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Rekenthaler Report

The Problem of Swimming With the Big Fishes

Their scraps aren't necessarily nutritious.

The Investment Food Chain
Bloomberg's Matt Levine writes that, when arranging equity financing, privately held businesses prefer those investors with the deepest pockets: venture capital firms, private equity funds, and corporate buyers. For simplicity's sake, better to have several buyers than several dozen, and better yet to have only one. 

Effectively, then, the largest institutional investors have the right of first refusal. Companies seeking capital will begin by knocking on their doors. If the giants like what they see, they will make an offer. If not, the companies will move down the wealth ladder, pitching smaller institutions and/or family offices. If that doesn't work, then the companies will drop another notch, to the private equity buyer of last resort: the everyday wealth.

This process wouldn't harm the small fish if the big fish were undiscriminating. If that were the case, the merchandise that reached the bottom of the food chain would match the quality of that consumed by the top. Unfortunately for those who must await their turn, the big fish are skilled buyers. They are abundantly staffed with experienced investors, and they evaluate their potential deals more thoroughly than almost anybody does when purchasing a publicly traded stock.

As a result, writes Levine, there is "a sort of segmentation in the private markets, in which large institutions and very rich people [are] offered private opportunities that are disproportionately good and fast-growing, while just-barely-accredited people [are] offered private opportunities that are disproportionately frauds."

He continues, "On the whole, the companies with the best opportunities will probably want to raise private capital efficiently from a small group of big investors, while the companies with the worst opportunities will probably market themselves heavily to dentists." (He had better hope that his own dentist missed that column.)

The Defense Objects
Levine's thesis sounds convincing, but that doesn't mean that it should be accepted. His claim is short on data and long on intuition--and intuition can always be challenged. Yes, publicly held companies gain in convenience when they sell to large bidders, but also concede in price. As the savviest and best-informed buyers, giant institutions surely drive the hardest bargains. Why, then, don't the best private companies head straight for the easy marks? The extra effort would seem to be well-merited.

Pushing the point further, why bother with the private equity markets at all? They limit the amount of capital that can be raised from smaller buyers, by limiting the number of permissible buyers. No such restrictions exist in the public equity markets. On the stock exchanges, companies that can tell a good story can attract tens of thousands, if not hundreds of thousands, of eager investors.

In another context, Levine admits as much, when he writes that "the public markets work really really well for Elon Musk and Tesla in a very straightforward and old-fashioned way. Musk has a pitch … that resonates with the public, in a way that makes a lot of dispersed individual investors excited about buying his stock, which in turn allows him to sell lots of stock for lots of money to pay for buying cars. He needs the money, they want to give it to him."

Circumstantial Evidence
Despite these objections, I am inclined to agree with the general thrust of Levine's argument. It's dangerous for smaller investors to emulate the giants' behavior, for several reasons. They cannot conduct the same amount of research; they frequently are offered second-rate goods; and they are targeted by predatory Wall Street firms. They are viewed and treated as the suckers at the table.

For example, with initial public offerings, professional investors have frequently long prospered as the expense of individuals. Mutual funds buy IPOs on their launch dates, then "flip" them at higher prices to individuals. In addition, academic research has found that even when institutions do not immediately reap profits from smaller IPO buyers by selling them scalped tickets, they still outperform them.

In "Institutional Versus Individual Investment in IPOs: The Importance of Firm Fundamentals," authors Laura Casares Field and Michelle Lowry reported that, "Individuals disproportionately invest[ed] in the types of firms that earn[ed] significantly lower returns over the long run." That is, individuals bought fundamentally weaker companies.

Although the authors didn't examine how their study's IPOs were marketed, I suspect that the process was not unlike that described by Levine with the private equity markets: The investment banks brought to the general public the deals that had been refused by the institutions. Everyday investors believed that they dined with the giants; instead, they were fed the scraps that were deemed inedible.

The case of IPOs is not isolated. These days, "boiler rooms" don't often cold-call potential investors to sell them penny stocks--but when they did, nobody claimed that the investors who bought them were better off. Ditto for everyday investors who were talked into day trading, using options, or employing leverage.

Nor have ordinary buyers been well served by hedge funds. (In fairness, this statement applies to most institutional investors as well.) By the time that hedge funds became widely popular, in the early 2000s, their best performances were behind them. Over the past 15 years, the typical hedge fund has acted something like an expensive balanced fund. There have been occasional exceptions, but those exceptions rarely accept checks from individual investors.

Healthy Practices
The danger for everyday investors arises when the opportunities for the large and small fish are unequal, typically because of market structure (Levine's portrayal of private equities, IPO allocations, hedge fund availability) but also perhaps because of informational disparities. For example, professional day-trading organizations will likely possess both data and technical skills that amateurs lack.

Avoiding these hazards means investing in well-regulated, well-lit public markets, which restrict (if not entirely eliminate) the advantage of institutional access, and which have free information flows, so that rather than be left behind by their larger rivals, smaller investors can benefit from their efforts, by piggybacking onto their research. For example, no institution can or does own a significantly better stock market index fund than is readily available to the general public, including (yes) dentists. 


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.