03/28/2011 05:03 pm ET Updated May 28, 2011

More on Private vs. Public

Felix Salmon has been continuing his discussion of companies avoiding public listings to stay private. I posted on this when he first wrote about the trend in The New York Times last month, and he has since picked up a variety of fellow kibitzers, including here and here; some of his commenters also have a few interesting things to say. The issue has now broadened into related issues, notably the decline in initial public offerings, particularly of startups, something Treasury's Timothy Geithner publicly started worrying about recently.

Although it's very clear that a fall-off in IPOs does translate into more startups remaining private or getting gobbled up by strategic buyers, I'm not convinced that, despite the kerfuffle over Facebook remaining private, the underlying issues are the same. A big part of the IPO problem seems to stem from a reduced appetite by U.S. venture capital investors for traditional tech startups after the dot-com bust, a shift toward mezzanine investments in more established companies and a move to place VC money overseas, particularly in Asia. That may speak more to a) the long recovery of venture investing from the dot-com bubble; b) better opportunities overseas; or c) a maturity in large tech markets, of the sort Tyler Cowan wrote about in "The Great Stagnation." The decline of IPOs is worrisome, but not for the reasons Salmon talks about: that the great mass of investing Americans will lack investment opportunities, particularly compared with plutocrats tapping hedge funds and buyout shops. It's a concern because a lack of IPOs will result in a shift toward a larger, more concentrated, less nimble corporate economy.

Salmon brings a variety of assumptions to the table. First, there are historical assumptions about a sort of glorious age when most Americans had defined-benefit plans and played in bountiful stock markets. "In America," Salmon writes, "for pretty much all of the 20th Century, and in the rest of the world today, public markets have shown themselves to be a very good thing when it comes to value creation." There's a lot there that's arguable. Salmon particularly seems to be reading back into history the bull market in stocks that began building after World War II (and that relatively few Americans took advantage of until the '80s), then continued along, with a few interruptions (some considerable, like the '70s) until the 21st century, which so far has been generally lousy. Lots of Americans reaped stock market value in the '20s, lost it in the '30s, then had to wait until the '50s to begin to catch up. Through the '50s and '60s, most shareholding was individual, but it came from a very narrow slice of upper crust society -- and it was mediated by brokers who took, by current standards, huge fixed commissions. Institutions, including pension funds, only began to buy stocks in the late '50s. The "value creation" of stocks might have existed, based on the rise of the market, but relatively few Americans got rich off it and, relative to today, there were a lot fewer public stocks to play.

As for the rest of the world, well, Salmon sees a different world than I do. Most of the world's population has probably never heard of a listed stock. There are relatively few economies that have broad and sophisticated equity cultures that are open to the great mass of people. Even Europe has only developed one in the past few decades, and given its social welfare system, participation in share ownership remains relatively small. For decades the Japanese invested regularly in postal savings accounts, not a stock market that was viewed, with good reason, as dangerously volatile and perhaps crooked. Are ordinary Russians investing in the stock market? Are the great mass of Chinese? Are Indonesians and Indians? Many of these countries have the same relationship to the stock market that America had when it was emerging: It's a kind of game for those with large amounts of disposable income. The rest of the population mostly lacks the savings, the skills and the risk profile to participate. Now it may be true that the Chinese would all like to invest regularly in the stock market because they are optimistic about the future. (A broad ownership society, in which millions own stock, does generate political repercussions that might make authoritarian governments wary: a sense of ownership, to be sure, but an increasing need to be sensitive to the personal financial needs of a mass rentier class.) But that doesn't mean investing in equities is a widespread practice.

Salmon intones the venerable mantra that stocks over the long term will outpace bonds. That is certainly true; we've all consulted our Ibbotson. But as everyone also painfully knows by now, particularly if you're approaching retirement, value creation is relative to the time frame of the individual. Stocks may be swell over the long term, but they're risky over the short term. Every 30 years or so, we seem to submerge into decade-long torpor -- or worse. And stock markets, particularly when they fall, easily get charged with being a rigged game. Often, that's actually true, particularly in markets around the world with thin floats and spotty regulation. As we know, even mature systems suffer from regulatory woes.

This leads to a second and related assumption, which is that the underlying problem of this swing toward private ownership is inequality: The rich folks get the good stuff, leaving the rest of us the dregs. This seems to me, at best, overstated, at worst, wrong. The overstated part stems from the numbers Salmon seems to believe are hiding out in the private sphere and are thus inaccessible to ordinary investors. It's true. There is a large and vigorous private equity industry out there. But it's also true that most of what occurs in private equity happens not among the biggest public companies -- that was a phenomenon of 2005 to 2007, now over -- but in the middle market. A healthy percentage of LBOs in the middle market are buyouts of already private companies. Some of these companies will eventually be acquired by large public companies, a traditional exit. Some will be sold off to other buyout shops. Others will be taken public. Indeed, the IPO market would really be moribund if not for the large numbers of PE-owned companies re-entering the public markets, including giants like HCA. One way or the other, most of these take-privates will end up as at least part of a public equity.

Again, I think there's confusion here between the dearth of tech IPOs and the growth of private equity. Their dynamics are different. A startup that gets no funding will probably never go public. A company that's LBO'd is taken out of the public ranks, but eventually will return, acquired by either a strategic buyer, undoubtedly public, or by public investors. Arguing that private equity is removing good opportunities out of the public markets is like decrying M&A for reducing the number of companies. The real problem here is not M&A or PE; it's the deficient creation and financing of new companies.

It is true that the allure of a public listing isn't what it used to be. You can blame Sarbanes-Oxley, although I think that's exaggerated; and eliminating it to grease the skids may have little effect. I would argue two other considerations come into play, particularly in a situation where there's plenty of equity capital to go around (raising the possibility that both inequality and the private economy are somehow linked to increasing affluence). They're related. First, it's corporate governance, particularly the difficulty of aligning shareholder and managerial interests and the ineffectiveness of shareholder monitoring. In short, the promise of shareholder democracy has not been fulfilled, creating, if anything, dysfunction and distraction. Second, it's compensation. Managers can make more in private situations in which shareholders are compact and aligned. Pay is almost never an issue on the private side.

To link all this to inequality also raises difficult questions. The roots of inequality are complex and much debated. The rise of private equity, not to say hedge funds and big finance, may well have contributed to that inequality. But blaming inequality on too many companies staying private -- and thus offering opportunities only for plutocrats -- is like saying the financial crisis was caused by too much compensation. The fact is there are a dozen explanations, from rapid technological change to the passing of the industrial age to an inequitable tax structure to technological maturity that may explain deepening inequality. Conversely, to tackle inequality by focusing strictly on preserving public markets to some optimal, perhaps mythical level is useless. Again, in the golden age of American equality -- the '50s -- there was little involvement, active or passive (meaning through pension funds), in the stock market for the great mass of Americans. Finance was much smaller, and while opportunities in the market were "public," they were strictly limited by income. Perhaps this is what Salmon anticipates by supporting a market transaction tax, to reduce turnover and encourage longer-term investment. The trouble here is that a smaller finance, a simpler finance, would generate less liquidity and less opportunity for everyone - and whether that would produce a more equitable society is possible, if not certain. The kind of tech creation that Salmon favors might well be diminished; innovation, which perches on the riskier end of the spectrum, might well be among the first to go. It's unfortunately easier to create equality by leveling down than by leveling up.