I recall a conversation I had with one of my law partners at Calfee, Halter in the early 1980’s about private companies “trading” on an exchange. He was an older and smarter securities lawyer who understood many of the nuances that were lost on his junior partner. In those days the liquidity path for a private company was a one way street-IPO your company or remain illiquid.
Better Than The IPO
Fast forward 30 years and the idea of a robust exchange for change of control for even the smallest private companies has become a reality: no need for partial IPOs, no lock ups; no S-1s; no SEC comment letters; no nights at the printers; no investor conferences; no “Qs” or” Ks” or form 4s; no worries about relational investors; and no quarterly earnings pressures. The M&A market has become a much more efficient, more liquid and less cumbersome exchange for trading control of a privately held company than the public markets.
Even more remarkable is the evolution of a host of products and markets that give liquidity to owners and creditors without transferring control. Banks, hedge funds, mezzanine funds, business development companies and family offices are all participating in minority debt and equity hybrid products where influence is contractual and not based on governance control. It is like a partial IPO without any of the infrastructure and baggage.
Systemic Risks May Be Greater In Public Markets
As I have written in other blogs, we are constantly doing a sanity check on valuation by comparing private company valuations with publicly traded peer companies. I have argued in the past that conventional valuation theory suggests a pricing disconnect between the liquid public market with endless transparency and thousands of owners and the private markets with a concentration of ownership, murky transparency and questionable franchise values. Valuation theory says that the private markets should trade at a discount for lack of marketability.
Now that I am the age of my Calfee mentor, I, too, am seeing some things differently. Like many other investors I am disillusioned by the public markets. While I have incredible respect for the discipline and rigor of public company life and the thousands of managers and service organizations that cooperate in making the US stock market the eighth wonder of the modern world, I am concerned about a few things like central bank influence, concentrated ownership in pooled vehicles like mutual funds and ETFs and illusory liquidity in times of market turbulence. It also dawns on me that the hold period for a huge swath of the accumulated wealth is getting shorter and shorter as retirements loom and savings are spent which may create some volatility. Most troubling, however, is something we know very little about—The Depository Trust Company (“DTC”) and its parent company, The Depository Trust & Clearing Company (“DTCC”).
Depositary Trust Corporation Is Not A Household Name
You know you are researching a pretty obscure topic when Wikipedia only has 4 paragraphs written about it. Normally, I would not care about DTC except that 100% of the US stock market investments exist only in book entry form (an electronic blip) with an affiliate of DTC called Cede & Company. The aggregate volume of securities that cleared through DTC and its sister companies in 2014 was 1.6 Quadrillion trades and some experts estimate that the safekeeping values at DTCC and its subsidiaries exceed $ 60 trillion. DTCC subsidiaries handle bonds, municipal securities, ETFs and money market funds. It does not appear that DTC has any domestic competitors in its expansive role of safekeeping, recordkeeping, clearing, dividend posting and collection, and proxy services. DTC is a member of The Federal Reserve System and its parent company, The Depository Trust & Clearing Corporation which owns 100% of its voting stock is owned by the NYSE and 300 companies in the financial services industry. DTCC IS A USER OWNED MONOPOLY THAT HAS NO KNOWN DOMESTIC COMPETITOR.
DTCC guarantees the trading activities of its 300 participants and, in essence, provides its own balance sheet on a short term basis to facilitate and settle the trading activity of its members. Participants must keep liquid reserves with DTC to cover problems like customer defaults and the participants have certain cross guaranty agreements which act to provide a cooperative strength to weaker participants. For example, when Lehman and MF Global failed and their assets were liquidated under supervision of a trustee, DTCC underwrote the customer accounts for which its subsidiaries were providing custody services. DTCC’s 2014 audited statements claim that there will be no losses to DTCC or its participants on account of MF Global and Lehman’s collapse but it does disclose that the magnitude of the securities that it has recovered for Lehman and MF Global exceeds $500 Billion against a DTCC net worth of $980 million at December 31, 2014. At some point in time it probably had contingent liabilities from Lehman and MF Global that were many times its net worth.
A bigger scare was Superstorm Sandy which flooded DTCC’s vaults at 55 Water Street and caused the evacuation of its 2,300 employees and suspension of operations at that site. DTCC disclosed that there was significant damage to physical securities in its vaults and DTCC issued its own IOU in the form of indemnification certificates (DTCC IOUs) to serve in the interim while the damaged securities were replaced. There were almost 100,000 of those indemnification certificates issued in 2012 which by the end of 2014 had fallen to 1,500 representing $584.0 million in lost certificates. Assuming each certificate had equal value, DTCC peak exposure for securities damaged in the flood could have been $30.84 Billion against a DTCC net worth of $980 mil for the same period.
User Owned, Undercapitalized And Systemically Important
DTCC is a Systemically Important Financial Market Utility and its regulators have determined that it is undercapitalized. It is currently in the process of raising $400 million in equity capital to shore up the inadequacies in its balance sheet. Considering it clears and custodies ALL the market activities of the US Capital Markets representing at least $60 trillion of securities (not including the notional value of derivatives which are estimated at 500 Trillion), this doesn’t seem like enough extra capital for me? Thinking about investor security reminds me that if you do not have a break wall, how can we be certain you have a firewall?
Maybe Valuation Theory Is Changing?
So returning to the PE model and the private markets, maybe this is just one more reason we are seeing institutions and families more comfortable owning an asset that manufactures something or provides an invaluable service in a less cumbersome private market with efficient pricing and vast liquidity than a market where the only trading linchpin was literally flooded out of business. They call it “Water Street” for a reason.
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