Monthly Archives: December 2011
I’ve just updated Current Market Tactics
I’ve just updated Current Market Tactics. If you’re on the blog you can click the tab at the top of the page.
raising capital… (III): crowd funding
Wikipedia has a good rundown of the history of crowd funding.
what it is
Crowd funding, in the sense I think Washington is talking about it, has several elements. It intends to raise large amounts of money by:
1. obtaining small amounts of money
2. from large numbers of people
3. using the internet as a device for information, solicitation, and payment, and
4. giving an equity or creditor interest in a company or project in return for money received.
There’s also a sense in the name of counterculture and of a group of like-minded people banding together to get a common project accomplished.
examples
Fundraising by any non-profit cultural or religious organization fulfills criteria 1 through 3. So, too, does President Obama’s fundraising during his first election campaign.
The Green Bay Packers’ recent $63 million stock offering fits the crowd raising bill pretty well, although as I understand it you had to stand in line at Lambeau Field to buy a share for $250.
The Wikipedia article referenced above contains accounts of a number of fundraisings by bands or movie makers.
plusses
Crowd funding is very cheap., especially compared with investment banking fees in the US.
Management doesn’t lose control of the company/project, as it would in venture capital funding.
In an IPO, shares end up in the hands of the favored clients of the investment banking syndicate. The issuer may prefer that the shares be sold instead to people who are committed to the products/services of the company or to its corporate culture. This may only be a philosophical preference, or it may be the belief (well-founded, in my experience) that individual shareholders will become dedicated customers and will strongly support management in any corporate votes.
The company may be able to get a higher price for stock by avoiding the conflict of interest an investment banker has between the company (which wants a high price) and its brokerage clients (who want a low one).
There’ll be less obligatory disclosure of corporate strategy and of financial condition–meaning both less corporate expense and less leakage of information the company considers proprietary.
minuses
from the issuer’s point of view
1. SEC regulations limit the amount of money a company can raise, its asset size and the number of shareholders it can have, without complying with the agency’s reporting requirements. These rules were created after the stock market collapse of the late 1920s and are intended to protect investors from fraud.
There are also a multitude of state laws to comply with. Some deal with the dissemination of information across state lines, so they’re a particular concern for any firm wanting to use the internet as its distribution channel (meaning everyone).
2. Without a clear commitment to an IPO, a company may not be able to recruit the most talented staff. This may change, however, if the crowd funding route shows itself to be equally lucrative.
for investors
1. It’s not clear how investors will get reliable information about a company both before they invest and while they are shareholders. Companies having an IPO create a registration statement/prospectus that must contain all material information about the firm. The underwriting syndicate has (more or less) professional securities analysts who prepare periodic reports on the firm that they distribute to clients.
Private deals, on the other hand, typically have a large “trust me” element to them, at least in my experience. Hedge funds are an interesting example because a lot of academic research has been done about them. The general finding is that a considerable number of them falsify reports of their assets under management, their performance results and/or their managers’ qualifications.
2. A second main concern is the creation of a secondary market in the securities. This is also an area of heavy regulatory concern, again in order to prevent fraud.
3. We know that fraud occurs even in the highly-regulated public markets. Enron, for example, is a name everyone remembers. Less information, less regulation and unclear penalties all suggest that the danger of fraud in crowd funding securities may be very high.
Congress
Right now, any company with more than $10 million in assets and with more than 500 shareholders has to file financial statements with the SEC. This is a plus for shareholders, since they can find out stuff about company operations, but a considerable cost for tiny companies. The thrust of legislation now circulating in Congress is to stimulate small business growth by creating exceptions to this rule.
The initial proposal is the Entrepreneur Access to Capital bill, reviewed in the Securities Law Professors blog. It has already been passed by the House. It allows companies to raise $1 million per year without having to file financial statements with the SEC. Each investor would be limited to sending in the lesser of $10,000 or 10% of his income. The limit would be $2 million yearly if the firm files financials with the SEC. Issuers would have to use a crowd funding website (details = ?).
So far there have been tweaks to the idea that would, for example, limit investments to $1,000 per person and the total raised to $1 million.
At this point, it’s only clear to me that something will happen in Washington to allow some sort of SEC-exempt crowd funding. My guess is that, absent widespread fraud, the law that is passed will simply be a foot in the door. Larger exemptions will follow.
my thoughts
Crowd funding may come to nothing. On the other hand, it may well be the latest example of the internet destroying a traditional distribution network–in this case the existing venture capital and IPO apparatuses. The obvious strategy for VCs and investment bankers is to seize control of the crowd funding movement by providing their own crowd funding networks.
Cannibalizing your own business is always preferable to having someone else do it to you. But internal advocates of the (lucrative for them) status quo will typically fight this strategy tooth and nail. In bad firms, the latter will win.
No investment conclusion yet, other than that I think the whole movement bears watching.
“the emerging equity gap”: McKinsey (II)
Yesterday I outlined the McKinsey argument that a substantial “equity gap” will emerge in developing economies between the demand for stock financing for capital expansion and the money that investors are willing to make available to the firms that need it.
I believe the qualitative story
To recap: The qualitative argument the consultant makes starts with the idea (which I think is correct) that stock markets in almost all emerging nations are hazardous to investors’ wealth. The companies listed may be the politically connected dregs of the local economy, not the stars. Financial statements may not be reliable. Corporate management may not have shareholder welfare as a primary goal. The regulatory playing field is probably heavily tilted toward insiders. It’s ugly out there.
Firms may not find it easy to raise money under these conditions. Foreigners are unlikely to help, either, since in the developed world an aging investor base isn’t likely to have risk assets to spare.
Therefore, emerging economies will only fill the potential we all believe they have if their governments make substantial changes in their stock markets. Otherwise, companies in these countries will come up $12.3 trillion short of their equity funding needs by 2020.
This is a problem, not only for these countries but also for any investors who have bought emerging markets index funds or ETFs banking on emerging economies to flower fully.
I agree.
…the quantitative?
It’s the quantitative stuff that I have problems with. Specifically,
1. starting with a quibble…
McKinsey projects that global financial assets will be worth $371 trillion in 2020. It’s not $370 trillion. It isn’t $372 trillion, either. The precision of the figures implies that McKinsey can forecast the state of financial markets almost a decade ahead with an accuracy of +/- .25%. All the empirical evidence is that no one can forecast with this degree of accuracy even one year ahead. Stock market participants know the limitations of forecasts, because the real world beats them over the head with their misses every day. Why isn’t McKinsey aware?
…or maybe not
The “equity gap” McKinsey forecasts amounts to $12.3 trillion (not $12.2 trillion…). That’s 3.3% of projected financial assets in 2020. How much of the “gap” would remain if McKinsey didn’t stick with overly precise point forecasts?
2. using local GDP to forecast corporate profits
McKinsey assumes that the profits of publicly listed companies in a given country will rise in line with nominal GDP. Three reasons why I think this is a mistake:
–many parts of the local economy may not be represented in the stock market. On Wall Street, for example, autos, housing and real estate–all pretty sick sectors at the moment–have virtually no stock market representation
–in the US and UK, at least, publicly listed firms tend to represent the best and the brightest of the local economy. Private equity and trade acquisitions winnow the elderly and the infirm from the herd.
–in the developed world, foreign sales and profits make up a considerable portion of the stock market’s total. In the UK, for instance, maybe 75% of the earnings of the FTSE 100 come from outside that country–explaining its dominant stock market size in the EU, despite not being the largest economy. In the US, the best guess of S&P is that foreign earnings make up about half the total. The figure is rising.
My conclusion(s): the method McKinsey uses will understate corporate profits, and thereby the size of future equity market. This is not new news. Wall Street has been actively discussing the increasingly non-US nature of S&P profits for the past two decades. In other markets, it’s been a key subject for much longer.
3. we live in a post-internet world
It isn’t just the internet, either. Other key factors as well have conspired over the past couple of decades to substantially decrease the capital intensity of business.
–development of sophisticated supply chain control software, combined with internet communication and the rise of specialized logistics/transport firms, means everyone holds smaller inventories
—for many industries, today’s capital spending = servers and software, not machine tools and buildings. The rise of technology rental, software-as-a-service, for example, means decreasing capital intensity
—e-commerce has vastly decreased the requirement for repeated expensive advertising campaigns and ownership of physical retail outlets as tools to make potential customers aware of a product or service.
—the separation of design and manufacture that the internet allows means that companies use less capital intensive processes to make products in low labor-cost countries
in developing economies, too
There’s no doubt that emerging nations will still need a lot of development in capital intensive areas, like power generation, chemicals, water, roads, ports and related infrastructure. But there’s no reason to believe that these economies won’t also avail themselves of the same capital-saving devices in other areas that developed nations now do. For instance, eastern China is already outsourcing some manufacturing operations to lower labor-cost countries.
My point: in projecting the future capital needs of publicly trade firms the McKinsey assumption that companies will be as capital intensive as they have been in the past is the simplest one. I don’t think it’s right, though. In fact, the more I think about it, the odder it sounds.
A final thought on this subject: as prices change, behavior adjusts. If the cost of equity capital were to begin to rise, companies will rethink their spending plans and economize/substitute.
“the emerging equity gap”: McKinsey on financial markets in 2020 (I)
the McKinsey financial markets report
The McKinsey Global Institute just published a research paper titled: “The emerging equity gap: Growth and stability in the new investor landscape.”
The paper is the product of research by McKinsey consultants, in conjunction with “distinguished experts” from the academic world, government and private financial companies. No actual bond or equity market investors appear to have been asked to help with the work, with the possible exception of the head of index products for a UK insurer.
its conclusion
The study’s conclusion: by the end of this decade there could be a shortfall of $12.3 trillion between the amount of equity capital global firms will need to fund their operations and the amount that global investors will be willing to offer on current terms. To put this figure in perspective, total world financial assets are projected by McKinsey to be $371 trillion.
If this is correct, companies may:
–borrow more, thereby increasing their vulnerability to cyclical economic downturns ( a company always has to service its debt, but can reduce or omit dividends without triggering a default)
–issue equity on less favorable terms to the firms,
–use capital more efficiently, or
–expand more slowly.
I’m going to write about the McKinsey study in two posts. Today’s will outline the McKinsey argument. Tomorrow’s will have my thoughts.
the McKinsey argument
1. qualitative
Throughout its analysis, McKinsey divides world financial markets into those in the developed world (the US, Europe and Japan) and in the emerging.
the developed world
aging
A key starting point for McKinsey is the demographic fact that the US and Europe are old–and aging. This list of median ages (from the CIA) illustrates this point. Starting with Monaco, the Florida of Europe, median ages by country range as follows:
Monaco 49 years old
Germany 45
Japan 45
Italy 44
Sweden 43
UK 40
Spain 40
US 37
China 36
world median 28
Indonesia 28
India 26
Many African and Middle Eastern countries fall in the late teens or early twenties.
Why is this important?
As people become older they gradually shift from wanting to increase their assets to being happy to preserve the wealth they already have. This increasing risk aversion means they are less willing to buy equities.
pension plan shifts intensify this trend
In the US, corporations have pretty much completed the process of transferring the risk of paying for retirement from themselves to their employees. They’ve done this by substituting defined contribution pension plans for defined benefit ones This shift is now under way in Europe. Individuals tend to put a smaller proportion of their retirement assets into equities than the defined benefit mangers would have. In addition, corporations tend to shift the assets in their residual defined benefit plans into bonds to limit their risk exposure.
the emerging world
Although emerging economies will provide most of the growth in the world over the next decade, and have relatively young populations, they are unlikely to generate widespread–and increasing–domestic interest in equities. Two reasons McKinsey thinks so:
–most citizens are too poor to want to take the risk of holding equities, and
–most emerging markets have low standards of financial disclosure, are badly regulated and exclude foreigners. So they’re not places you’d really want to put your money.
2. quantitative
In the report, McKinsey attempts to estimate, on a country by country basis:
–how much equity money corporations will need through 2020, and
–the amount that investors are likely to allocate to equities over that period.
equity needs
McKinsey addresses the first task by trying to project what the total market capitalization would be for each country, based on the assumption that each can obtain all the equity funding it requires to fuel growth.
It assumes that aggregate assets and earnings will grow in line with nominal GDP. It applies a valuation multiple to them that’s derived from a two-stage present value model. McKinsey then adds the results of IPO stock issuance, which it extrapolates from past relationships between IPOs and GDP.
investor allocations
This is a complex process that McKinsey only describes in outline, even it the appendix to the report.
Basically, the consulting firm projects, country by country, future disposable income. It assumes that in the emerging world that individuals continue to put the same fraction of their disposable income into investments and that their allocation between stocks and fixed income remains constant. For the US and Europe, on the other hand, it shrinks the equity portion progressively–citing age as the rationale.
the results?
McKinsey estimates that investor demand for equities will grow by $25.1 trillion between now and 2020. However, worldwide corporate demand for equity financing will rise by $37.4 trillion, creating a $12.3 trillion “equity gap.”
According to the analysis, the US will have a slight funding surplus, despite a gradually waning interest in equities by Americans. Europe will face a funding deficit of $3.1 trillion.
The real potential problem is in emerging markets. China is in the worst shape, facing a potential financing deficit of $3.2 trillion. Other emerging markets face a total funding deficit of $7.0 trillion.
That’s it for today. My thoughts tomorrow.