Wednesday, May 30, 2012

Facebook Status Update: Silence is not Golden

It would appear that investors are losing confidence and continue to look for yield that is transparent. Aivars Lode

Silence about the fear this latest technical and pricing failure of securities markets has engendered disaffection among mainstream investors. The ones who have already pulled half a trillion dollars out of mutual funds that invest long-term in U.S. stocks, in the last five years.
He watches television talking heads deconstruct the debacle. He reads newspaper and website pontifications. He is barraged by arguments he says are well-constructed, even highly-intellectual, but fail completely at addressing human fears.
“All of the voices that I encounter on this problem, they all sound institutional, they don’t resonate. I just turn off— I being the general public. The general public doesn’t listen anymore,” says Verdi, co-founder and chief executive of the ad agency Devito/Verdi.
If you think the fallout from the Facebook IPO will end any time soon, think again. Ad executives, public relations experts, wealth managers and financial advisors say that the debacle – whereby untold scores of orders never made it from an IPO crossing system onto the market and the price of Facebook shares barely stayed above their opening price on opening day -- represents a real danger for Wall Street.
It’s more than just further plummeting of Facebook’s shares: down to $28.68 a share at midday last Wednesday. That’s a drop of 24.5 percent from its ballyhooed opening at $38 on May 18 – when mainstream investors expected to get a quick pop from putting their money into the social networking giant’s shares.
But now, a $50,000 investment is worth only $37,737. And the Facebook experience will make it harder for Wall Street and fund firms to salvage their relationships with investors who don’t live and breathe the ins and outs of trading. Investors who have day jobs that have nothing to do with finance.
“Facebook stock has plummeted since its IPO, and the company is in the midst of a crisis PR nightmare. From minute 1 of a delayed launch with Nasdaq technical problems to lawsuits swirling around, Facebook is entering a danger zone,” said Ronn Torossian, chief executive of the public relations firm 5WPR. “The court of public opinion doesn’t wait – and this downward cycle of media attention is harmful.”
So far, financial firms are doing little to address this subject. Two-and-a-half days of comment requests placed to Facebook, Morgan Stanley, J.P. Morgan and Goldman Sachs as well as a dozen major asset managers were either declined or ignored as of press-time.
“I do not see any of the major wire houses or financial firms attempting to answer client concerns with this IPO,” says Philip Cioppa, managing principal and chief investment officer at Arbol Financial Strategies.
“No one wants to be implicated if an error was made or unethical behavior is discovered,” he says. “Communication is a lost art in the financial world.”
Meanwhile, financial professionals such as Paul Franke are stepping up to the plate and calming investors who otherwise feel ignored by the rest of Wall Street.
“Over the Memorial Day weekend, nearly everyone expressed their outrage to me at the failure of the Facebook quote to rise much above the offering price of $38,” said Franke, who is director of research at Quantemonics Investing and also manages a portfolio on the social media platform Covestor.
“With nearly two years of non-stop hype building up to the offering, the Wall Street underwriters really look bad pricing the stock well above any common sense valuation when measured against the other internet companies already trading publicly,” he says.
Scared investors can be dangerous investors. Just ask Mark Martiak, senior vice president and senior wealth strategist at Premier/First Allied Securities, a New York broker and financial advice firm.
During the financial crisis of 2008, Martiak had a client who, despite Martiak’s pleas, sold out of his separately managed accounts only to lose millions, when prices turned.
“He lost his confidence and couldn’t stomach consecutive daily losses,” Martiak said.
Investors in Facebook, now behind the game by 24 percent or more, have to take a similar long-term outlook. And recognize that it will be around for a lot longer than two weeks of trading.
“Advisors need to provide assurances daily when they sense that their clients are shaken by the market’s volatility,” he said.
In fact, some say that the Facebook IPO is already creating marketing opportunities for fee-only wealth advisors who adhere to fiduciary standards regarding costs. The argument being thus: if an advisor doesn’t make money per transaction but rather from a percentage of assets, there is little incentive to repeatedly push customers into new products that could be risky.
“In general, it’s reasonable to assume that the Facebook IPO has raised questions— if not concerns— among investors regarding traditional Wall Street firms. Specifically, there’s a growing awareness that because these firms do not operate under a fiduciary standard they can -- and do -- maximize profits at the expense of their clients,” said Anderson Wozny, Director, Financial Planning, Edelman Financial Services.
What can fund firms who put clients’ assets into Facebook shares do? First off, says ad exec Verdi, acknowledge the fact that investors are scared, and then treat them like human beings.
Fidelity Investments, the mutual fund company which also runs a large brokerage, said it was working with "thousands" of brokerage clients to clear up what happened to their orders, when Facebook went public.
“With the Facebook IPO, people feel like you are messing with the American Dream a little bit. I’m supposed to be able to participate in this and not be screwed in the process,” he says. “You can’t mess with the American Dream and then expect people to participate in Wall Street.”
Also, financial services firms somehow need to develop a single voice. When dozens of different industry executives get on TV and espouse dozens of conflicting opinions on financial events, investors get confused and alienated.
“You need a voice—where is the voice of Wall Street? Before I can even listen to you, I need to trust you. That is the part many are missing,” Verdi says.
To show that it is possible for a company to handle—well—a public black eye, Verdi cited the efforts of British Petroleum to regain public trust after the oil leak disaster in the Gulf of Mexico. Little actions can have big effects, he says, like educational initiatives at local high schools. All told, the petroleum giant has poured more than $150 million into promotions to help the region recover since the Deep Horizon rig disaster two years ago.
“It’s all about perception. The reality of all of this is so much less important than the perceptions. Bad perceptions can become reality if you don’t handle them properly,” he says.

Monday, May 28, 2012

European funds cut equities in favour of alternatives – Mercer

This is why we created our alternate asset class fund focused on software yield investments. Aivars Lode

EUROPE – Pension funds in Europe trimmed allocations to equities over the last year and increased their exposure to alternative assets, Mercer's annual European Asset Allocation survey has found.

The trend away from equities is set to continue, according to the consultancy. In the UK, for example, 38.8% of schemes said they were planning to cut exposure to UK equities, while only 1.4% expected to increase it.

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Nick Sykes, European director of consulting in Mercer's investments business, said: "As the euro-zone crisis continues unabated, pension funds are faced with the dual challenge of managing portfolio risk brought on by market volatility, while at the same time identifying opportunities that will generate returns to support future liabilities.

"In their quest to control volatility without sacrificing long-term returns investors have turned their attention to alternative asset classes," he said.

Falls in overall equity holdings at European pension funds were mainly driven by cuts in domestic equity allocations, according to the report.

Funds with less than €50m in assets saw equity allocations fall to 34%  – down from 40% the year before – while at the other end of the scale, average allocations to equities at large funds with €2.5bn or more dropped three percentage points to 24%.

Pension funds are now considering investing in a wide range of alternative asset classes, the survey of more than 1,200 European funds shows. Half of the schemes surveyed now have an allocation to alternatives, up from 40% last year, Mercer said.

The largest falls in equity allocations were seen at schemes in the UK and Ireland.

Funds in these countries still have the heaviest equity weightings among European schemes, but UK allocations to domestic and non-domestic equities fell to 43% from 47% over the last 12 months, while Irish allocations dropped six percentage points to 44%, Mercer said.

The gap between the traditionally equity-heavy pension funds of the UK and Ireland and funds from other European countries had now all but vanished, Mercer observed.

Their average equity allocation was now approaching that of Belgium and Sweden, it said.

The most popular alternative investment types for European pension funds outside the UK were hedge funds, emerging market debt and high yield bonds, according to the survey, with almost 20% of schemes allocating to one or more of these areas.

Mercer said this trend was more marked for larger schemes. About 60% of funds with €2.5bn or more in assets had allocations to one or more of these asset classes, up from 40% in 2011.

The most popular alternative asset classes for UK funds were diversified growth funds, global macro hedge funds and funds of hedge funds, with 23.2%, 13.6% and 10% of schemes having allocations respectively.

Sykes said schemes were looking towards asset classes that were less exposed to the sovereign debt crisis, focusing particularly on emerging markets for both equities and bonds.

"Investors are also looking globally for yield in bond markets, since the crisis has pushed core yields in Europe to very low levels," he said.

"Liquid asset classes are also favoured, as investors value access to their assets in such turbulent times."

Author: Rachel Fixsen

There are two types of value: intrinsic value and speculative value.

Thanks Rob, thoughtful and provoking when thinking about investing. Aivars Lode

The best definition of intrinsic value is cash flow.  Pretty simple. Easy to
calculate and mostly what "fixed income" (e.g. debt, bond) markets are all

The other type of value is speculative value sometimes called equity. The
most obvious manifestation of speculative value is the stock market, where
"equities" are issued, then bought and sold, over and over.

Speculative value (equity) is basically the concept of buying and selling a
title to some "asset". (The term asset is used loosely in the context of
equities.) The buyer of the title to the asset believes that in the future
there will be some event or change of perception that will allow them sell
it for more money than what they paid when they bought it. The thing backing
up the equity could be completely vacuous like an eyeball looking at a
webpage (worth speculatively millions), or a physical thing like a building,
which may have a replacement cost of say $10 million but could be be worth
zero or even have negative "equity" (you have to pay to demolish it.)

In theory, over the long term, the events that create equity value are an
increase in dividends (more on dividends in a minute) or an improvement in
the balance sheet (retained earnings, accumulation of sellable assets,
issuance of notes payable, etc.). But in the real world equities are valued
on pure perception (speculation). Actually, the second or third derivative
of perception (i.e. "I perceive now is the time to buy equities, because I
perceive that others who do not perceive now is a good time to buy equities
will down the road perceive that others will perceive that they should buy
equities in larger numbers... "ad infinitum) In other words the equity value
of an equity is derived from the belief that someone in the future will
believe that down the road further, someone will else will pay more. It is
really that simple. The real trick to equity pricing is to try to figure out
what people believe and what is likely to change their minds - 100%
psychology and like ALL FORMS of psychology, no science whatsoever - just

I am not saying people do not love to toss around numbers in equity markets.
Is there growth in earnings? Is there growth in revenue? Is this "expected"
or not (e.g. beat the official estimates and/or "whisper numbers")? Does
this company's "equity" have the same price to earnings, or price to
revenue, ratio as a competitor of the same size, balance sheet, same growth,
same margin, etc. If not, can these discrepancies be accounted for? Does the
company pay a dividend? Is it increasing?  etc. etc. But these are just
mental masturbations The only thing that matters is playing the perception
game. This is why stocks frequently go down after a stunningly good quarter.

Equity markets move from a numeric analysis to a perception analysis in the
blink of an eye,  That is not to say the numbers do not matter to some
extent, but numbers only matter to the degree they change perception.
So-called good numbers do not always lead to a good change in perception
(again, not the first derivative). There is a ton of evidence in equity
markets that demonstrates these phenomenon, but my favorite is looking at
the stock price movements when a company "misses the quarter" could go up -
could go down - could stay the same - depending on what the expectations are
and how they changed. Hence the source of, "I buy on dips."

One other note before moving on to intrinsic value is an analysis of
dividends. For equities that pay dividends, a partial intrinsic value can be
found in the ratio of dividend amount to speculative price. But be careful,
paying a dividend actually reduces the theoretical equity value of a company
(reduces cash).  Dividend values of equities (unless the dividend is
abnormally high compared to a corporate bond) is typically a minor kicker to
the stock. Increasing dividends has a de minimis impact on equity value as
compared to speculative values (i.e. the attempt to buy low and sell high).
Sometimes an increase in dividends will move a stock, but not because of the
intrinsic value, but because it is perceived to be a signal that will be
perceived by non-believers that the company has more "good news" which will
further change perceptions in the future. I am quite serious.

Bottom line: equities are valued on speculation.

Intrinisic value is a whole 'nother kettle of fish.

Intrinsic value is almost all mathematics. Intrinsic value is simply the
cash flow generated by an "asset". The formula can be quite complex taking
into account the net present value of the cash flow and the risk the that
cash flow is not secure and steady (predictable).  But no cash flow - no
intrinsic value. Period. For investors to balance a portfolio the future
will be products that have a relatively high cash flow (yield) with
relatively low risk.  Funds that do not take equity, but accumulate "bonds"
by concentrating on securing intrinsic value claims (cash flow) via secured
structures will provide stability in an investment portfolio.  Investments
are technically more like Convertible bonds than straight debt, because of
covenants that give ultimate control of operations without a traditional
default event. Funds like this are the future unique, modern,
differentiated, not a PE, not a VC, not a traditional bank, not a
hedge-fund, etc.

There is some confusion around intrinsic value "assets" like corporate and
government bonds because, in addition to yield, they also have a "price" -
i.e. some bonds do indeed trade. Bond trading is the result of a pseudo
perceived speculative value around relative yield and relative risk.  The
factor that causes speculative changes in the price of bonds is the global
shifts in interest rate expectations (speculation) for the same level of
risk. If you own a ten year U.S. Treasury eight years away from maturity
with an intrinsic value (yield) of 2% and the market begins to speculate
that the government will next issue ten-years for 2.2%, then the "price" of
your bond will go down. Notice that the price of the bond does not change
when the new higher rate bonds are sold if the speculation on future rates
is confirmed and does not create new speculation. But this assumes you would
sell it before maturity (now). If you own a ten-year bond with one year left
to maturity the speculative impact of a change in global interest rates is
tiny. If your intent is to hold to maturity the "price" of your bond beyond
intrinsic value is irrelevant.

Consequently, intrinsic value assets that do not trade do not have
speculative value. Intrinsic value assets that do not have a maturity are
probably impossible to speculatively price objectively, anyway.  The only
objective value is the current cash flow.

Sunday, May 27, 2012

Public Pensions Faulted for Bets on Rosy Returns

The truth is hitting home. There are barely any home runs for investments. Aivars Lode

Published: May 27, 2012

While Americans are typically earning less than 1 percent interest on their savings accounts and watching their 401(k) balances yo-yo along with the stock market, most public pension funds are still betting they will earn annual returns of 7 to 8 percent over the long haul, a practice that Mayor Michael R. Bloomberg recently called “indefensible.”

Now public pension funds across the country are facing a painful reckoning. Their projections look increasingly out of touch in today’s low-interest environment, and pressure is mounting to be more realistic. But lowering their investment assumptions, even slightly, means turning for more cash to local taxpayers — who pay part of the cost of public pensions through property and other taxes.

In New York, the city’s chief actuary, Robert North, has proposed lowering the assumed rate of return for the city’s five pension funds to 7 percent from 8 percent, which would be one of the sharpest reductions by a public pension fund in the United States. But that change would mean finding an additional $1.9 billion for the pension system every year, a huge amount for a city already depositing more than a tenth of its budget — $7.3 billion a year — into the funds.

But to many observers, even 7 percent is too high in today’s market conditions.

“The actuary is supposedly going to lower the assumed reinvestment rate from an absolutely hysterical, laughable 8 percent to a totally indefensible 7 or 7.5 percent,” Mr. Bloomberg said during a trip to Albany in late February. “If I can give you one piece of financial advice: If somebody offers you a guaranteed 7 percent on your money for the rest of your life, you take it and just make sure the guy’s name is not Madoff.”

Public retirement systems from Alaska to Maine are running into the same dilemma as they struggle to lower their assumed rates of return in light of very low interest rates and unpredictable stock prices.

They are facing opposition from public-sector unions, which fear that increased pension costs to taxpayers will further feed the push to cut retirement benefits for public workers. In New York, the Legislature this year cut pensions for public workers who are hired in the future, and around the country governors and mayors are citing high pension costs as a reason for requiring workers to contribute more, or work longer, to earn retirement benefits.

In addition to lowering the projected rate of return, Mr. North has also recommended that the New York City trustees acknowledge that city workers are living longer and reporting more disabilities — changes that would cost the city an additional $2.8 billion in pension contributions this year. Mr. North has called for the city to soften the blow to the budget by pushing much of the increased pension cost into the future, by spreading the increased liability out over 22 years.

Ailing pension systems have been among the factors that have recently driven struggling cities into Chapter 9 bankruptcy. Such bankruptcies are rare, but economists warn that more are likely in the coming years. Faulty assumptions can mask problems, and municipal pension funds are often so big that if they run into a crisis their home cities cannot afford to bail them out.

The typical public pension plan assumes its investments will earn average annual returns of 8 percent over the long term, according to the Center for Retirement Research at Boston College. Actual experience since 2000 has been much less, 5.7 percent over the last 10 years, according to the National Association of State Retirement Administrators. (New York State announced last week that it had earned 5.96 percent last year, compared with the 7.5 percent it had projected.)

Worse, many economists say, is that states and cities have special accounting rules that have been criticized for greatly understating pension costs. Governments do not just use their investment assumptions to project future asset growth. They also use them to measure what they will owe retirees in the future in today’s dollars, something companies have not been permitted to do since 1993.

As a result, companies now use an average interest rate of 4.8 percent to calculate their pension costs in today’s dollars, according to Milliman, an actuarial firm.

In New York City, the proposed 7 percent rate faces resistance from union trustees who sit on the funds’ boards. The trustees have the power to make the change; their decision must also be approved by the State Legislature.

“The continued risk here is that even 7 is too high,” said Edmund J. McMahon, a senior fellow at the Empire Center for New York State Policy, a research group for fiscal issues.

And Jeremy Gold, an actuary and economist who has been an outspoken critic of public pension disclosures, said, “If you’re using 7 percent in a 3 percent world, then you’re still continuing to borrow from the pension fund.”

The city’s union leaders disagree. Harry Nespoli, the chairman of the Municipal Labor Committee, the umbrella group for the city’s public employee unions, said that lowering the rate to 7 percent was unnecessary.

“They don’t have to turn around and lower it a whole point,” he said.

When asked if his union was more bullish on the markets than the city’s actuary, Mr. Nespoli said, “All we can do is what the actuary is doing. He’s guessing. We’re guessing.”

Vermont has lowered its rate by 2 percentage points, but for only one year. The state recently adopted an unusual new approach calling for a sharp initial reduction in its investment assumptions, followed by gradual yearly increases. Vermont has also required public workers to pay more into the pension system.

Union leaders see hidden agendas behind the rising calls for lower pension assumptions. When Rhode Island’s state treasurer, Gina M. Raimondo, persuaded her state’s pension board to lower its rate to 7.5 percent last year, from 8.25 percent, the president of a firemen’s union accused her of “cooking the books.”

Lowering the rate to 7.5 percent meant Rhode Island’s taxpayers would have to contribute an additional $300 million to the fund in the first year, and more after that. Lawmakers were convinced that the state could not afford that, and instead reduced public pension benefits, including the yearly cost-of-living adjustments that retirees now receive. State officials expect the unions to sue over the benefits cuts.

When the mayor of San Jose, Calif., Chuck Reed, warned that the city’s reliance on 7.5 percent returns was too risky, three public employees’ unions filed a complaint against him and the city with the Securities and Exchange Commission. They told the regulators that San Jose had not included such warnings in its bond prospectus, and asked the regulators to look into whether the omission amounted to securities fraud. A spokesman for the mayor said the complaint was without merit.

In Sacramento this year, Alan Milligan, the actuary for the California Public Employees’ Retirement System, or Calpers, recommended that the trustees lower their assumption to 7.25 percent from 7.75 percent. Last year, the trustees rejected Mr. Milligan’s previous proposal, to lower the rate to 7.5 percent.

This time, one trustee, Dan Dunmoyer, asked the actuary if he had calculated the probability that the pension fund could even hit those targets.

Yes, Mr. Milligan said: There was a 50-50 chance of getting 7.5 percent returns, on average, over the next two decades. The odds of hitting a 7.25 percent target were a little better, he added, 54 to 46.

Mr. Dunmoyer, who represents the insurance industry on the board, sounded shocked. “To me, as a fiduciary, you want to have more than a 50 percent chance of success.”

If Calpers kept setting high targets and missing them, “the impact on the counties won’t be bigger numbers,” he said. “It will be bankruptcy.”

In the end, a majority decided it was worth the risk, and voted against Mr. Dunmoyer, lowering the rate to 7.5 percent.

Tuesday, May 22, 2012

Volatility hitting corporate yields, not just gilts – Mercer

Private entitles where earnings are transparent may be an alternative source of low risk yield. Aivars Lode

UK – Market volatility seen this May has led to the largest single month-on-month increase in pension deficits in nearly two years, according to a Mercer analysis of UK pension funds.

Speaking with IPE, pension risk group leader Ali Tayyebi noted that, unlike the euro-zone related turbulence of last August, current doubts over Greece's ability to stay within the single currency had also impacted corporate bond yields.
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"Although trustee funding calculations will be different to company accounting figures – because different assumptions are required – market conditions currently are placing more or less identical pressures on them, so trustees will be considering how to react to similarly bad news," he said.

Tayyebi said the impact of the sovereign debt crisis in the autumn of last year had presented different symptoms – with only government debt yields falling, while corporate rates remained stable.

"The trend now appears to be contrary to the increase in the perceived risk of corporate bonds as measured by credit default swaps and could be due to the significantly reduced issuances of corporate bonds in recent months," he said.

He said while Mercer was unsure of the exact underlying causes, the effect was that pension fund deficits had risen to levels last seen two years ago, with the biggest single rise in funding shortfalls since August 2010.

Mercer added that the ongoing crisis had exacerbated the "perceived safe-haven status" of the UK, with 20-year fixed interest gilt yields falling to 2.76% at the end of last week – bringing it close to the lowest point seen all year.

The consultancy estimated that, as a result of declining yields, deficits in FTSE 350 companies had increased by around a quarter, rising by £25bn (€31bn) to £94bn.

The figures are roughly in line with rival Towers Watson's calculations, although the latter consultancy estimated a steeper overall increase since the beginning of May – with deficits up by £30bn.

Despite this, Mercer and Towers Watson disagreed on the overall size of the 350 companies' deficits, with Towers Watson estimating a shortfall of only £92bn.

Author: Jonathan Williams

Monday, May 21, 2012

Smart money cashing out in a big way; welcome to the modern-day IPO

Even an IPO won't get you your yield, and it comes with risk unless you are insider. Aivars Lode

Facebook IPO great for insiders — but what about investors?
By Jeff Benjamin

May 21, 2012 1:26 pm ET

If you were patient enough to wait until the second day of trading for the most-hyped public stock offering ever, you might feel good about getting Facebook Inc. (FB) at more than 11% below Friday's IPO price.

Even so, you're still stuck with a stock that the smart money already is selling.

“The IPO has become little more than a way for insiders to cash out,” said George Feiger, chief executive of Contango Capital Advisors Inc., a trust company and advisory firm that manages $3.3 billion in assets.

Mr. Feiger isn't down on Facebook for any reason related to the fundamental value of the social-networking company. He is down on it because it represents the epitome of what's wrong with the present-day IPO.

“Twenty years ago, a company went public to raise capital for growth, but today, it's just the opposite,” he said. “You have huge pools of private money that fund private businesses.”

With that in mind, Mr. Feiger said the best way to tap into the growth of a new business venture is through private-equity and venture-capital funds.

“I have no idea what the valuation on Facebook should be, but I know it is the most-hyped IPO in history and insiders are selling out massive amounts of stock,” he said. “Plus, most IPOs are selling below the issue price after 12 months.”

Saturday, May 19, 2012

The big engine that couldn’t

This is why transparent secured investments in private companies make a lot of sense. Aivars Lode

PUBLIC companies have been the locomotives of capitalism since they were invented in the mid-19th century. They have installed themselves at the heart of the world’s largest economy, the United States. In the 1990s they looked as if they would spread round the world, shunting aside older forms of corporate organisation such as partnerships, and newer rivals such as state-owned enterprises (SOEs). China’s former president, Jiang Zemin, described NASDAQ as “the crown jewel of all that is great about America”. Russia rejected five-year plans in favour of stockmarket listings and Wall Street banks abandoned cosy partnerships in favour of public equity: Goldman Sachs, the last big holdout, went public as the decade came to an end.

But during the past decade, the title of a 1989 essay, “Eclipse of the Public Corporation”, by Michael Jensen of Harvard Business School, has turned out to be prescient. In 2001-02 some of America’s most prominent public companies imploded. They included Enron, Tyco, WorldCom and Global Crossing, which, before their demise, were admired. Six years later Lehman Brothers collapsed and Citigroup and General Motors turned to the government for salvation. Meanwhile, SOEs were growing in emerging markets, challenging the idea that public companies are the biggest fishes in the sea. Private-equity firms flourished in the West, challenging the idea that public companies are the best managed. And the rise of the Asian economies, with their legions of family-owned conglomerates, challenged the idea that they are best equipped to advance capitalism’s geographical frontier.

Public companies triumphed because they provided three things that make for durable success: limited liability, which encourages the public to invest, professional management, which boosts productivity, and “corporate personhood”, which means businesses can survive the removal of a founder. In 1997 the number of American companies reached an all-time high of 7,888 (see chart 1). Even now, American listed companies are as profitable as than they have been for 60 years.

So, even though public companies are flush with cash (American firms are sitting on $2.23 trillion, see Free Exchange) and even though the world’s most talked-about entrepreneur, Facebook’s Mark Zuckerberg, is due to take his company public on May 18th, the signs of health are misleading. Public companies are in danger of becoming like a fading London club. Their membership is falling. They spend their time fussing over club rules. And, as they peer out of the window, they see the bright young things heading elsewhere.

The number of public companies has dropped dramatically in the Anglo-Saxon world—by 38% since 1997 in America and by 48% in Britain’s main markets. The number of initial public offerings (IPOs) in America dropped from an average of 311 a year in 1980-2000 to just 81 in 2011 (chart 2).
Going public no longer has the glamour it once had. Entrepreneurs have to wait longer—an average of ten years for companies backed by venture capital, compared with four in 1985—and must jump through more hoops. Lawyers and accountants are increasingly specialised and expensive; bankers are less willing to take them public; qualified directors are harder to find, since even “non-execs” can go to prison if they sign false accounts.
The great IPO famine
Even when their firms do go public, the most successful technology entrepreneurs manage to preserve a lot of personal control. Google introduced a third class of non-voting shares despite the fact that its three bosses, Eric Schmidt, Sergey Brin and Larry Page owned 60% of voting shares. Mr Zuckerberg put off taking Facebook public until he had little choice (you have to publish quarterly accounts like a public company once you have more than 500 private shareholders); he will control more than half of Facebook’s voting stock.
The IPO crisis has coincided with a boom in other corporate life forms. Familiar companies have started to put unfamiliar letters after their names: Chrysler LLC and Sears Brands LLC. The University of Illinois’s Larry Ribstein called this “the rise of the uncorporation”.
Private-equity companies have taken some of the most familiar names on the high street private, including Boots, J.Crew, Toys “R” Us, and Burger King. They also bagged some of the biggest stockmarket beasts: in 2007 Blackstone bought Hilton Hotels for $25.8 billion.
Partnerships, too, are thriving, reversing a decline that began in the era of Charles Dickens’s “Dombey and Son” (1848). Partnerships provided unlimited liability to the partners but limited their number. This meant partners could be ruined if their company failed (as Dombey was) but could not expand if it boomed. Now, thanks to three decades of legal reforms, partnerships can offer most of the benefits of listing, such as limited liability and tradable shares. In America they also boast a big tax advantage: partnerships are liable for only one lot of taxes, whereas companies must pay corporate taxes as well as taxes on dividends.
The result has been a revolution: one-third of America’s tax-reporting businesses now classify themselves as partnerships. They have adopted exotic forms of corporate organisation, such as Limited Liability Limited Partnerships (LLLPs), Publicly Traded Partnerships (PTPs) and Real Estate Investment Trusts (REITs). Private-equity firms are typically organised as private partnerships. The individual funds through which they raise money are limited partnerships. And they treat their managers more like partners than employees, rewarding them accordingly. The former CEO of the Gap retail chain made $300m running J.Crew, a clothing firm, on behalf of Texas Pacific.
Policymakers have embraced alternatives to the public company, too. Britain’s Conservative prime minister, David Cameron, is happier praising employee-owned John Lewis than your average PLC (public limited company). American corporate reformers regularly cite a private firm, W.L. Gore, as a model; the maker of the eponymous Gore-Tex employs 9,500 “associates” and “sponsors” (not workers and bosses). Such companies use shares to motivate their employees but shield themselves from the capital markets. Employees become co-owners when they join and may not sell their shares when they leave.
Governments have made it easier to create such alternative corporate structures. Seven American states have passed laws to allow companies to register as “B” corporations which explicitly subordinate profits to social benefits. The British government has established a class of Community Interest Companies which issue shares and dividends but exist to promote social purposes. It has also handed over the management of hospitals to “trusts”— public-private hybrids.
The rise of new economic powers has further changed corporate organisation. In the 1990s it seemed that emerging-market companies would take the Western public company as their model. In fact they have embraced two slightly different corporate forms: SOEs and family conglomerates. These companies list on the stockmarket but do little to constrain the power of the state or of family shareholders.
In June 2011 SOEs accounted for 80% of the value of China’s market, 62% of Russia’s and 38% of Brazil’s. They include some of the world’s most important concerns: the 13 largest oil companies, the biggest gas company (Gazprom), the biggest mobile-phone company (China Mobile), the biggest ports operator (Dubai Ports).
The most serious challenge to SOEs comes from family-controlled conglomerates. Family businesses account for about half of listed companies in the Asia-Pacific region and two-thirds in India. Families exercise tight control of their empires—and limit the power of other shareholders—through a variety of mechanisms such as family-controlled trusts (which have more power than boards), appointing family members to managerial positions and attaching different voting rights to different classes of stock. Diversified family firms are good at taking a long-term view, diverting money from cash cows to new industries that might take a long time to produce results. They are also good at dealing with the government failures that plague emerging markets. It is remarkable how fast even India’s lumbering government can move if a Tata or an Ambani calls.
Family companies of a different type have had a good decade in Europe. German family firms have led the country’s export boom by dominating niche markets such as printing presses (Koenig & Bauer), licence plates (UTSCH) and fly swatters (Aeroxon). These firms pride themselves on a professional approach to management: Nicholas Bloom and John Van Reneen, of the London School of Economics, point out that only 10% of German family firms choose their CEOs through primogeniture compared with two-thirds of family-owned firms in Britain and France. They also pride themselves on long-termism, investing heavily in training and upgrading their machinery.
Getting better versus getting worse
Some of the reasons for the decline of public companies and the success of alternatives may prove temporary. The fall in the number of listed firms owes something to the dotcom bust, a one-off event. The private-equity boom was fuelled by cheap debt. SOEs have been turbocharged by the rise in the price of oil and other commodities. The next decade may not be as easy for the emerging-world’s family conglomerates as the past decade. But there is also something more fundamental going on: these various corporate forms have all learned how to manage their problems better than public companies have, while continuing to exploit their advantages.
The biggest advantage of SOEs is political: ties with governments can protect them from unwelcome competition. That, of course, is also their problem: they can easily become bloated and lazy. So state-capitalist governments, particularly the Chinese, have turned to overseas listings to force staid monopolies to become nimbler, capable of responding to market demands, as well as government fiat.
The big advantage for family firms is their capacity for long-termism. The drawbacks are family feuds and a lack of professionalism in the second or third generations. So, like state-capitalist governments, family companies are turning to market mechanisms: professional managers, private-equity firms and private markets such as SecondMarket and SharesPost, which allow private firms to trade shares without public scrutiny.
In contrast, public companies have got worse at managing their problems, three in particular. Mr Jensen argues that their biggest drawback is what economists call the principal-agent problem: the split between the people who own the company (principals) and those who run it (agents). Agents have a nasty habit of trying to feather their own nests. Dennis Kozlowski, Tyco’s former boss, even spent company money throwing a $2.1m birthday bash for his wife that featured a Manneken-Pis-like replica of Michelangelo’s David dispensing vodka. But, as the current “shareholder spring” attests, principals have been bad at monitoring their agents.
Mr Jensen’s solution was to give managers “skin in the game”—that is, make their pay reflect company performance so they act like owners. This has backfired: some bosses manipulated their companies’ share prices to enrich themselves and most have seen their pay outpace company performance. The total remuneration of FTSE 100 chief executives rose by an annual average of 10% in 1999-2010, whereas returns on the FTSE 100 rose by an annual 1.9%.
The second problem is regulation. Public companies have always had to put up with more regulation than private ones because they encourage ordinary people to risk their capital. But the regulatory burden has become heavier, especially after the 2007-08 financial crisis. America has introduced a raft of new rules, from the 2002 Sarbanes-Oxley legislation on accounting to the Dodd-Frank financial regulations of 2010. According to one calculation, Sarbanes-Oxley increased the annual cost of complying with securities law from $1.1m per company to roughly $2.8m. But that is nothing compared with the costs of distraction. In 2007 Oaktree Capital Management, a hedge-fund advisory firm, chose to raise $880m in a private placement rather than an IPO because, as the founders put it, “they were happy to sacrifice a little public market liquidity, and even take a slightly lower valuation, in return for a less onerous regulatory environment and the benefits of remaining private.”
The third problem is growing short-termism. The capital markets have increased their power dramatically with the rise of huge institutional investors and the intensification of shareholder activism. Mutual funds count their money in trillions rather than billions. Data providers such as Risk Metrics arm shareholder activists with plenty of ammunition. And hedge funds are not afraid to take on corporate Goliaths such as McDonald’s and Time Warner if they think they are failing. And as capital markets have flourished, corporate life has become riskier. The average life expectancy of public companies shrank from 65 years in the 1920s to less than ten in the 1990s. So has the life expectancy of CEOs. The average job tenure of the CEO fell from 8.1 years in 2000 to 6.3 years in 2009, according to Booz & Co, a consultancy. Léo Apotheker lasted just nine months as head of SAP and ten as head of Hewlett-Packard.
Sometimes, investors are right to kick out managers (they own the firm, after all). Companies must strike a balance between the short and long term, satisfying the market’s demand for profits today, while planning for the future. The worry is that regulators and owners both seem to be making it harder for bosses to look beyond quarterly earnings. Boards are devoting less time to strategy and more to enforcing regulations. Leo Strine, a judge with expertise in corporate law, accuses institutional investors of “gerbil-like” activity as they move money from one company to another. Standard Life Investors complains that the noise generated by quarterly earnings has become an “unwelcome distraction” from thinking about the long term.
Public company as public good
What should one make of the public company’s travails? There is every reason to celebrate the fact that businesses have more corporate forms to choose from. Indeed, the menu should be lengthened by inventing new arrangements or revisiting old ones. France’s “SCAs” or Sociétés en Commandite par Actions have two tiers of partners: general ones jointly and severally liable for a company’s debts, and limited partners who are ordinary shareholders with little power and who can lose only what they invest. This might provide a model for investment banks.
But there are reasons to worry that the downgrading might go too far. Can the private-equity industry function properly if private investors cannot easily cash out through IPOs? Can SOEs avoid stagnation if conventional multinationals are struggling? Public companies are parts of an ecosystem of innovation and job creation. IPOs give venture capitalists and entrepreneurs a chance to make fortunes if they spot a game-changing idea. They also provide new companies with capital. The Kauffman Foundation has shown that one reason America has been better at generating jobs than Europe is its skill at creating innovative companies such as Amazon, eBay and Google. These companies took off when they went public.
William Draper, one of Silicon Valley’s most successful investors, speaks for many when he argues that this ecosystem may be drying up. Venture capitalists are recouping their investment by selling new companies to established ones rather than preparing them for independent life. In 2010 five large companies gobbled up 134 start-ups—more than the entire crop of American IPOs that year. Two of the most talked-about start-ups of recent years—Skype and Zappos—chose to sell themselves to giant firms (Microsoft and Amazon respectively). This may not be good for the start-ups. Imagine if Microsoft or Apple had sold themselves to IBM in the 1980s and you get a sense of the problem.
Public companies produce annual reports, hold shareholder meetings and explain themselves to analysts. Private companies by comparison operate behind a veil of secrecy. The danger is that regulators are creating a corporate version of the dual labour market. By shining a spotlight on public companies, they are encouraging businesses to take refuge in the shade of the private sector.
Public companies also foster popular capitalism. The 20th century saw shareholding broadened thanks to privatisations in the 1980s and the rise of mutual funds. Today shareholding is in danger of narrowing again. The reduction in the number of IPOs is making it harder for ordinary people to put money into a future Google. The rise of the private-equity industry and the proliferation of private markets such as SecondMarket gives more power to a magic circle of company founders and experienced investors.
Public companies have shown an extraordinary resilience. They have survived the Depression, the fashion for nationalisation, and the buy-out revolution of the 1980s. But the challenge to them looks unusually strong at the moment, and the auguries for the future grim.