Dispatches from District 48
For this post I just wanted to make a more narrow point -- one reason that unicorns (private startups with valuations north of $1 billion) like WeWork and Uber and Peloton had their valuations get so out of whack is because there is no way to short stocks in the private equity world.
Companies like Lyft and Uber and WeWork have seen private funding rounds at ever-increasing valuations. These are done outside the accountability of the broader market and untethered to any sort of normal valuation metrics like earnings or even revenues.
Lots and lots of investors, perhaps the vast majority of them, believed that the last private round that valued WeWork at $45 billion was insane. Many folks, including myself, would have gladly shorted the stock at this price had we been able. Heck, many of us would have shorted back at $10 and $20 billion valuations for the company. Because there is no short selling in this private equity world, unicorn valuations are +based on information from a very limited number of the most optimistic company supporters. And because of this faulty price discovery, billions of capital that could be doing something more productive have been wasted in many of these companies, poured into business models that don't work or, worse, the tequila and drug fueled Gulfstream flights of the founders.
As I wrote over a decade ago, short selling broadens the group of people who can "vote" on a company's value
At the start of the bubble, a particular asset (be it an equity or a commodity like oil) is owned by a mix of people who have different expectations about future price movements. For whatever reasons, in a bubble, a subset of the market develops rapidly rising expectations about the value of the asset. They start buying the asset, and the price starts rising. As the price rises, and these bulls buy in, folks who owned the asset previously and are less bullish about the future will sell to the new buyers. The very fact of the rising price of the asset from this buying reinforces the bulls' feeling that the sky is the limit for prices, and bulls buy in even more.
Let's fast forward to a point where the price has risen to some stratospheric levels vs. the previous pricing as well as historical norms or ratios. The ownership base for the asset is now disproportionately made up of those sky-is-the-limit bulls, while everyone who thought these guys were overly optimistic and a bit wonky have sold out. 99.9% of the world now thinks the asset is grossly overvalued. But how does it come to earth? After all, the only way the price can drop is if some owners sell, and all the owners are super-bulls who are unlikely to do so. As a result, the bubble might continue and grow long after most of the world has seen the insanity of it.
Thus, we have short-selling. Short-selling allows the other 99.9% who are not owners to sell part of the asset anyway, casting their financial vote for the value of the company. Short-selling shortens bubbles, hastens the reckoning, and in the process generally reduces the wreckage on the back end.
I am not advocating some goofy plan to bring short-selling to private equity. What I am saying is that prices set in markets with a robust ability to sell short are going to be much more trustworthy than prices set where short-selling is not an option.