Twitter, J.P. Morgan, and the Future of Capitalism

Let me admit my bias right here: I don't “get” Twitter. This isn't just because I'm too old. My teenage daughter, Isabel, tells me she thinks it's pointless and that none of her friends use it. I also don't see how Twitter will ever make money, though it's certain that some of the best minds in Silicon Valley are already working on that problem. But this article isn't about any of that.

Echoing Goldman Sachs's investment in Facebook in January, which gave that company a notional value of $50 billion (which has subsequently risen to $70 billion in the secondary market), it was announced today that J.P. Morgan's Digital Growth Fund is in negotiations to buy a 10% stake in Twitter for $450 million. The J.P. Morgan fund, which has raised $1.22 billion of a planned $1.3 billion, also has its eyes on potential investments in Skype, the telephony provider, and in Zygna, a games maker. Any or all of these investments could lead a few years hence either to outsize profits or to people scratching their heads and muttering, “What were they thinking?”

None of this should normally be of any concern to anyone but the shareholders and investors in the target companies and in the banks and funds buying the shares, but there is something not quite normal going on here. In both the Goldman/Facebook and the anticipated J.P. Morgan/Twitter transactions, the purchased shares will be made available only to a tiny handful of very wealthy investors. The J.P. Morgan fund, for example, will have a maximum of 480 investors, which works out to an average investment of $2.7 million each. Although an initial public offering (IPO) for both companies is planned, with Goldman Sachs and J.P. Morgan having the inside track to manage the IPOs and reap the enormous advisory fees and commissions, there is no certainty as to what percentage of these companies will actually be floated, and what proportion will remain in the hands of the banks and their wealthy fund investors. It is possible – even probable –  that a majority of the ownership of these companies will remain vested with a very small group of people. Though a secondary market will certainly develop to allow these initial investors to dispose of their shares, it is also likely that activity in this market will consist primarily of private sales to other wealthy insiders.

Let's not be naïve; wealthy and well-connected investors have always had access to investment opportunities the rest of us don't even know about, and nothing will change that. But if Twitter- and Facebook-style investment arrangements become more widespread, it could undermine American capitalism, which for  the past hundred years has been based on the modern public corporation in which no individual or institution owns more than a few percent of the whole.  It's common nowadays for institutional investors to own well over 50% of big U.S. corporations, but even among these investors ownership is highly diversified. In very few Fortune 500 companies does a single institution or family group own more than five per cent of the outstanding shares or exercise control via a special class of shares (Ford Motor Company, in which the Ford family owns just 6% of the company but controls 40% of the voting shares is one of a very few exceptions). Even Bill Gates owns only seven percent of Microsoft. This model is now under threat.

As regular readers of this blog know, I am a capitalist. Capitalism, especially when it is based on widespread ownership and freely traded shares and debt instruments of large public companies, is the best way mankind has yet found to allocate capital to its most productive use. Anyone who doubts this can look at the legion of countries in which some form of central planning – Marxist, fascist, Peronist, or just plain old dictators and their cronies – has prevailed.

Stock markets – though we now recognize that markets are not perfectly efficient – have been a vital way for companies to raise capital. The link between the stock market and the real economy, in which companies and people produce and sell goods and services, has traditionally been strong. This is vital, since financial markets rest on an uneasy compromise: corporations and their financial advisors can make as much money as they want as long as everyone else has the opportunity to share in that wealth. The public shares in the wealth in a variety of ways, the most important of which is employment income and associated benefits. The public also shares in the wealth by having the opportunity to invest its savings in those same corporations. If this link is broken, public support for capitalism will wane, and the United States could go the way of Argentina.

Already, the signs are ominous. In 1961, individual investors accounted for 62% of the total value traded on the NYSE. By 2009, this had fallen to two per cent. Block trades of 10,000 or more shares in a single transaction accounted for only three per cent of the NYSE trading volume in 1961; today they account for around 25% of total U.S. market volume. By itself, this evolution is hardly worrisome; much of it can be attributed to the rise of mutual funds and similar vehicles, which have become the preferred investments of many individual investors and which can offer better risk-adjusted returns than those less sophisticated investors could produce on their own. But accompanying this trend is the rise of high frequency trading, which now accounts for over 70% of all U.S. equity trades. High frequency trading, based on sophisticated computer algorithms, involves holding large positions for a very short time – often fractions of a second – to generate huge returns. Their practitioners argue that they provide liquidity and reduce bid-ask price spreads, which may be true, but the banks and hedge funds employing such strategies are playing with their own capital and that of wealthy investors. Your average individual investor, who may have a portfolio of a couple hundred thousand dollars or less, does not play in this sandbox.

The stock market, which has forever been likened to a casino, has truly come to resemble one, and I am not referring to the two-dollar blackjack tables in Reno. It has become much more like the exclusive, velvet-roped areas where the likes of James Bond and Asian billionaires play baccarat or high stakes poker for millions of dollars.

Felix Salmon, the Reuters financial blogger, writes in an excellent op-ed piece in the New York Times, “The stock market is becoming increasingly irrelevant — a trend that threatens the core principles of American capitalism. These days a healthy stock market doesn't mean a healthy economy, as a glance at the high unemployment rate or the low labor-market participation rate will show… What's good for Wall Street isn't necessarily good for Main Street… the glory days of publicly traded companies dominating the American business landscape may be over. The number of companies listed on the major domestic exchanges peaked in 1997 at more than 7,000, and it has been falling ever since. It's now down to about 4,000 companies, and given its steep downward trend will surely continue to shrink… Put another way, as the number of initial public offerings steadily declines, the stock market is becoming little more than a place for speculators and algorithms to compete over who can trade his way to the most money.”

Even the NYSE, the one-time flagship of the American capitalist system, is becoming marginalized, as its recent acquisition by Deutsche Börse indicates.  According to John Gapper of the Financial Times,  in 2005 79 per cent of the volume in NYSE-listed shares was traded on the exchange itself. By March 2010, that figure had fallen to 23 per cent. Gapper writes, “The NYSE has been squeezed out not only by upstart exchanges such as BATS (an electronic trading platform, established in 2005, which now ranks as the third-largest exchange in the United States) but by ‘dark pools'  – private exchanges on which institutions trade with each other in large blocks – and by banks making transactions internally. The two now account for about a third of US equity trading.”

As long as individual investors can invest in the markets and feel that everyone, big or small, is playing by more or less the same rules and that the markets are essential to the income and jobs on which we depend, capitalism will thrive. When that connection is broken, and people come to believe that capitalism is a game rigged in favor of a small elite, it won't. The alternatives to capitalism, for the most part, are too awful to contemplate, so  the markets have to be reformed – soon –  for the system to survive.