Wednesday, January 5, 2011

What Goldman Sachs Gets

William D. Cohan, writing in The New York Times, has an op-ed talking about what Goldman will gain from the Facebook deal. While some of it is speculation at this point, it does hold water logically.

He talks about Facebook, it's valuation in this pre-IPO period, and the likely unsustainable valuation of the company. He also talks a little about the potential conflict of interests for the myriad of roles Goldman Sachs could play as the exclusive I-bank for Facebook (and likely Mr. Zuckerberg). If Goldman Sachs wins from this deal, who loses? "The average investor, of course, who will get stuck holding the bag when, someday, Wall Street realizes the firm's financial performance doesn't lived up to its hyped valuation."

Perhaps unethical was the wrong word, but this seems like the worst of the markets at work in a lot of different ways.

12 comments:

Colin said...

Of course, there is an easy solution for all this: don't buy the stock when it goes public. If you think it is overvalued, don't invest in it. Problem solved.

And again I will note the role the SEC plays in creating this situation, with its limit to 500 investors. If there were no limits the average investor would be able to get in on the ground floor. Instead, due to regulation, only the wealthy and well-connected may apply.

Ben said...

Of course, there is an easy solution for all this: don't buy the stock when it goes public. If you think it is overvalued, don't invest in it. Problem solved.

That's a nice notion but in practice it doesn't really work. IPOs are generally purchased not by individual investors but by institutional investors, like managed funds. Often, the individual investors that invest in managed funds have no ex ante control over what stocks are purchased by those funds. In this way, the individual cannot, as you suggest, simply not invest in the overvalued stock.

If there were no limits the average investor would be able to get in on the ground floor.

This is a rather tortured argument. The 500 investor number carves out a safe harbor from regulation designed to provide investors (individual and institutional) with reasonable information about a company seeking investors. Recognizing the burden of regulatory compliance, the Exchange Act allows companies with fewer than 500 investors to avoid compliance, presuming that smally held companies are closely held companies, reducing the information disparity problem giving rise to regulation in the first place. There are two possible solutions to this "problem": (1) Do away with the safeharbor and impose compliance obligations on all companies; or (2) Do away with the regulation wholesale.

The disadvantages of 1 are the very reasons for the safeharbor in the first places. The disadvantages of 2 are a return to investor-investee information disparity and, likely, fraud. It seems to me that both of these are bad alternatives.

The 500 investor test may be a poor test for determining whether a company is public today, but requiring public companies to make disclosures is good, both for investors and for markets.

Colin said...

That's a nice notion but in practice it doesn't really work. IPOs are generally purchased not by individual investors but by institutional investors, like managed funds. Often, the individual investors that invest in managed funds have no ex ante control over what stocks are purchased by those funds. In this way, the individual cannot, as you suggest, simply not invest in the overvalued stock.

Easily remedied as well -- if your fund invests in Facebook, get out. Or you can be like me and only invest in index funds, of which Facebook is unlikely to be a part.

The disadvantages of 2 are a return to investor-investee information disparity and, likely, fraud. It seems to me that both of these are bad alternatives.

If you don't think you are getting enough information from the company -- don't invest in it! What an easily solved problem. Fraud, meanwhile, is a different animal, as it implies giving someone bad information, not no information.

requiring public companies to make disclosures is good, both for investors and for markets.

Why is it good? Shouldn't that be up to the equity purchaser to decide? Why is it up to the government to determine?

Ben said...


Easily remedied as well -- if your fund invests in Facebook, get out. Or you can be like me and only invest in index funds, of which Facebook is unlikely to be a part.


As I said, there is no ex ante control. Is that not the point of choice?

Why is it good? Shouldn't that be up to the equity purchaser to decide? Why is it up to the government to determine?

Mandatory disclosure is good because it injects greater information into the market. It is also more efficient--companies are better positioned to disclose information about themselves (to which they have ready access) than customers/investors are to cull the information from otherwise recalcitrant companies; it further reduces duplication of efforts on the part of investors. Moreover, it encourages efficient markets by releasing information all at once and to the whole market, rather than piecemeal or to only select investors.

Greater information that is required to be correct (that is, not a misrepresentation) encourages investor confidence and increases capital market liquidity. It also reduces cost to companies by taking away the prisoner's dilemma of information disclosure inherent in a market not subject to mandatory disclosures.

Colin said...

As I said, there is no ex ante control. Is that not the point of choice?

But you DO have a choice. If you invest in an actively managed fund you run the risk of the fund manager investing in equities you don't like. That's the nature of the beast -- and a big reason I don't put my money in such funds. Other people can do the same. There is no problem here.

Mandatory disclosure is good because it injects greater information into the market.

If information is good, then investors will demand it and the market will provide it without government regulations. Frankly, I think anyone who invests in something without taking a look at the books is a fool, but if they want to do so it is their money and their right.

Again, this is no one else's business. The purchasing of equities is an consensual act between adults. If they feel the information being provided is insufficient they have no obligation to make the purchase. The government is injecting itself in an area where it is not needed.

The entire presumption here -- that the government knows better than the investors and entities that actually operate in capital markets -- is ridiculous and insulting.

Ben said...

Colin, many--if not most--people don't have a choice whether to invest in these funds. They are part of their retirement package, chosen by their employer, and leaving only the remotest choice of whether to accept employment with that employer. This hardly constitutes the real choice that under girds the market.

Your last few points are just idealistic and hardly reflective of the real world. I encourage you to read Choi & Pritchard, Securities Regulation for an excellent, even handed discussion of US securities regulation, the reasons for it and the problems associated with it.

Ben said...

A serious question for you, Colin: Is there ever a situation in which you favor--or, if not favor, recognize the utility of--regulation?

Ben said...

Additionally, how do you feel about insider trading?

Colin said...

Colin, many--if not most--people don't have a choice whether to invest in these funds. They are part of their retirement package, chosen by their employer, and leaving only the remotest choice of whether to accept employment with that employer. This hardly constitutes the real choice that under girds the market.

I had a defined benefit retirement program at my first job, which is increasingly rare. The investment company invested the money as it saw fit and when I left the company I was given a payout that was rolled into an IRA. I have no idea how that money was invested. Plenty of ridiculous decisions could have been made. But guess what -- until the money was deposited in my bank it didn't belong to me. Therefore you can't complain about the management of money that doesn't yet belong to you.

However, more and more companies do not offer retirement benefits, instead giving 401k matches that are invested by the employee themselves. I have been part of two 401k plans and helped my GF with hers. I still have yet to find one that does not offer index funds as an option.

It is still not apparent to me why this is some kind of problem.

A serious question for you, Colin: Is there ever a situation in which you favor--or, if not favor, recognize the utility of--regulation?

Sure. I have no problem with many kinds of environmental regulation. I don't think people should be free to pollute the air I breathe or water I drink at will. I also favor regulations to protect animals, such as on chicken farms to ensure that chickens are given certain space inside their cages for example.

I just don't see the point of regulating the actions between consenting adults, such as the purchase of equities.

As for insider trading, I agree with Milton Friedman's argument that it is useful as it helps to generate more information for investors. If you think that it makes the stock marget a rigged game, don't participate.

Ben said...

The investment company invested the money as it saw fit and when I left the company I was given a payout that was rolled into an IRA. I have no idea how that money was invested. Plenty of ridiculous decisions could have been made. But guess what -- until the money was deposited in my bank it didn't belong to me.

That isn't true. You have a vested property interest in your retirement account. It most certainly belongs to you.

Additionally, I'm certain that you considered your retirement plan to be part of your compensation package--as you would any other benefit--so this strikes me as an exceedingly strange statement.

Colin said...

That isn't true. You have a vested property interest in your retirement account. It most certainly belongs to you.

No, it didn't belong to me. Having an interest in something and it actually belonging to you are not one and the same.

You should further note that the plan was, as I previously stated, a defined benefit plan, meaning that my payout wasn't related to the fund's performance. They could have invested everything in Pets.com and I still would have received the same payout with my employer on the hook for making up any difference.

Ben said...

Sorry, missed the defined benefit note.

You should note that I was discussing a vested as opposed to a contingent interest. The distinction is relevant and, it results in ownership that I think most anyone would consider "belonging," though that word is terribly imprecise--particularly in the retirement fund context where a vested interest places the funds provided by the employer beyond the reach of the employer's creditors.