Weekend Reading Links

1. David Evans in the World Bank blog has an awesome compilation of the papers presented at the Northeastern Universities Development Consortium Conference.

2. FT has a nice article which explores the valuation problem in mature start-ups arising from a new category of private shares with guaranteed returns. The insurance against downside distorts the valuation since the investors are now less concerned about the valuation and only interested in the pre-determined guaranteed returns,

Many of the investments in the more mature start-ups are structured: in effect giving investors guaranteed returns and a degree of protection against any losses.Financial experts refer to these headline valuations as “marketing numbers”, highlighting that they are a function of image as much as anything else: the greater the degree of guaranteed return a company is prepared to give, the higher the hypothetical value that investors place on the company... Even some of the best-regarded tech companies have used these methods. At Uber, a major investor received a guaranteed 25 per cent return during an early investment round. Investors also received significant protections during Airbnb’s $10bn round last year.

Square, the most prominent of the current generation of start-ups to have so far opted for a public listing, is typical of this trend. In its most recent private fundraising investors paid $15.46 per share, generating headlines about a $6bn valuation. Those who bought in were guaranteed a 20 per cent share price bump in an IPO. Their compensation, if Square fails to hit this: extra shares to make up the difference, potentially diluting the value for earlier investors and many employees.These new investors may have paid a higher price for their shares, giving them less upside if the company does well. But they also have a degree of insurance unavailable to other investors if the company falls short of expectations.

These multi-share class structures, along with the lack of a liquid market for private shares, have made it almost impossible to calculate an accurate valuation for many start-ups. Even investment professionals whose job it is to assess the value of private shares in their portfolios admit that they cannot do this with 100 per cent certainty. In a private company, unlike in public markets, each class of share commands a different price because of the protections that come with it. In Square’s case, the headline valuation figure of $6bn assumes wrongly that all shares could command the highest share price.

This trend to guarantee returns has been driven by founders desire to join the unicorn club, which enables them to raise more cash, recruit employees and raise their profile.

3. Much the same is happening in India, with late stage VCs putting in tough riders to guarantee their investments and startups accommodating those demands in order to attract the capital required to both sustain operations as well as expand their market shares. Such conditions, commonly described as 'liquidation preference' (LP), ensure that the investor takes back "its entire capital or the amount due to it in proportion of its shareholding in the firm, whichever is higher". As valuations froth, the LP multiples demanded has been rising. The immediate losers from such deals are the start-up founders, whose shares come only after the late and early stage investors recover their investments. 

4. John Reed, the former Chairman of Citigroup, comes out in favor of restoring Glass-Steagall and dispensing with the universal banking model. Apart from the questionable claims on financial benefits from a single entity, he also points to the unstable cultural balancing in bringing all activities under one roof,

As is now clear, traditional banking attracts one kind of talent, which is entirely different from the kinds drawn towards investment banking and trading. Traditional bankers tend to be extroverts, sociable people who are focused on longer term relationships. They are, in many important respects, risk averse. Investment bankers and their traders are more short termist. They are comfortable with, and many even seek out, risk and are more focused on immediate reward. In addition, investment banking organisations tend to organise and focus on products rather than customers. This creates fundamental differences in values.

5. NYT on the ubiquity of Samsung in South Korea,

In South Korea virtually all of your wants and needs can be met by Samsung, the most dominant conglomerate. You can be born in the renowned Samsung Medical Center, attend a prestigious Samsung-owned university, live in Samsung housing complexes — even buy life insurance from a Samsung subsidiary and go for vacation to the Samsung-owned Everland amusement park. It is possible to use virtually only Samsung electronic devices in daily life. And, if you ace the widely taken GSAT — Global Samsung Aptitude Test — you can land a prized job at one of its subsidiaries. No wonder that Samsung is so large that it is responsible for a fifth of South Korea’s exports and about 17 percent of the annual gross domestic product.

6. FT has this dismal assessment of the impact of QE exit on emerging markets,

By some estimates, $7tn of QE dollars have flowed into emerging markets since the Fed began buying bonds in 2008. Now, a year after the Fed brought QE to an end, companies in emerging markets from Brazil to China are finding it increasingly hard to repay their debts. The excess capacity these companies created became apparent just as China’s slowing economy triggered a collapse in global commodity prices, hurting companies across the emerging world and sending Brazil’s economy into deep recession. Some experts say QE policies by the Fed and other central banks have left a legacy of oversupply from which it will take years to recover.

The article also describes how the search for yields resulted in leveraged 'carry trade' from developed to EM economies. The BIS estimates an amount of $9 trillion flowed into the EM economies as bank loans and bonds in the 2009-14 period. As I have blogged earlier, it also found evidence of cash-rich EM firms using this route to speculate with 'carry trade' rather than for investment purposes.  

This has had the effect of driving up EM private sector debt, raising concerns about its repayment once the interest rates in developed economies start to rise.

The disturbing thing about this debt build-up is that it comes at a time when the EM economies are themselves slowing down sharply and consumer demand has been tanking. Apart from declining asset prices, the massive over-capacity in many of these economies mean that the ability of local borrowers to repay their debts once the capital flows tide reverses, as it can in very quick time, is seriously suspect. 

7. The FT has a graphic of the 10 most polluted cities in the world, with India contributing 6 and Pakistan 3.

In fact, the latest Global Burden of Disease report estimates that ambient air pollution was responsible for 586,788 premature deaths in India in 2013, up from 365,592 in 1990.

8. FT reports that peer-to-peer (P2P) lending platforms like Lending Club, Funding Circle, and Prosper have the potential to disrupt the banking sector in a Uber-style revolution. They offer higher yields to lenders, and faster, cheaper, and more convenient loans to borrowers of different categories - consumers, students, small businesses etc. Investors globally have raised more than $80 bn over the past two years for direct lending funds. Though, P2P lenders make up just 1.1% of all unsecured consumer loans in the US, PwC expects annual P2P lending in the country to soar from $5.5 bn in 2014 to $150 bn in 2025. As the article writes, their business model,

P2P lenders say their algorithmic credit scoring technology is as good as the banks. But because they do not need to hold regulatory capital or liquid assets, operate expensive physical branches or deal with costly legacy IT systems, they are more efficient than banks... the “frictional cost” for their companies in making a loan is equal to about 2 per cent, against about 5—7 per cent for a typical bank... As a result, P2P lenders can offer investors a higher yield than banks do to depositors. 

The P2P market has attracted insurers and asset managers who have launched direct lending arms, lending especially to small and mid-sized companies.

Four observations on this trend. One, as banking sector regulations tighten, such platforms could crowd-in the riskier categories of borrowers. Two, the very nature of such lending makes it difficult for the emergence of large lenders. Given that the major source of P2P financing are high-net worth individuals and also given the limits to how much you can lend through impersonal and algorithmic due-diligence, there may be an inherent self-limiting factor to the sizes of such enterprises. Three, this may be a welcome trend shift in the global banking sector in so far as it promotes greater systemic risk diversification. Four, however, the entry of financial institutions like insurers and asset managers makes greater regulation, atleast of their P2P lending arms, essential. Or this could end up being yet another of the "dark corners" of financial markets. 

9. This FT graphic is a very good illustration of the state of the Chinese economy. All the leading indicators of economic growth are falling.

10. In the recently concluded local government elections in Kerala, a corporate social responsibility initiative group won the Panchayat elections in Kizhakkambalam of Ernakulam district in Kerala state. Candidates of Twenty20 Kizhakkambalam, a CSR initiative of the local Anna-Kitex group, a Rs 15 bn garment and aluminium company, won 17 of the 19 wards and 2 out of 3 block panchayat seats. The village, with an area of 32 sq km, 8000 households and population of 23000 is predominantly agricultural and has a literacy rate of 94.74%. The 'party' campaigned on a platform of "improving facilities for drinking water, housing, food, toilet, electricity, healthcare, education and employment besides reviving agriculture in the village".

11. Finally, a reminder of the global downturn comes from this,

The price of iron ore in Qingdao, the widely accepted benchmark for Chinese metal consumption, is down 76 per cent from its 2011 peak... The Baltic Dry index, a measure of the cost of shipping commodities around the world, subsided this week to its lowest ever. It has now dropped 95.5 per cent from its peak set in 2008, shortly before the financial crisis.