The Corner

Just Friends, or a Secret Club?

William Cohan has a nice post up on this week’s deal between Goldman Sachs and Facebook. Part of the agreement involves Goldman selling $1.5 billion in Facebook stock to the investment bank’s private clients (that is, rich people). 

The structure of the transaction will help Facebook get around some inconveniences. Facebook wants more investors. But it is not a publicly traded company, so it faces restrictions on selling shares. For one thing, Facebook is not supposed to have more than 499 stock investors. If it wants to sell stock shares broadly, it is supposed to register with federal authorities and release information about itself publicly and regularly.

Facebook doesn’t want to do that. Goldman is helping the social network avoid this dilemma by selling shares, not in Facebook to the bank’s private clients, but, more likely, shares in one large Goldman investment vehicle whose only investment is, well, the Facebook shares. That way, Goldman turns hundreds or thousands of investors into one investor. 

Facebook wants the benefits of having a bigger investment base without the drawbacks. At first glance, this arrangement appears to be none of our business. Goldman’s rich clients often have their own high-priced advisers, and they should know what they’re doing. If they want to pay hefty fees — “a 4 percent initial fee plus 5 percent of any profits,” says Cohan – to run the risk of losing their own money in an opaque venture underwritten by an opaque investment firm, let ’em. 

The problem is, though, that we’re inching toward a financial world comprised not of public exchanges but of private agreements like this one.

A public financial marketplace is integral to capitalism. In an open and free marketplace, millions of investors with competing agendas can jostle to determine what Facebook is really worth, from nothing to hundreds of billions of dollars. Many people will be wrong, but chances are better that everyone won’t be wrong all at once.

Under this deal, by contrast, just a handful of people at Goldman and its advisory and auditing firms will have an outsize say in what Facebook is “worth” on behalf of investors. Chances are greater that this roomful of people, whose bias is (probably) for Facebook to increase in value, will make a catastrophic mistake.

Eventually, real information about Facebook’s value would get through. But it would take longer, and be more difficult, for the marketplace to correct mistakes. That means mistakes would have a bigger impact on the broader economy. (And politically and socially that means, yes, more bailouts and stimulus. Conservatives who don’t like these things should start here, not there.)

If investors were to perceive big problems at Facebook, for example, and they couldn’t short Facebook, they would short Goldman, and short firms, including other important financial firms, that did business with Goldman. Plus, it is quite likely that Goldman will allow its private clients to borrow against gains in the value of their Facebook shares, multiplying risk.

Okay, just one of these deals is probably not a grave risk to the financial system as we know it. But multiplied across the system, it could be a real danger. We learned this lesson — or should have — with mortgage-backed securities and credit default swaps. We don’t need to take the class again. 

And, yes, private equity has an important role in the economy. But blurring the line between private and public equity, as this deal will do, is inadvisable. Traditional private-equity managers should be against it, too. Anything that confuses public opinion about the private-equity business model is a risk to that business model. 

To discourage these transactions without forbidding them, the SEC should make clear that it will consider every individual potential investor in Goldman’s Facebook vehicle as an individual investor for the purposes of public-disclosure requirements. That’s better than nothing for now. 

Nicole Gelinas is a contributing editor to the Manhattan Institute’s City Journal. 

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