A crazy market called ‘Private Placements’

Do you remember the times when IPOs were the rage in India? The broker would whisper to you a few months before the proposed issue, that the shares are available directly from the promoter’s holdings, the so-called management quota, which offers assured allotment. The IPO is a lottery, you may or may not get the shares, if you get them you may get too few, this is an opportunity not to be missed, such things don’t come around too often, everyone is making money look at the previous issue from the same promoters, the fact that he is under investigation by the CBI is proof that he’s made so much money that the politicians are jealous of him’… You rush to subscribe since you don’t want to miss out.
People who missed the Google IPO at $85 are feeling pretty miserable today since they don’t want to miss the next big thing – Google’s shares are quoting above $600. If you missed out the recent Coal India IPO you will be feeling a little left out. Never mind the several other IPO’s that tanked. Human memory is short on failures and long on successes. On hindsight, we always see ourselves picking out the winners.
Venture Capital and Private Equity firms invest in companies before they go public. They keep looking for companies that are run by committed promoters, have a good idea that has great potential, have already shown that the product has takers, have exhausted their initial funds, are not yet ready for an IPO, and are desperate for additional funding to see them through till the IPO. The VC takes a substantial stake and gives the company a new lease of life. Whether the company will succeed or not is still uncertain, but if it does the VC makes multiple times his investment. The VC gets in at a reasonable valuation, and cashes out at the IPO. For every five investments he makes, he expects two to tank totally, two to at least return his principal, and one to do so well that it makes up for the rest.
People who invest in VC and PE firms are very clear about the risks they are taking. They are definitely expected to be in the HNI category.  Then there are the Angel Investors who enter at an even earlier stage than VC’s. Their money at stake is lower but their risks are much higher. All these investors do a lot of Due Diligence, including sending a team of marketing, accounting, finance, and legal experts to rip apart the company’s books and rip open the promoters’ brains, before taking the call to invest. The company’s financials, mind you, are not available in the public domain since it is not listed.
And then there is the IPO and the post IPO secondary market. This is where the early guys cash out, and the public boards the bus. Considering that it is now a public company where a lot of uninformed guys like you and me invest, widows put in their pension money, etc. the degree of disclosure is mandated at a far higher level by law. There is a whole ecosystem of analysts and reporters who mine the company’s accounts for information and write informed pieces for the larger audience.
The system, with all its kinks and flaws, seems fair. At least on the surface. Till Facebook happened; and Zynga, Groupon, and Linkedin.  Facebook and Linkedin are “social” companies that need no introduction; Groupon is a “social” site that gets people together to buy things by driving better bargains; Zynga is the gaming company that is behind the “social” games like Farmville, Mafia Wars, and the like. Facebook has 500 million subscribers today – if it were a country it would be the third largest after India and China – and it is growing. Groupon just refused a $ 6 billion buyout offer from Google (that’s Rupees 25000 crores). Zynga’s games are spreading faster than any virus, and show signs of staying in the human system far longer. All very successful, and all following the latest theme of “social networking”. Reminds us of the 90’s  when dotcom was the rage.
And all of them are yet to come out with their IPO’s. They are run by their promoters – usually kids just out of college which is not to take away from their genius – who still exercise total control, have a few employees, a lot of server farms, and zillions of column centimeters in the media. Their total investments in the venture thus far would be in the region of a few (ok maybe a few hundred) million dollars – definitely nowhere near even a billion.
They are sitting on a gold mine. How do they cash out? They can go in for an IPO and sell part of their stake and still retain control and net a few billion each.  But this involves greater disclosure, more scrutiny, and more accountability to the public. They will get there eventually, but every promoter is reluctant for obvious reasons.
They could invite VC’s or PE’s who will descend with their lawyers and accountants and dig into the innards before they put in their money; and they are savvy investors who can afford the experts’ fees.  They can’t sell to too many of them of course; SEC rules stipulate that any company that has above 500 investors will have to comply with higher disclosure norms irrespective of whether it is listed or not. And a lot of employees in these companies already have stocks; some of them have even sold their stakes to others.
Or they could do something in-between that enables them to have the cake and eat it too. Facebook has got in touch with smart merchant bankers. They are creating an investment fund, or Special Purpose Vehicle (SPV), call it what you will, for investors to put in their money so that it can be invested in Facebook. There are hundreds of investors at the backend but the tally for SEC purposes is just one, since the “vehicle” is shown as the investor. Facebook has just raised $ 2 billion through this route. The problem is, this is based on zero public disclosure, no one knows what they are getting into, the  investors into those vehicles are funds which handle other people’s money (people like you and me), they are investing on a faith and a promise, and a lot of hype. The implied valuation of Facebook based on the current placements is $ 50 billion dollars, which is a lot of money if you come to think of it. Considering the fact that Facebook just issued $ 120 million to a PE investor Elevation Partners six months back at an implied valuation of $ 14 billion things look definitely scary.
There is a lot of criticism. The SEC is investigating, but current laws seem insufficient to deal with this. People are asking questions as to how this can happen. But the merchant bankers are unfazed. They are saying things like this gives an opportunity to people to get in early, it broadens the market, it deepens the market, it is akin to late stage private equity investment, it is good for the economy, it is good for the entrepreneur, and so on. But merchant bankers are known to be masters of spin, quite unscrupulous, and very thick skinned.
Linkedin, Groupon, and Zynga – it’s a similar story out there.
Where will this go and end? Let us watch developments. At the pace at which events unfold nowadays, the denouement cannot be far away.
 Anyone betting on a repeat crash like what happened during the dotcom or the subprime?

By Dinesh Gopalan
Fidelity India Finance
Bangalore

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