Wednesday, November 30, 2011

My son, Conor, sent me this very interesting graphic he found on-line at

It shows an interesting correlation between Computing Power and Trading Volumes on the NYSE.

Perhaps just a co-incidence, but may not.  It makes sense to see that computers have given the Exchanges much more power to handle trades than when they were first organized to operate by people doing trades on paper.

Maybe, however, what we have now is too much of a good thing?

Tuesday, November 22, 2011

How Private is "Private Equity"?

Yesterday I was looking at the website of Insead ( where Cynthia Owens posted her article: "Private equity comes of age in China, India and Brazil".

Some colleagues and I are working on several projects that have connections into China, including one that is based in Brazil, so the article caught my eye.

One point I picked up on was this.  Private equity in China is very dependent on exchange listing (Initial Public Offerings) for investor exits.  India seems to be more of a Mergers & Acquisition play.  Brazil is more of a public markets play.

This got me thinking that "Private Equity" is really a misnomer.  These funds are really better described as "Pre-Public Equity".  It seems the US model is being copied internationally, with real access to capital being made available only to an Enterprise that commits to become funded through an Exchange (or to get sold out to another enterprise that is Exchange-traded).  The only real difference between public equity (i.e. exchange-traded financial instruments) and this kind of Private Equity, so-called, is timing.

The great strength of public equity, which is also it's greatest weakness, is it's laser-focus on a single point of value: the market clearing price.  This single-point-of-value dynamic is deceptively simple.  The truth is, the market clearing price is actually driven by a large number of converging dynamics, some of which are related, and others not.  Fundamentally, the price is determined by expectations for share price appreciation, which, in theory, are driven by supply-demand dynamics in the underlying commercial markets.  In practice, the layers don't line up so well.  And there is the added complication that the real, structural value of an exchange is to provide liquidity to investments that are not, of themselves, particularly liquid.  So, we have the core business of the exchange, which is arbitraging differences in the liquidity needs of different investors at different times, layered over the micro-economics of value creation inside the Enterprise, wrapped up inside the bubble-causing effects of macro-economic faith in historical trends as predictors of future value, all being spun around by the "herd mentality" of price point speculators, producing the herky-jerky up-and-downs, and booms-and-busts of the exchange-traded solution.

By comparison, rocket science is simple!

So-called Private Equity is not really an alternative to this.  It's more of a transition point into it.  Instead of guessing today what the market clearing price is likely to be tomorrow (the typical short-term event horizon of the average public equity stock portfolio manager) these Private Equity portfolio managers take what they like to call a long-term view: they look out 3-5, maybe 7 years, and guess what the market clearing price will become, out in the future, once a market is established for the stock.

That's not really private.  It's pre-public. And it's not really long-term.  It's more pre-term.  The fundamental structural problems remain, unchanged.

The Enterprise still cannot base decision-making on what is best for the business, in terms of profits, but also sustainability and what John Fullerton of the Capital Institute has nicely dubbed, "resiliency".  Enterprise still has to do what the Exchange demands.  Today.

Investors (not their professional management agents, but the actual, principal sources of capital available for deployment in expectation of earning returns by sharing in the value being created inside an enterprise) still find it next to impossible to achieve true programmatic alignment between investment goals (both financial and additional) and investment choices.  They still have to take what the Exchange gives them. At the moment.

Not much of an alternative, really.


I posted a comment on John Fullerton's blog at that got cited yesterday as Comment of the Week.  Pretty cool.

Wednesday, November 16, 2011

Inverted PIPESs

A PIPE is a private investment in a public entity.  It is a financing technique useful for bringing new equity capital into a public reporting company without increasing the number of shares floating around the stock market, at least not right away.  It's primary competitive advantage is that is allows some control over the potentially adverse impact of perceived dilution when new equity is brought into a company that is not immediately accretive to earnings, i.e. that will not produce incremental new profits right away.

I got to thinking about this, because I am aware of an Enterprise looking at putting together some mining interests in South America, with possible Investment out of China.  Doing a little background research on mining companies, lead me to the website of Barrick Gold, a company that promotes itself as the largest gold mining company in the world.  They are a US public reporting company so they are required to disclose considerable amounts of detail pertaining to their business, which is worldwide.

Searching through all this data hoping to get some insights into the mining business, generally, it struck me that very little data about their underlying businesses are actually reported to the public.  In truth, I see this company as more of a highly specialized investment management business, whose corporate activities really relate to its success at managing a portfolio of investments in Enterprises, some wholly owned, some apparently owned in partnership with others, that actually conduct mining operations.

They are a kind of inverted PIPE: a public investment in private entities.

I think many of our largest public reporting companies are properly described as "inverted PIPEs": more highly specialized investment funds, than businesses directly engaged in commercial enterprise.

Explains a lot.

Monday, November 14, 2011

"Playing with the House's Money"

As I sat thinking over morning coffee today, I puzzled over the curious experience I have, when talking with investors about an investment opportunity that pays returns from the cash flows generated by the Enterprise, how much trouble people seem to have with cash flow as a return strategy.

Consider this.  I have been aware for the last while of an Enterprise that for some very special reasons can sell large amounts of its product for long periods of time at market clearing prices that allow the Enterprise to earn really, really big profit margins.   I see this Enterprise as a "poster child" for the use of a partnership solution for its financing needs.  In part, because of its very robust cash flow waterfall; and in part because its capital needs are also extraordinarily small, relative to that waterfall.

To me, this would be a phenomenal opportunity for a return motivated investor to earn a simple return (payback of principal) on a very accelerated timetable, from shares of cash flows generated by the Enterprise, so that in a very short period of time, the investor would have really nothing invested in the deal, but would still be getting substantial cash distributions: they would be "playing with the House's money".

When I talk to people about this idea, they always ask: "but how will I get my money back?"  It doesn't seem to resonate that they get their money back first, in the form of early cash payouts, then start making money as they continue to receive additional cash payments from the Enterprise over time.

People seem to need some form of exit by sale.  Even when I show them, side by side, how a traditional exit-by-sale strategy returns them less money than this kind of partnership pay-out strategy, it doesn't seem to resonate.  They want the sale, even though it's worth less.  A lot less.


Wednesday, November 2, 2011

Banks vs. Institutions

Liquidity vs. Prosperity

Yesterday I was reading on article on Peter Victor, published over the Capital Institute blog (

Peter is an economist who thinks a lot about the challenges we are facing and will continue to face coming to grips with what he sees as our new reality of encountering the physical limits of the Earth's ecosystem.  Heady stuff!

Among his many insightful comments, Peter laments our perceived structural inability to make choices that are not driven by considerations of short term immediacy.

That set me to thinking.  I believe Peter is right in some respects, but also points the direction to places where we can make the important innovations we need to make to build and operate an economy that can deliver sustainable prosperity in a new reality that does not include open-ended possibilities for geopolitical expansion along a Western Frontier.

As Peter points out, the economy we currently live within is dominated by an intellectual ethos of Growth, but what underlies that ethos is our obsession with liquidity in the Capital Markets.

This is interesting, because many, if not most, of the actual capital providers to our Capital Markets are Financial Institutions that have a longer term view of their wealth building needs.  These include Pension Funds, Endowments and Life Insurance Companies.  All of these Institutions are mostly interested in making investments that will empower them to meet their wealth needs over the long term, out in some future point in time.  They tolerate liquidity -- and volatility -- because "that's how it's done", but do they really need it?

I would also suggest, although this I cannot prove, that most individual investors, both the wealthy and the not-so-wealthy, when they think of investing, are thinking of the future.  They want most of all to grow their wealth over time, so it will be there if and when they need it, down the road.

It's the banks -- both commercial and investment -- that value liquidity.  Why?  Because that's what they know how to do.

Commercial banks provide liquidity in the form of loans against assets and future earnings.

Investment banks provide liquidity in the form of trading in financial instruments.

Growth becomes important to investment banks, especially those making a market in corporate shares, because they depend on constantly accelerating growth in "shareholder value" to drive constantly accelerating increases in share price to constantly attract a growing number of new buyers to keep their markets liquid.

Of course "constantly accelerating growth" is the financial equivalent of a perpetual motion machine: nice, but not possible.

The result, as we all know too well, are massive disruptions of underlying economic processes that give us a prosperity of booms that always, eventually, go bust.

Interesting thing is, both the instruments that investment bankers trade and the customers they effect trades for actually share longer-dated realities.  Neither one of them really likes it when they get caught up in a boom that goes bust.

This raises the question: why are we doing this?  Why don't we just construct a Capital Market that is designed and operated to match longer-dated wealth-creating Enterprises with the longer-dated wealth-building event horizons of Investors, both individual and Institutional?

Food for thought.

Tuesday, November 1, 2011

Solyndra and Sustainability

There has been much noise in the media this last while over the dramatic collapse of solar technology innovator Solyndra, after receiving a very large - and spectacularly unsuccessful - US Government guaranteed loan financing.

Much energy seems to be getting spent looking for people to blame, and reasons to blame them.  This unproductive finger-pointing is keeping us from the more difficult, but important, work of understanding the fundamental design flaw in the government guarantee program as a tool for using taxpayer dollars to shape market choices.

It would have been better if the DOE spent those same dollars by taking up the role of customer in a project financing, buying power at prices sufficient to make the project viable, economically, and re-selling that power to the local load serving utility or other commercial customer at prices that come closer to a competitively determined market clearing price.   The Government would absorb the negative spread, in order to subsidize initial efforts to commercialize this new and needed technology solution.

This is effectively the Defense Department model, and it works quite well there.  The Government contracts with private enterprise to purchase the output of new and needed technology innovations, paying pretty much whatever it takes.  Stabilized by a reliable customer willing to buy volume at a price that works, the Enterprise can focus on building its knowledge base, its network of commercially important connections and its routines for delivering new and needed products to the market.

Some don't make it.  If the Military proves to be the only customer willing to pay the price, the Enterprise must either build its prosperity solely on making Military sales, or it must find something else useful to do.

Some do.  Stabilized by Military contracts, they perfect their ability to deliver products to the private sector on commercial terms.  Witness: the mircowave oven.

Another solution that works: targeted tax credits.

Tax credits are anathema in some circles.  I don't get it.  A properly constructed tax credit program is a proven, effective, "minimally invasive" technique for using taxpayer dollars to adjust market dynamics to align them more closely with the public good.

An effective tax credit program does have to be designed properly, but we have a proven design in the Low Income Housing Tax Credit.  This is a true federal-state, big-small, public-private partnership program that has effectively and efficiently delivered decent housing to decent Americans who just need a little extra help getting by. It has done this for more than 30 years.

There are Energy Tax Credit programs, but for some reason, the design of the Energy Credits does not build on the successes of the LIHTC design.

Why is that?