U.S. institutional investors should be concerned about the implications of the Facebook debacle, in which Goldman Sachs Group Inc. cut them out of a potentially highly profitable private equity deal.
First, they missed out on the opportunity to get in on the mezzanine floor of one of the fastest-growing companies anywhere. That is, they missed out on the opportunity to reap large capital gains when the company ultimately is taken public.
Second, they should be concerned that Facebook is reluctant to go public at this time, even though it is clearly large enough to do so, and apparently could use the financing a public offering could bring. A public offering almost certainly would be cheaper than a private placement of the size Goldman Sachs put together for the company.
Regulation could drive companies to defer initial public offerings in favor of private placement transactions. With pension fund and other institutional investor allocations to private equity rising, companies don't necessarily need IPOs to raise large amounts of equity capital. There is a growing appetite from investors for private equity.
The market is global and much of it is outside U.S. regulatory reach. U.S. companies such as Palo Alto, Calif.-based Facebook don't have to confine their capital-raising effort to the United States. Major investment banks such as Goldman Sachs also are global and have clients worldwide, so their marketing isn't limited to U.S. investors. Regulation, however, is generally regional, and so can be avoided.
Institutional investors also should be concerned that the global capital markets are now so deep and so intertwined that rapidly growing U.S. companies can raise the capital they need from private sources without the participation of U.S. investors. Perhaps more companies will be tempted to avoid U.S. regulations by raising the capital they need outside the U.S. That could mean fewer opportunities for U.S. institutional investors.
The furor arose when Goldman first offered participation in a private $1.5 billion offering of Facebook Inc. shares to investors, including U.S. institutions and wealthy individuals, and then withdrew the offer for the U.S. market. Details of the offering had leaked to the public and had been reported in the media. In a Jan. 17 statement, Goldman said it had “decided to proceed only with the offer to investors outside the U.S ... Goldman Sachs concluded that the level of media attention might not be consistent with the proper completion of a U.S. private placement under U.S. law.” SEC officials won't comment on whether the commission is investigating the transaction, said John Nester, SEC spokesman. Regulations surrounding private equity transactions in other countries are not as strict.
Perhaps U.S. institutional investors can take consolation in the fact that U.S. investment regulations prevailed and dissuaded Goldman Sachs from pursuing an offering to investors in the United States that potentially would violate U.S. securities regulations.
Major public and union pension funds have been leading proponents of tough regulation of markets, disclosure and marketing. For example, they helped drive passage last year of the Dodd-Frank Wall Street Reform and Consumer Protection Act and, in 2002, the Sarbanes-Oxley act, toughening public company accounting oversight and investor protection.
Goldman Sachs, as one of the firms at the center of the financial market crisis, was likely particularly sensitive to the appearance of breaching SEC regulations, having only a few months before agreed to pay the largest SEC settlement ever by a Wall Street firm in connection with marketing practices of another investment. Goldman paid $550 million to settle SEC charges the firm “misled investors in a subprime mortgage product just as the U.S. housing market was starting to collapse,” according to an SEC statement at the time of the settlement July 15. As part of the settlement, “Goldman acknowledged that its marketing materials for the subprime product contained incomplete information,” the SEC statement said.
If U.S. investors promote certain investment standards, they should be content to abide by them and live with the outcome, even if those standards impose costs in the form of lost of investment opportunity. Issuers and investors will move to where the costs and benefits are best balanced.
Investors should re-examine the standards regularly to either reaffirm them or seek changes when they see them as costly obstacles to transactions. And they should realize that in a global market, they face competition for investment returns from investors outside the United States. They should be alert to further evidence that U.S. securities regulation has gone so far as to make U.S. capital markets less competitive.
U.S. institutional investors might have other opportunities to invest in Facebook, should the company issue its IPO. However, private equity investors reap the cream of the profits when a company goes public and becomes highly successful, like Apple, Microsoft or Google.
