Thursday, January 6, 2011

The intriguing case of Facebook valuation

For some time now, private market valuations of non-listed business enterprises and their assets have been one of the most controversial areas within financial markets. They form part of the larger issue of lack of transparency and evident conflicts of interests that plague these markets. There is now ample evidence that conclusively points to their critical role in the sub-prime meltdown and the resultant financial crisis.

The recent news that Facebook has been privately valued at a whopping $50 bn and the euphoria surrounding it clearly indicates that Wall Street and investors appear to have learnt little from the tumult of the past three years.

For the record, Facebook which was valued at $27 billion in August 2010, has a reported $2 billion in revenue and negligible profits. Its current valuation makes it more valuable than the likes of Time Warner, DuPont and Morgan Stanley, leave alone Yahoo and Co. More unrealistically, its valuation has jumped 20% virtually overnight from last week's private market valuation of $42.4 billion. Talk about Goldman's midas touch!

Early this week, news came out that Goldman Sachs has invested $500 mn in Facebook in a transaction that values the company at $50 bn. As part of its deal with Facebook, Goldman is expected to raise as much as $1.5 billion from investors for Facebook through private placement route. Goldman has signalled to prospective investors that they would need to invest a minimum of $2 million and would be prohibited from selling their shares until 2013.

Goldman's eye-popping $50 bn valuation of Facebook is in line with similar staggering valuations of privately held technology firms in the last decade. However, what is of great concern is the virtual absence of transparency associated with this valuation exercise. Little or no information is available in the public domain about the details of this valuation.

In fact, there have been allegations that Goldman have been not too forthcoming with information and time for potential investors to make informed investment decision on Facebook. Goldman has given its clients limited information and time to conclude the deal or lose out on a potentially lucrative investment opportunity.

In this context, a recent Times article points to two examples of the capricity associated with such valuations. The $ 7 bn investment made in Freescale Semiconductor in 2006 by a pack of three private equity firms - the Blackstone Group, the Carlyle Group, Permira Advisers and TPG Capital - is valued at $3.15 billion, $2.45 billion, and $1.75 billion respectively by the three firms. Similarly, Kohlberg Kravis & Roberts (KKR) and TPG Capital attach widely different values to their investments in the largest private equity deal ever, the $48 bn buyout in 2007 of Energy Future Holdings of Texas (formerly TXU). KKR now values its investment at 20 cents on the dollar, while TPG values its stake at twice that, 40 cents.

These wide differences in valuations are an accurate representation of the lack of transparency in private equity investments. The differences are all the more baffling since the same securities, the same company, the same data and the same information from board meetings are used to arrive at these widely varying valuations.

Some of the differences can be attributed to the timings of the respective valuation exercises. The major part of the differences come from the variations in the accounting principles and their interpretation. Accounting principles suffer from numerous discrepancies that even experts disagree on the interpretation of certain provisions. For example, one of the commonest source of difference is the variations in the weights placed on various measures like discounted cash flow.

In the prevailing environment, there is no reliable means for investors to assess the value of their investments. They have to ipso facto accept the valuations attached by their fund managers in the private equity firm. This opacity in valuations will continue so long as private equity investment valuations are done in confidentiality without any disclosure requirements. The lack of transparency has generated considerable concern, so much so that the US SEC recently initiated an enquiry against the unprecedented surge in the trade of shares of privately held Internet companies.

There is a clear conflict of interest at work here. On the one hand, private equity firms manage the finances of their clients on a partnership of trust. They promise competitive returns on investment and are duty-bound to present all available details about their investments without with-holding anything. But on the other hand, private equity firms have a clear interest in boosting the valuations of their investments. Higher valuations attract investors, lured in by the prospects of the high promised returns. Besides, it also ensures higher management fees for the PE firm.

Of even greater concern is the fact that Goldman is not only acting on behalf of its clients, but is also a directly interested party. It has leveraged its balance sheet to make the $500 mn investment in Facebook. It is therefore in its immediate interest that the value of this stake get amplified through a surge in investor interest. The structuring of the investment and the route for raising the $1.5 bn, apparently through an SPV, is seen as an attempt to avoid SEC disclosure requirements and maintain the opacity in these transactions. In simple terms, as William Cohan wrote, Goldman is assuming several roles at once — investor, salesman, money manager, IPO underwriter - thereby creating serious conflicts of interests.

Faced with these two conflicting choices, many PE firms have been found to have acted dis-honestly with their investors. Goldman, in particular, has been accused many times, even recently, of being less than honest, even untruthful, with its clients.

Though not yet listed, like other technology majors before, Facebook shares/stakes are traded in the secondary market. Sellers are either employees or investors trying to off-load their stakes, while buyers (like Goldman's clients) are high net-worth investors looking for high returns. Goldman would benefit in atleast two ways from the deal - immediately bag investment banking fees by raising and managing money and being ahead in the race to manage Facebook's inevitable lucrative IPO.

The systemic risks posed by these subjective valuations arise from the fact that public pension funds, local governments, endowments, and institutional investors have considerable exposure to private equity firms. At the slightest eruption of market uncertainty, these valuations are likely to unravel wiping out billions of dollars and generating a cascading downward spiral.

The Times quotes Harvard Professor, Josh Lerner, who points that though private equity firms are usually riskier than underlying public markets (since they use borrowed money for their investments), they ought to have "declined atleast as much as the public markets did, if not more — probably considerably more" in the late 2008 crash. That they did not is an indicator of "smoothing" and "stagecraft".

Update 1 (7/1/2011)

Simon Johnson makes the important point that Goldman's bank-holding company status provides it unfettered access to the Fed's discount window (it can borrow against all kinds of assets in its portfolio). This coupled with the moral hazard arising from the "too-big-to-fail" syndrome incentivizes Goldman to assume excessive risks without any fear of downside. In case of any crisis, Goldman and its creditors are sure to be protected. All this keep Goldman's financing cost much cheaper than before and than its competitors.

James Kwak puts this TBTF interest rate subsidy to be around 50 basis points for banks with more than $100 billion in total assets. As Prof Johnson writes,

"It has effectively become a new form of government-sponsored enterprise. Goldman is not a venture capital fund or primarily an equity-financed investment fund. It is a highly leveraged bank, meaning that it borrows through the capital markets most of the money that it puts to work...

Most of its operations could be funded with equity – after all, it is not in the retail deposit business. But issuing debt is attractive to shareholders because of the subsidies associated with debt financing for banks and to bank executives because their compensation is based on return on equity — as measured, that increases with leverage. If banks have more debt relative to equity, this increases the potential upside for investors. It also increases the probability that the firm could fail — unless you believe, as the market does, that Goldman is too big to fail."


KP said...

Dear Gulzar,

I have a couple of questions here.

Heres an interesting case where investing 500 M USD has made a firms value appreciate by more than 100% of its last known value.

So effectively by signalling - GS has provided a gigantic boost to a valuation that may? be way beyond its capacity to generate real revenues.

I have found it intriguing that even in stock markets the marginal increase in value that I should offer to buy a stock ( or make the owner part with his stock)represents / reflects a value movement and judgement across the entire equity base.

- without a close competitor and a lot of liquidity back in the system again, do you see the slightest possibility of this scheme failing? what can derail it - excluding legal action / US political intervention - but anything in the market - I don't.

- If this is a way of wealth creation (bubble or otherwise).. GS like the rest of the US banking system is only playing to create wealth and signify the health / wealth of its industry / ideas / innovative edge. That only the rich are invited to participate is true of any economy. ( a little better allowing retail investors to participate in India)

- China's action against facebok may reflect a deeper philosophy of not allowing american companies to gain value using access to its citizens without any proportional revenue accrued to the chinese government. Hypothetically, if the government can auction / sell spectrum - should it also tax access to citizens (and their data)?

Your views?


Sai Prasad said...

I think, the time has arrived to call the act of stealing just that.

Companies get valued by a bunch of hired hands on criteria which are not made clear. Even if the said criteria were to be made public, their turst worthiness is doubtful. I think the basic reason for such errors in valuation arises out of not linking them to actual earnings and basing them on projected growth and assumed earnings.

Why is really out of fashion to value companies based on actual earnings rather than predictions based on flawed assumptions?