Chip Krakoff
submits:
Let me admit my bias right here: I don't "get" Twitter. This
isn't just because I'm too old. My teenage daughter, Isabel, tells
me she thinks it's pointless and that none of her friends use it. I
also don't see how Twitter will ever make money, though it's
certain that some of the best minds in Silicon Valley are already
working on that problem. But this article isn't about any of
that.
Echoing Goldman Sachs' (
GS
) investment in Facebook in January, which gave that company a
notional value of $50 billion (which has subsequently risen to $70
billion in the secondary market), it was announced that J.P.
Morgan's (
JPM
) Digital Growth Fund is in negotiations to buy a 10% stake in
Twitter for $450 million. The J.P. Morgan fund, which has raised
$1.22 billion of a planned $1.3 billion, also has its eyes on
potential investments in Skype, the telephony provider, and in
Zygna, a games maker. Any or all of these investments could lead a
few years hence either to outsize profits or to people scratching
their heads and muttering, "What were they thinking?"
None of this should normally be of any concern to anyone but the
shareholders and investors in the target companies and in the banks
and funds buying the shares, but there is something not quite
normal going on here. In both the Goldman/Facebook and the
anticipated J.P. Morgan/Twitter transactions, the purchased shares
will be made available only to a tiny handful of very wealthy
investors.
The J.P. Morgan fund, for example, will have a maximum of 480
investors, which works out to an average investment of $2.7 million
each. Although an initial public offering [IPO] for both companies
is planned, with Goldman Sachs and J.P. Morgan having the inside
track to manage the IPOs and reap the enormous advisory fees and
commissions, there is no certainty as to what percentage of these
companies will actually be floated, and what proportion will remain
in the hands of the banks and their wealthy fund investors. It is
possible - even probable - that a majority of the ownership of
these companies will remain vested with a very small group of
people. Though a secondary market will certainly develop to allow
these initial investors to dispose of their shares, it is also
likely that activity in this market will consist primarily of
private sales to other wealthy insiders.
Let's not be naïve; wealthy and well-connected investors have
always had access to investment opportunities the rest of us don't
even know about, and nothing will change that. But if Twitter and
Facebook-style investment arrangements become more widespread, it
could undermine American capitalism, which for the past hundred
years has been based on the modern public corporation in which no
individual or institution owns more than a few percentage points of
the whole.
It's common nowadays for institutional investors to own well
over 50% of big U.S. corporations, but even among these investors,
ownership is highly diversified. In very few Fortune 500 companies
does a single institution or family group own more than five per
cent of the outstanding shares or exercise control via a special
class of shares (Ford Motor Company, in which the Ford family owns
just 6% of the company but controls 40% of the voting shares is one
of a very few exceptions). Even Bill Gates owns only seven percent
of Microsoft. This model is now under threat.
As regular readers of this blog know, I am a capitalist.
Capitalism, especially when it is based on widespread ownership and
freely traded shares and debt instruments of large public
companies, is the best way mankind has yet found to allocate
capital to its most productive use. Anyone who doubts this can look
at the legion of countries in which some form of central planning -
Marxist, fascist, Peronist, or just plain old dictators and their
cronies - has prevailed.
Stock markets - though we now recognize that markets are not
perfectly efficient - have been a vital way for companies to raise
capital. The link between the stock market and the real economy, in
which companies and people produce and sell goods and services, has
traditionally been strong. This is vital, since financial markets
rest on an uneasy compromise: corporations and their financial
advisors can make as much money as they want as long as everyone
else has the opportunity to share in that wealth. The public shares
in the wealth in a variety of ways, the most important of which is
employment income and associated benefits. The public also shares
in the wealth by having the opportunity to invest its savings in
those same corporations. If this link is broken, public support for
capitalism will wane, and the United States could go the way of
Argentina.
Already, the signs are ominous. In 1961, individual investors
accounted for 62% of the total value traded on the NYSE (
NYX
). By 2009, this had fallen to two per cent. Block trades of 10,000
or more shares in a single transaction accounted for only three per
cent of the NYSE trading volume in 1961; today they account for
around 25% of total U.S. market volume. By itself, this evolution
is hardly worrisome; much of it can be attributed to the rise of
mutual funds and similar vehicles which have become the preferred
investments of many individual investors and which can offer better
risk-adjusted returns than those less sophisticated investors could
produce on their own. But accompanying this trend is the rise of
high frequency trading, which now accounts for over 70% of all U.S.
equity trades.
High frequency trading, based on sophisticated computer
algorithms, involves holding large positions for a very short time
- often fractions of a second - to generate huge returns. The
practitioners argue that they provide liquidity and reduce bid-ask
price spreads, which may be true, but the banks and hedge funds
employing such strategies are playing with their own capital and
that of wealthy investors. Your average individual investor, who
may have a portfolio of a couple hundred thousand dollars or less,
does not play in this sandbox.
The stock market, which has forever been likened to a casino,
has truly come to resemble one, and I am not referring to the
two-dollar blackjack tables in Reno. It has become much more like
the exclusive, velvet-roped areas where the likes of James Bond and
Asian billionaires play baccarat or high stakes poker for millions
of dollars.
Felix Salmon, the Reuters financial blogger, writes in an
excellent op-ed piece in the
New York Times
,
The stock market is becoming increasingly irrelevant - a trend
that threatens the core principles of American capitalism.
These days a healthy stock market doesn't mean a healthy
economy, as a glance at the high unemployment rate or the low
labor-market participation rate will show… What's good for Wall
Street isn't necessarily good for Main Street… the glory days
of publicly traded companies dominating the American business
landscape may be over. The number of companies listed on the
major domestic exchanges peaked in 1997 at more than 7,000, and
it has been falling ever since. It's now down to about 4,000
companies, and given its steep downward trend will surely
continue to shrink… Put another way, as the number of initial
public offerings steadily declines, the stock market is
becoming little more than a place for speculators and
algorithms to compete over who can trade his way to the most
money.
Even the NYSE, the one-time flagship of the American capitalist
system, is becoming marginalized, as its recent acquisition by
Deutsche Börse indicates. According to John Gapper of the
Financial Times
, in 2005 79 per cent of the volume in NYSE-listed shares was
traded on the exchange itself. By March 2010, that figure had
fallen to 23 per cent. Gapper writes:
The NYSE has been squeezed out not only by upstart exchanges
such as BATS (an electronic trading platform, established in
2005, which now ranks as the third-largest exchange in the United
States) but by 'dark pools' - private exchanges on which
institutions trade with each other in large blocks - and by banks
making transactions internally. The two now account for about a
third of US equity trading.
As long as individual investors can invest in the markets and
feel that everyone, big or small, is playing by more or less the
same rules and that the markets are essential to the income and
jobs on which we depend, capitalism will thrive. When that
connection is broken, and people come to believe that capitalism is
a game rigged in favor of a small elite, it won't. The alternatives
to capitalism, for the most part, are too awful to contemplate, so
the markets have to be reformed - soon - for the system to
survive.
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours.
See also
Autos, Retail and Manufacturing on Tuesday's
Economic Calendar
on seekingalpha.com