The recent WeWork IPO debacle shows that the markets can still work. WeWork’s IPO problems show how risk transfer mechanisms expose risks and risk management is an important part of well-performing markets.
Here’s the storyline.
Private Equity (PE) money takes risks. That’s Ok and a good thing. PE place bets across industries. That’s a good thing as well. The really smart people, we hope, that society should applaud are doing something more concrete then moving money around (yes, sometimes after a “hit” people move to PE). But hope is not a strategy. In the end, we have a bunch of PE people who want returns from their investments and they obtain returns from the work of others–say WeWork. Given all the bets PE places, many will lose, some will win big.
Since money is involved, there is bad behavior–everywhere. Money makes some people crazy. Look at WeWork. Bad behavior from people we want to succeed trickled upward into PE where bad behavior already existed. PE players reinforced and “played up” up WeWork. Of course, they played it up regardless of what they thought about WeWork. PE had significant investments in the company and they wanted to win big. PE wanted to convince people that their investment made sense so they would buy into it–a classic sell job. Their bad behavior made WeWork look like it was worth tens of billions when in reality it is a corporate office rental company.
Here’s where the “markets still work” comment comes into the story.
Imagine one party that takes many risks and plays up its investments–“these investments are great!” However, public equity markets run on a higher level of transparency. Financial documents describe a company’s organization and show investors where the “value” is. Financial reporting and transparency is a public market function and was explicitly designed to expose issues like WeWork’s. Public equity markets like hard facts such as earnings. While you might argue that public equity has its downsides and is sometimes not so smart, public equity is a much larger pool of money to tap into and much more liquid. PE wants “public.”
If you move money from PE to public equity, the risk is also moved. For example, risk shifts from a few PE companies to the public. The public risk pool is much larger. Assuming that private risk assessments were held to the same standards as public risk assessments, we can use their “results” to predict how smooth the transfer will be. While there are exceptions to the rule and bad behavior during transfers happens, when the risk profiles are more or less in agreement, there is an orderly transfer of risk. Each risk holder in the public area, in theory, holds less risk “per unit” as the equity holder pool typically becomes much larger. The public benefits because the “common” investor can invest in companies. PE benefits–payback. That’s all Ok.
However, when the risk profiles between private and public are a mismatch, we see a situation like what happened with WeWork. The risk profiles were way out of whack, and the friction between the two was exposed. The mismatch was huge, and WeWork collapsed.
Sometimes the mismatch continues for a while and gets corrected later. Most “middle-men” businesses, like WeWork, Uber, and “last mile” delivery companies, are not technology companies. They are service companies using technology–very common and mundane. Service companies get a much lower valuation/multiple. The middle-men players may see a bump for a bit, but over time, they are just a “tax.” These costs need to be squeezed out. Facebook is like this as well, but less so on this particular topic.