Augmenting the three day blitz on private equity regulation, liquidity and valuation, DealBook today points to an article on Investment Dealers' Digest that outlines the growth in the secondary market for private equity interests. Says IDD:
The secondary private equity market that is taking shape today is more than simply a larger version of that of five or 10 years ago. The business is in the midst of a sea change-and a shift in the balance of power between buyers and sellers. But despite increasing liquidity, the market remains extremely opaque. And for the most part, general partners prefer to keep it that way.
I think the development of a stronger secondary private market further deadens the liquidity concerns and the valuation issues I touched on yesterday. Obviously, a well developed secondary market provides liquidity, and gives more valuation data points. It probably does not do so in the early stages of new funds (as I doubt interests often come up for sale in those stages) so that problem remains thorny. That is, if you think it is a problem. Personally, I do not.
A brief review of the theory of the firm is perhaps in order. I've done it before, but a second pass is probably a good exercise to undertake.
The background that underlies corporate structure is specialization. Those with capital don't always possess management expertise. Those with management expertise don't always possess capital. This is a critical concept. Let me say this again in another way, because it really is critical. Just because you are rich, doesn't mean you are smart. In fact, there might be a negative correlation. (See e.g., Mark Cuban). Aside a few, exceptional, dynastic Italian families that bore exceptional eldest son after exceptional eldest son for five generations in a row, a lack of specialization locks a firm into (and therefore limits a firm to) the management abilities of the capital holder.
We solve this problem today via a corporate form that separates ownership from control. Generally, this is a "good thing." With a healthy market for corporate control and general liquidity of investment, capital holders have a wide variety of options in which to invest. Careful selection combined with some speculation should permit capital holders to avail themselves of the best managerial talent, and concentrate their efforts on whatever other thing it is that they do best. It is important to note that "whatever other thing it is that they do best" could easily be professional wine drinking, collecting expensive and beautiful silk panty garments, or simply the pursuit of plain 'ole debauchery. Their incompetence is no longer particularly relevant to the economy. We have removed it as a drag on assets. Their large gains on their investment, made possible by specialized and outsourced managerial talent, boost the local economy via their equally large expenditures on frivolous parties, lavish dinners, opulent estates, and etc. Of course, if they are actually good at something, their time is freed from managing their own investments and they can be productive at what they do best or most enjoy. (Hopefully this isn't buying and manging their own sports teams and in turn creating massive losses). Underestimating the impact of the introduction of these sorts of economies in the seventeenth and (more so) the late eighteenth century would be a serious error.
As a consequence of the separation, managerial talent can be "poor, smart and hungry" (thank you Gordon). They can, with no pedigree whatsoever, rise from the dust through pure merit to succeed. Their merit is measured simply: financial returns. Let me distinguish "financial returns" from "wealth." Wealth requires nothing more than birthright or the selection of a certain 6 random numbers on the right day to acquire. Accumulated wealth is the wrong (but increasingly common) measure of financial acumen. Occasionally, large windfalls (and I mean this in the truly random sense, not the recent, politically motivated oil profit redefinition) land in the laps of total idiots. What is important is what they do with it. What is important is their return on assets, not the size of the assets.
I strongly suggest those interested in these underpinnings do some research into the massive sociological and cultural changes that occurred during e.g., the transition between the Baroque and Enlightenment periods. It was the rise of individualism in the face of the centralized power of the state and the aristocracy that broke down the caste structures in a way that permitted a "mere merchant" to act as a King's agent, for instance. It is the kind of thing that permitted Armand Jean du Plessis, born only to lesser French nobility, to become "Cardinal Richelieu," the financial and political powerhouse behind Louis XIII's dynamic reign. Appreciating the unprecedented nature of this agency relationship is both important and difficult. Louis XIII effectively ceded all the financial decisions of the French Empire to Richelieu at a time when the centralized power of the monarch approached absolute. It was both a departure and counter to the social norms of the day.
A full understanding of these social changes and the rise of individualism in this context is essential, I believe, to grasping the importance of these concepts, and to understand where we might be stuck today without them. Without an understanding of this basic premise an understanding of the theory of the firm is incomplete. If you are a glutton for punishment you might even read Richard Evans' political biography of Caius Marius' whose reform of the Roman legions from a strictly caste based military system into a citizen army opened the way for Rome to meet the many military challenges that would follow.
There are, of course, complications related to the separation of ownership and control. Agency costs, as they are known, are perhaps the most thorny. Simply put, how can we be sure that the agent is acting for the principal, rather than in self-interest? The modern answer is that we impose some duties on the agent. The duty of care. The duty of loyalty. As a result the playing field looks like this:
Capital holders have a variety of fairly liquid options and a variety of illiquid options in which to invest. They go into these investments knowing that they are appointing agents to mind their capital and direct it. There should be no surprise to the holder of a public security that they do not have much power over the decisions to manage the firm. They can vote on a variety of corporate actions including the election of directors. Their vote is proportional to their holdings. Some votes are binding. Some are not. All of this is fairly carefully laid out in the by-laws and other charters of the corporation. It is not a mystery that compelling the management to change the color of the walls because you read a recent study that indicates off-pink increases productivity is not in the cards. This arrangement is what Justice Scalia is famous for calling "The Deal." The arrangement between holders of capital and management talent. Don't like "The Deal"? Don't buy the stock. Today, with the many information sources (like ISS and such) on corporate governance and control provisions there is no "ignorance" excuse left.
Enter the market for corporate control. Occasionally, we come across holders of significant capital who also possess superior management acumen. Today, through the market for corporate control, these capital holders can wrest from existing managers control of the corporation. This gets easier when management performs poorly and control (in the form of reduced stock price) gets easier to acquire. This is the check on management incompetence. Shareholders can vote with their feet, move their capital into another investment (creating a lower cost for the acquisition of corporate control by new managers- wonderful thing capitalism, yes?) or band together and oust the current leaders. Very democratic, really. Also remember, no one requires shareholders to invest in these public firms. So long as there is liquidity there are a wealth of other opportunities.
Now enter the complications and interference. There are a variety of modern constraints on the market for corporate control. Usually, calls for these constraints are shrouded in evil characterizations of the character of aspiring candidates for corporate control.
Then, there are daft holders of capital like, say, Mark Cuban, who seems to believe that if you permit management to run the company in which you hold shares you are, to put it a brand of eloquence unique to him, "a Corporate Ho." As Bonos go Cuban is on a roll. He's got his own radio program on satellite now. A bigger microphone to distribute his drivel on corporate America. I suppose there might be someone less qualified to criticize "windfall profits" but I'm not sure who it is. I guess I don't know why Cuban doesn't just mount some hostile takeovers if he is such an outstanding manager.
See, to Cuban your interest as a shareholder extends to a variety of things over and above providing capital for other managers and voting with your feet if your profits are low. Things like "corporate responsibility," a term which has a meaning that varies depending on what is convenient to the speaker, and denying your shares to other capital holders who want to short the company you are invested in. I constantly marvel at those who are all for free markets when they rise but whine about the inequity of short sellers when they fall. But then, these things are to be expected from people who don't understand corporate law or the separation of ownership and control or why it is a good thing. People who, in the manner of as many spoiled brats, want to buy shares under one set of assumptions but then change the underlying restrictions intrinsic to the corporate form once they own them. They want to be owners and managers, suddenly. Are they willing to forgo limited liability protection as well then, I wonder? If they want to be managers so bad why not spur a shareholder revolt, or sell their stake and found their own corporation. (Bet you my last dollar they will resort to the public equity markets to fund this corporation and then whine about shareholder activism too).
I speak of those who call for liquidity in private equity investments in the same breath. It was no secret that you were going to be subject to a lock-up period when you wrote the check. Why do you now want to change the rules? The "have your cake and eat it too" crowd seems to get louder (if not larger) every day. Leave the market for corporate control alone. Stop legislating takeovers.
As for secondary markets in buyout funds? Again, I persist in my view here, anything that shortens the investment horizon term is counter-productive to buyout endeavors. Want liquidity? You have many options. Just don't expect the same returns.