Is the return on publicly-held companies now lower?

Assume that the net average return on all companies has stayed about the same.  Yet because the wealthy are wealthier than before (economic growth plus rising inequality), they have less need to go public for reasons of liquidity.  Thus if they have private information that their private companies will remain profitable for a while longer, they will keep them private and earn those extra-normal returns.

That means on average publicly-held companies will earn lower average returns than before.  Which in turn will increase income inequality between the top one percent and the top twenty percent.  Which may in turn make this effect even stronger.

So should you buy into the Twitter IPO?


How does being wealthier imply a larger liquid asset base?

Especially if that extra wealth is in the form of equity/stock in a privately held company, it should be significantly less liquid than stock in a publicly-traded company.

I love this blog, but sometimes it can be depressing!

Interesting. Yet, is telling that the bulk of corporate law/regulatory "reform" that Progressives (who should care most about the issue you raise) have supported for the last decade has had the unintended(?) effect of discouraging the public ownership of company equity.

Rather than string assumptions together can this question not be settled empirically? What's the recent few years' relative return, public vs private?

I think this is the case even without TC food for thought.

Consider: financial reporting and accounting regulations have been making it more difficult for companies to go public (or raised the cost of going public). Ceteris peribus, fewer companies will go public. This means investors will have access to fewer businesses; the same number of investors will be chasing fewer investments.

Or, as you put it, regulations are discouraging public ownership of company equity. The irony is that these regulations are supposed to help investors.

Does wealthier imply lower liquidity needs? It could imply more, that depends on the credit constraints for private equity holders.

The total return to publicly held companies is a difficult question to answer because of survivorship bias. VCs and other angel investors aren't quick to disclose when they value a company at hundreds of millions of dollars and it goes belly up. Given the lackluster return to VCs as an asset class it isn't clear that public market investors are missing out on much.

But if growing companies are now waiting to IPO to avoid Sarbanes-Oxley costs until the extra fees are a small percent of revenue then the small stock premium in the Fama French model should be disappearing, assuming it was ever anything more than an anomaly caused by bid ask spreads in illiquid stocks and arithmetic averaging.

>Given the lackluster return to VCs as an asset class

I disagree (unless I'm misunderstanding your wording). I was under the impression that VCs usually enjoy a relatively high rate of return. Sure, many small companies/startups go belly up, but the ones that don't have returns that justify the high risk. A VC might put $100,000 each into 50 different software startups, and see 48 of them flop but the two that survive go on to see that investment equity grow to $50,000,000 each.

Of course not all VC investments are software startups, but the example still stands, with less extreme risk/reward numbers, for other forms of business. If VC type investments didn't statistically provide a high rate of return, then (rational) VC's would not invest in them, due to their high risk.

Well when there is disagreement we should look to the data. The data is relatively sparse - see here for VC as an asset class from a relatively large foundation:

There are some top firms that do really well, but if you aren't invested in the top quartile of VCs you are likely losing money and definitely under-performing the market.

There are some sources that show really good returns, but these are often from VC trade groups who want to encourage capital allocators to increase their exposure to the asset class.

Page 14 on that report confirms that VC returns in the EU have been pretty dismal too: VCs appear to invest to earn other factors than return (warm glow, tax breaks, whatever)

Under SEC rules, once a company has a certain number of securityholders, which for this purpose includes those who have employee stock options and restricted stock, the company must begin filing reports under the SEC rules. This was one of the reasons that Facebook went public when it did. In addition, the rules governing disclosures to employees who receive stock options only allow a limited dollar value to be granted each year before a registration with the SEC is made. (Google ran into this issue.) At some point, it is difficult, though not impossible, to have a modern compensation program and to remain private, once a certain scale in operations and employment is reached. Twitter in particular faces these issues, because the employee talent it seeks expects equity compensation.

Yes, there are constraints, but didn't Facebook get them greatly lifted? I doubt Twitter yet faces them.

Stock appreciation rights plans (among other models) allow a private firm to compensate employees in proportion to the company's health without running into SEC filing rules.

It should be noted that the JOBS Act made it possible to stay private significantly longer--e.g., it increased the shareholder limit from 500 to 2000.

Your premise is not exactly clear to me, but I think you are wondering if business owners/investors are less inclined today to go public than at some point in the past. I think we have the answer is a few places. One is the use of debt to buy back shares in order to prop up share prices. When you can borrow at near-zero, you are more inclined to take on debt than when the costs are close to historical averages. This would impact the decision to go public as well. The early investors could sell their some portion of their shares back to the company, which borrows to finance the transaction.

So should you buy into the Twitter IPO?

Regulators forbid you bereft simpletons from exercising that choice, buy public shares or don't buy shares at all. You didn't want those founder shares of Facebook anyway, so we nudged you into an Emerging Economies Growth fund.

This is a possible explanation to Kaplan/Schoar on the persistence of above-average private equity returns vs. the market.... but not a very compelling one.

Public equity holders are not stupid. If the risk doesn't justify the return, fewer buyers will emerge for the IPO - and the price will fall. What's so distressing about this post is that Tyler's argument is the same logic inherent in many of our worst securities laws (Private owners strip value from the company and then go public... duping the poor dunce's that run some of the world's largest investment services). Frank Easterbrook and Daniel Fischel are my favorite commentators on this fallacy - though there are plenty others out there.

Tyrone? Is that you?

Oh please give me break. Assume this, assume that.

If one were empirical about this hypothesis one would get off ones duff and look at Census NAICS establishment data and IRS establishment data and also look at compustat data, or even look at Funk and Scott's directories.

But, no lets just speculate

An intriguing hypothesis at first glance: public financial markets as markets for lemons. What would we need to believe for this to be true?
- None of CAPM, Fama/French, or Miller-Modigliani hold
- The public actually demands a lower return to participate in a broken market. Do used cars of uncertain quality tend to sell at above intrinsic value (high price = low returns)?
- Arbitrage between public and private markets is possible
- The liquidity premium is negative (i.e., liquid assets earn higher returns than illiquid assets)

What am I missing?

This seems reasonable amongst high wealth investors/companies. But because of this wealth stratification issue, the reverse is also true. There are more low net worth individuals, and assuming the pool of good ideas is more evenly distributed than the distribution of wealth or income... that might mean that many individuals will have good ideas for companies or products and still be looking investment through all sorts of investment avenues like venture capital, IPO's, etc.

I think there's a more significant reason why Internet companies wait longer to go public - which is that they tend to be pretty cheap to run. Their main expense is their talent and they can largely pay them in stock. Capital needs are relatively small.

The answer is 'no', right?

Twitter IPO is bette than the alternative!

I would guess the opposite. If demand for liquidity has gone down (which I'm not necessarily saying is the case), then so should the liquidity premium for owning private equity. Fewer IPOs corresponds to fewer investors selling (previously, before the IPO) private equity and using the proceeds to bid up the price of public equity. Thus, relative to the case of more IPOs, the valuation discount of private equity relative to public equity would be less and, hence, so would the expected return spread of private equity over public equity. It would be a strange result if the less investors cared about liquidity the more they earned for holding illiquid assets. The inequality angle here is a red herring by the way.

The funniest event was when that private equity firm went public.

Since almost all large-cap companies are public, an increase in information adversity on public/private status should more significantly impact the returns to small-caps. This would entail a diminishing or reversal of the traditional excess return associated with small caps. I.e. people who believe this hypothesis should invest heavily in blue-chips.

Yes you should buy. Twitter is planning on a relatively small IPO - only 10% of Twitter stock is being put up for sale, which suggests that Twitter founders are still interested in keeping a large amount of the stock.

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