Tag Archives: venture capital

As the bridge is gapped: tech disruption in finance

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When we think about innovation we think about Silicon Valley, and when we think about finance we think about New York. There is plenty of finance in the Valley, and New York has built a technology startup culture with such rapid success that even the mayor is beginning to participate (again). Nevertheless, there is a history on both coasts, and culture is hard to manufacture or replicate. That Google, Apple, Facebook, Oracle, Hewlett-Packard, the Sand Hill Road venture capitalists, (and further north, Microsoft and Amazon), are out there, could be cause or effect; but it is nonetheless a reality. And that New York’s most successful technology startup (by far) was the mayor’s financial tool is also true for a reason.

When we learn about Facebook launching a major presence in New York – and interestingly not for advertising and business development, (as had been the case for some of its west coast predecessors in town), but to focus on technology – we think to ourselves that the coasts are coming together. We think to ourselves, with some pride, that New York has at last transcended its finance and Madison Avenue roots and is on the technology map at last, as it should be. When we learn about a technology campus planned for the premises, in competitive pursuit by the world’s finest technology programs, we even go so far as to daydream about New York overtaking the other coast. But that’s because we are New Yorkers and we can’t help ourselves, we think grand thoughts, operatically, we are surrounded by skyscrapers and Broadway.

What we New Yorkers have not yet begun to think, however, perhaps because we are entrenched in a culture in which all roads eventually lead to “Wall Street,” is that the technical innovation in which New York may serve as global center could be used to disrupt finance itself. In previous articles in this space there has been discussion about a relative absence of innovation in finance during the past couple of decades, about a convergence of previously disparate capital markets and money flows, and about the significance of alternative markets that have emerged. Taken in combination with New York’s recent push for technology innovation and its financial culture, as noted, the ingredients are falling into place for the next major disruption to occur right under our noses, in the most traditional of all industries that we call our own.

As we consider the possibility of disruption on Wall Street – driven by such things as the social web, big data, and online commerce, (that we currently know about) – let us reflect on the possibilities also in the context of current events. To wit: Facebook is planning its IPO in a way to bypass bankers, contacting institutional investors directly and, needless to say, having direct access to a public market that is 800 million strong. IPO bankers in the meantime, (and maybe defensively?), are holding conferences for technology startups, venture capitalists, and angel investors, at which the IPO candidates of the very distant future are presenting their very distant opportunities today. All the while, capital necessary for building new technologies is diminishing, while the capital pursuing proven and popular platforms is growing.

The themes described speak to market fragmentation and democratization, disruption as well as efficiency. These themes have the potential to speak to other offshoots in the years ahead, and one senses that we are standing at the entrance to a new domain – if not a new field altogether, perhaps a remodeled, refashioned variation of prior modes and traditions. Interestingly, as a technology bridge is constructed to connect disparate cultures of west coast innovation and east coast finance, another bridge will be torn down, that connected financial systems rooted in a distant past to a present marked by very different realities.

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The “cash crunch” is only relative

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For startups, and even later-stage ventures, money is never an end. It is a means, really a beginning. But money being hard to come by – for startups and for anyone – the issue is often confused. The completion of a funding round is seen as cause for celebration, when it is in fact a reason to lose sleep. With funding comes responsibility, with funding comes a liquidation preference and a stepped up value expectation. Pre-money, anything is possible, it’s all in PowerPoint and can be changed on whim. Post-money, the slide deck gets tossed aside and actuality commences.

What’s more, when considering actuality and value creation and responsibility and such – especially in regard to shareholders who rank senior in the cap table – we are dealing in continuity. No one but miners and oil drillers seeks to finance a depleting asset, and as value is mainly in the exit for most – whatever form this may take – the pressure to build value grows with each successive money flow: each exit is somebody else’s entry. The expectations never end: Post-money and post-money and post-money… from what was once an unfunded idea, full of unrealized potential and all option value.

There is now talk about a cash crunch for startups. Data has been published that shows both new venture funds raised and available liquidity in existing funds to have diminished. The class of seedlings coming out of 2009 and 2010 will soon confront this situation, if not already there. The big flood of seed capital will now squeeze into a much littler funnel, and issues like valuation, continuity, ranking, liquidity – will manifest themselves for many in a less jubilant atmosphere than before. This should not be a surprise, nor a cause for alarm, because it is part and parcel of natural business evolution and the funding that parallels it.

The only difference this time is perhaps one of proportion, but the idea of seed moving on to series A is no different than the latter continuing into its B and C and D and IPO. Expectations increase each time, and for any successful business there is going to be another step ahead. (There has been talk lately, for example, about the combination of two media titans, both of which could use a boost in stock price. This combination will result in much redundant expense being eliminated. If such a merger is consummated, shareholder value will immediately be created. And then what? How does the second day post-merger look?)

There has been a tendency in the past several years – as entrepreneurship has grown and seed capital with it – to emphasize execution above all else. This is legitimate enough, but it is wrong to emphasize execution too narrowly, just as it is wrong to define value and money raised in a limited way that stops with a particular closing. Execution and strategy go hand in hand, and both are circularly tied to finance. Within reason, a long-term perspective is imperative to all three, which are perhaps really the same. In an environment determined by change, it is a tall order to act on this unity in concert. But that, in the end, is what value creation means, for small as well as big and all points in between.

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Adaptation of perspective along the evolutionary path

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To understand a complex system it is sometimes useful to isolate its characteristics in a simplified example and let the imagination wonder from there. Recognizing that enterprise, economies, and markets are highly complex and intertwined systems, let’s investigate two simplified extremes – at polar ends of a continuum – and proceed to draw conclusions.

Let’s assume that there are two types of enterprise: the pure startup and the perfectly mature. The pure startup is made up of pure possibility and nothing actual, and the perfectly mature enterprise is completely actual and has no potential outside of that. At one extreme, thus, all value is option value, and at the other the business value is the value of the underlying asset (in its most fundamental state). The pure startup represents the most speculative form of equity and will be funded with the most flexible form of capital, and the mature asset will be funded with debt because it is completely predictable and has no upside at all.

Beyond this, the two isolated ends of the described enterprise continuum also differ in operational and strategic ways. There is, for example, a difference in management style required – as has been touched upon in a previous article here – with vision and leadership ranking high for the startup, where nimbleness, competitive positioning, and direction in a volatile scenario are all critical to growth. For the mature business, pure operating management and maintenance of the status quo are the necessary executive objectives. The respective management teams will accordingly require different types of boards, different forms of advice, and different offerings from its assorted service providers: On one hand a highly strategic, forward looking, aggressive and anticipatory approach; and on the other a conservative method based on historical observation, predetermined formulas, and careful asset conservation. To state this slightly differently, the difference is between entry and exit.

Now, while there are countless real examples of the two extreme scenarios, the vast majority of enterprise is likely to fall at one point or another in between. At such points there will be greater or lesser emphasis – combinations and permutations – of the characteristics described above. Depending on where an enterprise exists along the trajectory from entry to exit, as it were, it will have to be analyzed, managed, funded, and serviced accordingly. Sometimes there is a challenge in doing so effectively, because analysts, managers, funding sources and service providers are commonly only prepped and ready in one thing. This is especially true in an era of high specialization, and sometimes this disconnect is exacerbated by revolutionary changes that take place within whole sectors or, even more notably, as whole new sectors are born. To take the subject to an even higher plateau, the described nuances may even be manifest at the macro-economic level.

Regardless of one’s perspective in such matters – whether it is analytic, strategic, operational, financial, (political), or service oriented – it would be, I believe, a correct approach – maybe even the most correct – to first and foremost isolate the subject of one’s perspective and try to find its place along the evolutionary continuum. As hopefully demonstrated herein, not all such places are to be handled identically and not all such places demand cookie-cutter solutions. From a very high level looking down, one could even argue that our global economy, our technology, and our capital markets, are at a general point that is closer to the startup extreme – and all this signifies – than the other. The greatest mistake anyone can make – assuming one has an interest in the subject – is to fail to recognize this reality. Consequences and repercussions are multiple.

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Growth is not actually change, and speed is not actually innovation

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Some of us can remember the market crash of 1987. A recent college graduate, bright eyed and bushy tailed, eager to learn from peers and many levels of superiors, with Wall Street Journal ink stains on my hands around the clock, my desk at the time was with a group of others like me, next to institutional salespeople on a mid-sized floor by current standards. The manager, who was wise, had access to a computer terminal with greenish market quotes and all sorts of fine-print, but that was inaccessible to us young’uns. We had to call a special number that played a message, updated irregularly, in order to catch the latest vibe. We ran up the phone tab that day, and that was at a time when the flat-rate plan, even for local calls, had not yet been invented. There were almost no wireless phones, not even for wise managers, not even the brick-like ones that would become more widespread later, so we were frozen solid at our desks all day, dialing. Wall Street, back then, was almost a cottage industry.

That’s an exaggeration, but only a mild one. The balance sheets of the biggest banks, as I recall, bumped up against $100 billion. For the RJR Nabisco deal to get done the bank syndicate was the whole finance SIC code. The whole industry, more or less, was a co-manager and got league table credit. That was in the early days of league table credit, but Wall Street firms were inventive that way right from the start. Then came the S&L crisis and we invented product with more conservative risk elements than buying companies at… ten times cash flow! (I smile as I type, we were so cute back then, so delicate.) This is how asset securitization came into existence – to strip out risks that were undue – which started out with credit card receivables and was eventually extended to other financial assets and led, eventually, to Enron and the sub-prime mortgage bubble.

That’s also an exaggeration, also a mild one. And anyway it skips over the NASDAQ bubble. That started as a dot-com phenomenon and quickly branched into other fields, including the development of what had actually been a cottage industry to that point – venture capital – transforming it to a global institutional giant. Like all things, this too passed, and this too returned, and we pretty much know the rest, even the youngest among us who may still remember 2008 and 2009 and 2010. And as I look back on these years and decades with their ebbs and cycles all the way to 1987, I can’t help but feel as though Wall Street – despite asset securitization, as mentioned, and other novelties like mechanized trading and greater global financial flows that were made possible, in no small part, by a smaller cellphone that also churns out price quotes in colorful apps – is more or less the same.

Well, that’s not entirely true, it’s probably overstated and I wouldn’t recommend a literal reading of the statement. Having lived through the changes and eras described, I am keenly aware of the differences in the segment between then and now. But by the same token it seems to me that bigger, faster, louder, is not in essence the same thing as more advanced, and, on a certain level, is not even particularly different. To explain myself more clearly, let’s take a look at the sector by way of contrast. When we think of innovation in healthcare, for example, we think of technologies and drugs that have and can lead to a complete transformation of human possibilities. When we think of innovation in energy, we think of new sources that can turn personal consumption and the geopolitical landscape on its head. In aerospace and transportation, we are contemplating space travel. And in communication and media, we wouldn’t even know where to begin as we scan the timeframe covered by this article.

In finance, on the other hand, innovation has been mostly superficial. We have introduced electronics and computing into the mix – using technology advancements made in other sectors – but the nature of the business is unchanged. We have sliced up risks in different ways, but that has only made the same balance sheets bigger. Fundamentally, Wall Street is no different from what it was in 1987, even as other sectors have evolved – in some cases to the point of becoming unrecognizable.  And yet those other segments (i.e., industry and consumerism) are what ultimately shapes banking and finance, even if Wall Street dictates capital flows. For this reason, and particularly in light of economic disruption that has impacted all categories, I expect innovation to start happening in finance and banking in much more meaningful ways ahead. I expect to see advances that mirror the era of invention and change in which we live.

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Because everything matters, lack of vision catches up

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The case is being argued again that entrepreneurship and venture investing are insulated. The turbulence that happens in markets (and otherwise) apparently does not matter, (although the good things that happen in technology, and otherwise, apparently do). Almost as if in direct response to the bubbly argumentation, almost as if to demonstrate that everything in actuality does matter, that everything is related and codependent, Standard & Poor’s has downgraded the long term debt of the U.S. Treasury for reasons both external and internal to it. The rating downgrade itself (or its consequences) is for purposes of this discussion less interesting than the rationale and the litany of issues raised by the analyst institution.

Here is a sampling, in no particular order: There is concern about the effectiveness of management, there is concern about the realization of financial assumptions, there is concern about future funding needs and market receptivity thereto, there is concern about the veracity and reliability of historical results, and there is concern about the relative quality of the asset in comparison to its peer group. In addition, the possibility has been raised that certain entities that are dependent upon the risk profile and wellbeing of the U.S. Treasury will, through a sort of domino effect, also be downgraded. These same institutions, by the way, happen to be many of the usual and customary limited partners (LPs) of venture funds and other private investing vehicles. It’s all connected you see…

Which brings us full circle back to entrepreneurship and why capital markets (and many other things) do matter. Even if it were the case that an enterprise is fully funded and is as a result no longer subject to outside whims and flows of capital sources, an enterprise functions in a broader context and is reliant on an economy for revenues, the levels of operating expenses, and the very nature of operations (technical & otherwise). Capital markets are not only a reflection of all these things, but impact them directly. Much more critically, however, an enterprise is rarely if ever fully funded. Not even the U.S. Treasury is so, apparently, let alone a seed- or venture-stage project.

This drives the argument straight to the core of where the risk and potential disingenuousness lies, of insisting that entrepreneurs should not bother about capital markets. (And we are all entrepreneurs, really; even, apparently, the Secretary of the U.S. Treasury.) As long as a business is funded by external capital – to some extent, of course, all capital is external – the markets very directly matter. Whether in relation to immediate or longer-term investment sources, whether in relation to the mood and liquidity of current investment sources (remember the Sequoia slides?), or whether just as a means of anticipating the behavior of a customer base that is itself pushed and pulled by all of the same issues, fund flows and market swings are critical. Paying attention to these, even if outside of any direct sphere of influence, is not only necessary but one of the principal criteria by which an entrepreneur (of any stage) should be measured.

Why some would insist that the capital markets are irrelevant to entrepreneurship, and especially as these are sophisticated investors making such claims, is frankly baffling. These are not investors who can guarantee the permanent funding and wellbeing of an enterprise in a manner independent of external variables. As we now understand, “guarantee” is a strong word, and no investor can firmly stand behind such a commitment in a “risk-free” manner, not even the U.S. Treasury. Investors of lesser stature ought to be more cautious handing out advice that is at best careless, and at worst cavalier swagger. There comes a point when lack of planning catches up, even for the most advanced and solid of startups.

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Entrepreneurship in the movies (3)

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It seems like a distant past, or maybe fantasy, perhaps something that only happened on screen. Entrepreneurship led its financing rather than the other way around, and entrepreneurs thought larger than a product. Take, for example, Tucker, take Howard Hughes, take that young visionary in The Social Network. Presumably these characters, as portrayed in film, had some basis in actuality. Presumably these were cases of real founders who succeeded because of big ideas, big vision, that caused capital to form. These entrepreneurs were passionate about building big businesses, rather than completing big financings, and the finance arrived on its own. In contrast, according to studies that may or may not be less fictional, entrepreneurs are now focused on the exit. Usually this means a relatively small and quick turnaround, driven by market conditions, one or two steps after funding is in place.

The differences in execution style are multiple between one case and the other. On one hand, the attention to exit is an attention to the venture community and the satisfaction of its needs. It is an approach to entrepreneurship that caters to the interests of financing sources, that seeks instruction from investors, and that requires permission more than vision. On the other hand, and in this context, the duality is also one of going public versus selling to a strategic buyer. If the ultimate goal were to build a business for the long term and to operate it independently, with a view to greatness rather than exit, that is an IPO in the making. When the IPO market is closed off one must look to M&A, and in this scenario the end-goal is different. It is closer to building a product than building an enterprise. The business acquires, the product gets bought.

It is then, to some extent, due to circumstance that entrepreneurial style may have shifted. Although IPOs are picking up, these are still only accessible by a limited sub-segment of the start-up universe. These are companies with substantial revenues, that surpassed the product stage years ago and that were committed to becoming large and robust even when others were shying away. This approach was a rare thing and as the IPO market remains an exclusive club, the entrepreneurial mind-frame still isn’t (generally speaking) molded these days for long-term independence. The issue is circular and it remains a question of building to a vision, or building to an exit.

Stripped down to the core, the issue is one of definition, as is so often the case. And by definition I also mean scope. What drives what, who drives whom, where goes how, etc. and so on. If, rather than catering to the whims of funding sources – which are fickle and short-lived – entrepreneurship (broadly speaking) would remember its permanent place, its purpose – that is to say, its nobility and beauty, its essential role in economic progress, the reward it offers to successful entrepreneurs in itself when the job is well done – then the tables may be turned, as they should be. In other words, entrepreneurship should then be the driver rather than the driven, and should be a means and an end, rather than merely the former. In this way, maybe unwittingly, new enterprise becomes both a better investment for the venture community and an exit, as it were, unto itself. The chips will fall well where they will.

This was the third in a casual series of unrelated articles. The first two are here and here.

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To have and have not in a bubble

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With one social media IPO complete and two popular web IPOs recently filed, the argument that had almost been forgotten has been remembered again. Is there or is there not a tech bubble, so it goes, and as much as we can all have a good time dissecting this tired specimen, the nature of the argument on both sides is doing more to butcher than to analyze. In the not-bubble camp, the case is more or less as follows: “With Apple trading at a multiple of about 12x trailing operating income, how can it be a bubble when LinkedIn is trading at about 400x? When in the 90s all you had to do was call yourself “dot-com” to secure a venture round, how can it now be a bubble when only a select few can raise $41 million on the basis of an almost-baked idea?” Do you see the rationale? Eh, whatever, it sounds much better when you hear it in real-time.

On the other side, the argument is no less unstable. It is presented in roughly this fashion: “When significant sums at not insignificant valuations are being offered to pure startups without too many questions asked, this is a bubble. When investors without access to financial information are fighting for private shares as though for crown jewels, this is also a bubble. When a company that is more than ten years old and still operates at a loss can expect to go public with a market cap of some $1.5 billion, this is not symbolic of rational market behavior.” Well, maybe that’s all true, it is anyway food for thought, but the mistake is not dissimilar to the opposition’s case. Namely, it is a lapse of generalization, it is an absence of finesse, it is painting with bold strokes what really warrants delicacy.

To start with the not-bubble argument demolition, comparing 2011 to 1999 in an industry segment that was born in, say, 1995 and has since progressed at unprecedented speed, is to ignore (in disturbing fashion) the relative growth opportunity, and how this evolves with time. In other words, the popular web is no longer in its infancy, and if certain investors are now clamoring to inject tens of millions into few new ideas – that are imitations of others that are themselves less than groundbreaking – this is not a phenomenon to take lightly. It speaks to a maturity in the innovation cycle, and a potential failure by some to acknowledge its reality (while others make up for small target-zones with flavor-of-the-month focus). Comparison of the past era to the current is nostalgia at best. Apple trades at the multiple it does for a reason.

On the other hand, the counter-argument (i.e., in support of a tech bubble) is not correct simply because the not-bubble crowd is wrong, or at least wrong in the rationale presented. The reality out there in the trenches is that the market’s love affair with LinkedIn and Facebook – and others of similar marquee profile – does not spill over into the second tier. At least not universally. On secondary private exchanges, it’s still a core handful of names that attract attention to the trade, and in post-startup venture capital it is for most still a hard and heavy push to raise the next round or the one after. We read about the glamorous successes, but there is a large and growing crowd that is not nearly as well covered… and that’s simply because there isn’t a whole lot to read about.

The subject of a bubble, or not-bubble, and the distinction between a bubble and a herd, have been written about here – as almost everywhere – before. As the weeks roll on and the theme has had time to gel, increasingly it seems that the argument should not be one of bubbles, but rather about haves and have-nots. This is a topic that has been extensively dealt with in areas of economics, politics, general market flows, and so on, but not much (if at all) in relation to technology investing and its drivers. When we point to a tech bubble that seems to be in the making, we are really pointing to the haves. When we point in the other direction, we are usually using the have-nots for evidence. As the IPO market is starting to blossom, as secondary private trade and seed investing continue to forge ahead, the chasm between the two sides is growing. This is the more important issue, and one that warrants more extensive study than some light and easy back-and-forth between apples and oranges leading nowhere.

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Public signals for private markets to watch

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So, let’s assume that the stock of a certain company nearly tripled in value on the day of its IPO, in relation to where the stock had been trading on private exchanges in prior weeks, because of a discount rate differential. Let’s assume that the breadth and depth of liquidity in the public market are so vast, compared to the private market, that the same risk can be discounted at a fraction of the private hurdle rate. If the risk-free rate is, say, 2.5% (about the 7-year treasury), then the risk premium for a public stock would have to be considerable to even come close to a private market benchmark of 20-25% – not atypical for a later-stage venture.

Whether private investors actually spend much time calculating betas and risk-free rates is debatable, but if the assumptions illustrating the preceding paragraph are more or less reasonable, then the liquidity premium that investors have paid (or illiquidity discount they’ve applied) is sizable nowadays. And this could explain the sizable pop at the time of a major IPO, even on the heels of an active private market and when nothing about the company’s operations was known to change. How much longer will this differential survive?

As all good things must come to pass in an efficient market, it stands to reason that the illiquidity discount described will evaporate – at least for those private stocks most likely to go public – if the general hypothesis laid out is correct. And as the private secondary market is becoming increasingly efficient, one would expect the shares of the next IPO candidates in line to surge in coming weeks. (The situation could turn even more interesting if such a rise in valuation were to extend beyond the immediate IPO prospects to the more distant, or further still, rippling out to companies for whom an IPO is still a remote outcome.)

None of this is unusual, of course, as public valuations have always served as a benchmark for private ones, and there has been a trickle-down or trickle-up of sorts, depending on perspective, in all capital markets. There is one circumstance, however, that does make a difference in the current state of affairs, namely that the state is in important ways unnatural. If the original premise of this article holds true, that both the risk-free rate and equity risk premiums are exceedingly low these days, and if this is largely due to an artificial infusion of money into markets (QE2), then it is by the same token possible that all the trickling – of whatever upward or downward variety – will reverse when (if) the source of liquidity is cut off.

Many have argued about the impact on public markets of such an event. Now that the bridge between the public and the private has been solidified, now that the two realms have come closer as a result of secondary private (quasi-public) trade, the argument should accordingly expand. There are only another few weeks to go until $100 billion of fresh liquidity will no longer cascade into the public market every month. The broader indices have maybe already begun to pay homage to the departure. LinkedIn, on the other hand, has shown tremendous resilience around its stratospheric debut. If one of these two public dynamics breaks, one way or the other, we’ll have an important clue about private market direction in the foreseeable future.

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Beyond the secondary one-off trade

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The virtue of secondary private markets seems to be in their IPO semblance. Rather, this is the virtue we anticipate, should the pattern and trajectory continue. It is a new phenomenon, however, and so perhaps it is too soon to draw conclusions. On one hand, the popularity of these private exchanges (and bulletin boards) has grown with the rising popularity of its participants – the canonical names in the Internet investment lexicon – Facebook and LinkedIn, for instance. On the other hand, LinkedIn is about to price its IPO and Facebook is interviewing bankers to do the same, suggesting that this imitative private alternative will only go so far, despite wonderful liquidity both companies have discovered there – and outside the scrutiny of regulators.

In an IPO market where none but the very big and established have access, and which only the very profitable can justify as a recurring operational expense, secondary private exchanges provide an efficient liquidity option for minority interests. In theory, companies that could have gone public through the traditional route in prior years, or companies that still could but for whatever reason don’t want to, can imitate the activity on secondary markets. This is nice for their shareholders, and it is for shareholders that companies accessing these exchanges are opting to do so. But whether such access is also nice for the underlying enterprise – in the way that an IPO may be – that is a different question altogether.

From what we seem to know so far, the answer is murky and mainly depends on priorities and investor composition and distance from an actual IPO. Without getting too deep into subjects already discussed at length in other places, the principal reason for a company to assist with the secondary private trade of its stock – as it must do for the deal to be consummated – is to facilitate the liquidity of employees. A reason that may be as important, if less discussed, is the facilitating of liquidity for venture capital (and the like). Depending on amounts involved in either of these reasons, and the roles of the interested parties, the histories and circumstance, motivating factors, transaction costs, incoming shareholders, and much else, the deal may or may not, in the last analysis, make sense.

But this is only the beginning of the thought. Setting aside issues of information flow and unequal access between buyers and sellers in an unregulated market – matters with which the enterprise does need to concern itself on certain levels of propriety, if not legality, and so on – there is a conceptual issue that is much more pertinent to the business and its long-term strategy: The deal, as it were, is one-off. Unlike a strategic sale, that (at least in theory) adds lasting value to both buyer and seller (and others), and unlike an IPO that opens up a new frontier underpinned by market-making, research support, and – at some price – immediate and inexpensive action for shareholders liquidity, a private trade is simply that, one trade. The next one is independent, if and when it is.

In other words, there is an accommodation taking place that may be just for the sake of it, an accommodation and nothing more. Yes, liquidity to some shareholders does have its eventual value to the enterprise; but for the secondary private market to thrive and position itself as a true and long-term alternative to IPOs – so that LinkedIn if not Facebook, and certainly Twitter, feel no need to ever leave its circle – what needs to happen is for the action to become repeatable and swift. Perhaps some of this is incumbent on the perfection of boilerplate mechanics, certainly the continuous availability of trade liquidity, and quality research (and a clear regulatory direction). But even more than that, I think, for private exchanges to more truly resemble their public counterparts, these have to become a mechanism for raising primary capital. The trade, then, will be more than a gesture of goodwill. That’s always important.

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A finance purist’s view of artificial markets

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A bubble can only exist in a market. To debate the existence of a value bubble is to presuppose the existence of a market. In a market, motivated buyers and motivated sellers meet, and the more fragmented this market – the deeper and more liquid – the more efficient it is. That is to say, it’s more true, it’s more indicative of buyers’ and sellers’ motivation. (This would not negate the possibility of a bubble, on the contrary, it makes a bubble true.) What we have now, what we have had for some time, is a false market.

Here is the view of one legendary fund manager on the subject: “‘It’s not a free market. It’s not a clean market.’ The Federal Reserve is doing much of the buying of Treasury bonds lately through its ‘quantitative easing’ (QE) program, he points out. ‘The market isn’t saying anything about the future. It’s saying there’s a phony buyer of $19 billion of Treasurys a week.’” Although this observer is referring to the debt market, there are ripple effects. The Fed’s bond purchases is money added to the financial system, and while the complexities of bank capital accounting, currency exchange, money supply measures, and high-frequency trading are too much for the human mind to grasp, especially in unison, $100 billion of artificial supply added each month is straightforward.

And it’s no joke. For perspective, consider: Sequoia’s latest fund, large in its peer group, is $1.3 billion; Apple’s cash balances (as of the latest quarter-end) were about $30 billion; Google’s operating cash flow in the same period was roughly $3 billion; BoNY Mellon’s total balance sheet at the end of 2010 was almost $250 billion. When we think about $100 billion of new investing liquidity added to the system monthly, we are thinking in the realm of almost 100 new Sequoias, a whole bunch of Apples, several dozen Googles – monthly – and a major new bank every quarter. With a small pause in the middle of 2010, it’s been two years now.

In the opinion of another prominent money manager, the Fed’s policy is to promote “good inflation” – or, stated differently, a run-up in stocks – which was of course no secret from the very outset of QE2. (The plan has worked.) That this truly constitutes “good inflation,” however, is to argue that an artificial market, a manipulated market, is a good thing for as long as price levels rise. Far be it from me to speak against rising stock prices, but a false market renders these meaningless, no? I don’t mean that statement, obviously, to diminish actual trades and actual investments made for actual dollars at actual valuations. But in a market in which price levels and liquidity flows are unnatural, there are artificial ripples that lead to fragile consequences and the risk of flawed decisions, that are also actual.

Again, the point here is not to bring up bubbles, because peripheral traits of unreal markets are also illusive, and at least according to my idealistic definition this market is unreal. Raised to believe in market efficiency, educated in the capital asset pricing model, modern portfolio theory, discounted cash flows, weighted average cost of capital, alphas and betas, leveraged betas, and so on, I suppose I am a finance purist. And so my beef is not with any over- or under-valuations, but that the environment in which transactions are taking place is one in which we simply cannot know. Investment judgment, in the era of QE2, is not based on investment fundamentals, but on the analysis of QE2 and its continuation. For the sake of markets, true markets, I am rooting for the program to stop.

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