and austere requirements. But enough resources will be provided to keep everything rolling over.

The top three French musketeers – President Nicolas Sarkozy, Jean-Claude Trichet (ECB), and Dominique Strauss-Kahn (IMF) – presumably they think they will end up running things. More surprising is the reaction of other European leaders, who genuinely seem convinced that what they are doing makes sense – as opposed to being a series of crazed improvisations.

The market is telling them otherwise, and the market is probably right. Faced with the ugly reality of the loss of confidence in European finance and institutions, the Germans and even the normally sensible Swedish government are increasingly blaming “irrational” markets and speculators for homegrown problems.

The messy solution of the EU leaves the world at risk of the type of shocks we observed last week. This particular iteration may blow over, but another will arise when there is backlash in Athens, Dublin, Lisbon, or – heaven forbid – Madrid.

Meanwhile, rational market participants are selling debt of risky nations, and getting out of the euro. The whole fiasco is now leading to a shift away from risky assets all around the world, and the worldwide cost of such volatility is not small. Debt peonage looms for a range of countries that were recently thought immune to serious fiscal crisis, including the United States and UK.

It is inappropriate for the Europeans to subject the rest of the world to these large, chronic risks. Europe should recognize that insolvencies never end well. The crisis in Britain in the 1970s is the model for what can go wrong : ongoing strikes, populations disenchanted with authority and great economic disruption. When the assets are cheap, deep-pocketed investors from the US, China, India and, of course, Russia will swoop in for the crown jewels.

For more from Peter Boone at the London School of Economics and Simon Johnson at MIT Sloan click here.

08 May 2010  — Tony Barber is one of my favorite FT columnists. Here is a great column titled “Ignorant elites fume at markets”:  

17 September 2009 — Here is a very interesting analysis of modern macroeconomics.

Some fires are best left to burn out

William White   Financial Times OpEd    17 September 2009

Copyright The Financial Times Limited 2009

Forest fires are judged to be nasty, especially when one’s own house or life is threatened, or when grave harm is being done to tourist attractions. The popular conviction that fires are an unqualified evil reached its zenith after a third of Yellowstone Park in the US was destroyed by fire in 1988. Nevertheless, conventional wisdom among forest managers remains that it is best to let natural forest fires burn themselves out, unless particularly dangerous conditions apply. Burning appears to be part of a natural process of forest rejuvenation. Moreover, intermittent fires burn away the undergrowth that might accumulate and make any eventual fire uncontrollable.

Perhaps modern macroeconomists could learn from the forest managers. For decades, successive economic downturns and even threats of downturns (“pre-emptive easing”) have been met with massive monetary and often fiscal stimuli. This was the case when the global stock market crashed in 1987, and it was repeated when the property boom in many countries collapsed in the early 1990s. Interest rate rises were put on hold during the Asian crisis of 1997, even though traditional indicators said some industrial countries were overheating. Rates were then sharply reduced in 1998, after the collapse of the hedge fund Long-Term Capital Management, and were lowered again when the stock market collapsed in 2001. Today, policy rates in most industrial countries are close to zero, in response to the financial crisis.

What needs reflection, against this backdrop, is whether the policy re-action to each successive set of difficulties laid the foundations for the next one. Worse, the encouragement by lower interest rates of debt accumulation and spending imbalances was the equivalent of allowing undergrowth to accumulate in a forest. This undergrowth not only made subsequent downturns more dangerous; it also made the available policy instruments less reliable in response. Looking back over successive cycles, interest rates have had to be reduced with ever more vigour to get the same (and sometimes reduced) response from spending. Most recently, new and untried policies such as quantitative and credit easing have had to be introduced. Logically, the end point of such a dynamic process would seem to be the mother of all fires and few if any means of resistance.

The current Keynesian mindset rightly observes that we have a shortage of aggregate demand. It then concludes that demand stimulus, from whatever quarter, is to be welcomed. However, in addition to the undergrowth problem on the demand side, we can also have an undergrowth problem on the supply side. This was the core of Friedrich Hayek’s position when he debated Keynes in the early 1930s. In response to demand stimulus over recent decades, with investors implicitly assuming that the future would be like the recent past, there has been a massive increase in supply potential in many industries. The upshot is that many of them are now too big and must be wound down. This applies to automobile production, banking services, construction, many parts of the transport and wholesale distribution industries, and often retail distribution as well. Similarly, many countries that relied heavily on exports as a growth strategy are now geared up to provide goods and services to heavily indebted countries that no longer have the will or the means to buy them.

In this supply side context, policies such as “cash for clunkers” and value added tax cuts in countries with very low household saving rates and massive trade deficits are clearly sub-optimal. So too, in countries with large trade surpluses, is resistance to exchange rate appreciation along with a continuing reliance on export demand. Such policies are equivalent to trying to resuscitate a patient long since dead. Not only will time prove that such attempts are futile, but they also impede the desirable adjustment from declining industries to those that should be expanding. In effect, relying solely on macroeconomic stimulus may well head off a more violent downturn, but only at the expense of a more protracted recession. Maybe this is the principal lesson to be drawn from Japan’s almost two decades of sub-par performance. Indeed, resisting structural adjustment could also imply a decline in the level of “potential growth” in the years ahead. This would bring with it the threat of a stagflationary outcome, if the demand stimulus from Keynesian policies were not to be adjusted downwards in consequence.

Where to go from here? In terms of future crisis management, governments should give more weight to the longer-term implications of their policies. Those that threaten to make future crises more costly, or that impede required structural adjustments, should be moderated. Such inter-temporal trade-offs imply, from time to time, accepting a temporary economic downturn to avoid even bigger future costs. In this sense, good crisis management also contributes to crisis prevention.

But still more might be done with crisis prevention. Just as good forest management implies cutting away underbrush and selective tree-felling, we need to resist the -credit-driven expansions that fuel asset bubbles and unsustainable spending patterns. Recent reports from a number of jurisdictions with well-developed financial markets seem to agree that regulatory instruments play an important role in leaning against such phenomena. What is less clear is that central bankers recognise that they might have an even more important role to play. In light of the recent surge in asset prices worldwide, this issue needs urgent attention. Yet another boom-bust cycle could have negative implications, social and political, stretching beyond the sphere of economics.

The writer is former economic adviser, head of the monetary and economic department at the Bank for International Settlements