(Bloomberg Opinion) -- Dell.
In 2013, Michael Dell closed a management buyout that took his eponymous computer company private. Being private had some advantages for the company (it could invest in a long-term turnaround rather than being subject to the short-term whims of the stock market, etc.), and for Michael Dell and his private-equity backers (they got all the upside if the turnaround worked). But it had a big disadvantage, which is that it made it harder for Dell to make ambitious acquisitions. Big public companies can buy other big public companies using their own stock. Dell, as a private company, couldn’t: If it wanted to acquire a big public data-storage company for $67 billion, for instance, it would need to either borrow a ton of money to pay cash, or go public again so that it could issue shares.
But in fact Dell did acquire EMC Corp. in 2016, in a deal in which it managed to both (1) borrow a lot of money to pay mostly cash for EMC shares and (2) sort of go public again so it could also pay stock for EMC. EMC owned about 81 percent of yet another public company, VMWare Inc. In acquiring EMC, Dell acquired that stake in VMWare. But Dell held it a bit at arms’ length: It paid for the EMC shares partly in cash but also partly in a new tracking stock, “Dell Technologies Inc. Class V stock,” designed to give EMC’s old shareholders an economic stake in VMWare. It’s almost as though Dell acquired EMC without acquiring EMC’s stake in VMWare, instead spinning out that stake to VMWare shareholders. (But only almost: Dell does own the VMWare stake; it just gave the old EMC shareholders a virtual stake in VMWare.) We talked about this back when the deal was announced; there were several reasons why Dell would want to do this convoluted thing, including that it made it easier to afford the EMC deal, and also that doing something less convoluted—like actually spinning the VMWare stake off to EMC shareholders—would have caused tax problems.
Doing it this way did require Dell to be public again—here are its 10-K and proxy statement—but not quite as public as it had been before Michael Dell bought it out. The Class V tracking stock holders don’t have much voting power. They don’t get economic exposure to much of Dell’s business. (Just the VMWare part.) Dell is still essentially private; it just happens to make public filings, and happens to be warehousing a separate public company—VMWare—through a tracking stock.
But the fate of all successful large leveraged buyouts is to eventually go public again. Normally the way to do that is to do an initial public offering, but since Dell is already sort of public it can build off of that:
Dell Technologies Inc. has offered to buy shares that track its interest in software firm VMware Inc., a move that would mark a re-emergence into the public markets for Dell.
PC maker Dell Technologies said Monday that it plans to buy the publicly traded DVMT, which tracks VMware. Each share of Dell Technologies Class V stock will be converted into about 1.37 shares of Class C common stock, Dell Technologies said. The implied value of the Class V shares is $109 a share, it added.
The Wall Street Journal reported that this “is the culmination of a strategic review the company has been conducting for months. Other options it considered include a combination with VMware itself or a straight initial public offering.” And the new Dell would still have dual-class stock, keeping control in the hands of Michael Dell and his private-equity backers.
Why do this rather than an IPO? One simple answer is that if Dell did a regular IPO—just sold shares of itself to the public—then it would still have this VMWare stake hanging around, and it is maybe a little annoying for a public company to also have a separate tracking stock. Of course after doing an IPO it could buy out the VMWare stake, for stock (now that it’s public) or for cash (using the proceeds of the IPO). But if you do that then you pay, in a sense, two bid-ask spreads: Companies that do IPOs normally have to sell their stock at a discount to get investors to buy, while companies that buy out their minority shareholders—as Dell would effectively be doing with its DVMT tracking-stock holders—normally have to pay a premium to get shareholders to sell. (Dell’s management had to negotiate with a special committee of its board of directors representing the tracking-stock holders to get it to agree to this deal, and the press release has slides about how the special committee was “Protecting and Maximizing Value for Class V Stockholders.”) Just giving the newly public stock to the tracking-stock holders, rather than selling it to the public, short-circuits that process: Instead of selling stock at a 20 percent discount and using the proceeds to buy out the tracking stock at a 29 percent premium, you can just issue stock directly to pay the 29 percent premium. (Though Dell is also offering a cash election as well as stock, paid for by a special dividend from VMWare.)
These days a lot of people like to complain about the IPO process, and particularly about the money that it leaves on the table in the form of investment-bank fees and discounts to get investors to buy stock. I suppose those things have always been annoyances, but in the olden days, when IPO companies were small and untested, there wasn’t much they could do about it. Now that companies stay private longer and many IPOs are for multibillion-dollar household names, the pushback seems a bit more serious, and companies are taking more seriously the idea of going public without an IPO. Dell happened to have a non-IPO way of going public handy, so why not try it?
Let’s say you and I both want to buy 100 shares of Microsoft Corp. stock. Let’s say that 100 shares are currently listed for sale on the exchange at $100. There are more shares listed for sale at $100.01, $100.02, etc., but the first 100 shares are all that are available at $100.00. We both think the stock will go up, so whoever doesn’t get the 100 shares listed at $100 will have to spend more—at least $100.01—to buy them. Which one of us should get the shares?
The answer, traditionally, is “whoever puts in an order to buy them first.” It’s a pretty good answer! For one thing, it rewards us for making prices more informative: Whoever moves more quickly to synthesize information into a view on the stock price is rewarded with the (cheaper) stock. For another thing, how else could it work? If someone is willing to sell the stock at $100, and I come in to buy it at $100, why would the seller wait around to see if some later bid comes in at the same price? How long should she have to wait? What if you want to buy the stock a week later? The seller wants to sell at $100 now because she wants to sell at $100 now; if I’m available to buy at $100 now and you aren’t, then I get the stock.
But what if we put in our orders at the same time? Then neither of us is more informative than the other, and the seller doesn’t lose anything by waiting around until both of our orders are in. You could imagine lots of good answers there. Maybe we’d each get 50 shares. Maybe priority would go to the one of us who is, I don’t know, a retail customer, or an institutional investor, or a good client of the exchange, or something. Or the exchange could run a little auction to see which of us is willing to pay more.
But the answer in actual U.S. market structure is, come on, there is no such thing as “the same time.” Do you know how many nanoseconds there are every single second? (A billion.) The odds that each of us would hit the “Buy” button at the exact same nanosecond are infinitesimal. So if I put in my order to buy the stock at 10:45:06.543210876 a.m., and you put in yours at 10:45:06.543210987 a.m., then I got there first and I win.
Is this a good answer? It has a simple appeal. It just gets rid of the question “who gets the stock if we put our orders in at the same time?” It replaces an economic question about how to allocate the stock with an empirical question of who got there first. It is consistent with our intuitions about the regular case where I got there, like, a week earlier: It rewards people for moving quickly to synthesize information and update prices, and it gives the seller immediacy rather than requiring her to wait.
Of course on a nanosecond timeframe, those intuitions feel silly. It is probably socially beneficial to update prices now rather than a week from now; it’s hard to see how it matters whether you update prices now or a nanosecond from now. Making the seller wait a week imposes a hardship on her; she can’t possibly notice if you make her wait a nanosecond. Still it is a nice continuous answer. Who decides that, say, a second matters but a nanosecond doesn’t, or that a week matters but a second doesn’t? “Whoever gets there first gets the stock” is an easy rule to state and justify, and has the feeling of fairness. “Whoever gets there at least five seconds earlier than anyone else gets the stock, but people within each five-second block are batched together and then run an auction to allocate the stock” is more complicated, and someone needs to decide what time increments matter and how to allocate the stock within those increments, and however they decide someone will probably think it’s unfair.
Plenty of people think the system of time priority is unfair too, because it privileges high-speed traders, and because they pay for co-location and direct feeds and fast connections to exchanges; the term “front-running” is sometimes thrown around; there are speed bumps; etc. etc. etc. etc. etc.; you know all of this.
But even if you are a total believer in time priority, it is somewhat problematic because, at some scale, that empirical problem of figuring out who got there first is hard. A nanosecond just isn’t very much time! If we both look at our watches and write down when we put our orders in, we won’t be accurate to the nanosecond. Even if our computers write down when we put our orders in, and frequently synchronize their clocks with the exchange’s clocks, they won’t match up to within a nanosecond.
But that’s just a problem of basic physics and so perhaps solvable. Here is a story about how “computer scientists at Stanford University and Google have created technology that can track time down to 100 billionths of a second,” and about how stock exchanges are working to get that level of precision in timestamping orders:
Because the orders are placed from locations around the world, they frequently arrive at the exchange’s computers out of sequence. The new system allows each computer to time stamp an order when it takes place.
As a result, the trades can be sorted and executed in correct sequence. In a networked marketplace, this precision is necessary not only to prevent illicit trading on advance information known as “front-running,” but also to ensure the fair placement of orders.
It seems like most people who write about market structure—outside of exchanges and high-frequency trading firms, anyway—are not total believers in time priority; to them, this level of accuracy seems misplaced. (“The technology might be interesting, but the worldview in which it would be necessary for finance is pathological, rendering ever more elaborate, ever less meaningful sorts of tournaments practical,” tweeted Steve Randy Waldman.) Who cares who got there a hundredth of a nanosecond earlier?
I do not have a great response. No one really should care. The social benefits of updating prices every second, of letting people sell stock the second they want to, are plausibly large; the marginal social benefits of updating prices every hundredth of a nanosecond, of letting people sell stock the hundredth of a nanosecond they want to, seem likely to be very small. The best response seems like a laissez-faire one: The benefits of immediacy and constant price discovery in general are probably large, and who are you—as a regulator or academic or journalist or whatever—to decide where to cut them off? If people want to trade stocks every hundredth of a nanosecond, why not let them?
But the other standard objection to this focus on nanosecond-level trading is that it creates a socially wasteful arms race, that brilliant minds are wasted on developing high-speed trading systems rather than curing cancer. And I don’t know! This particular problem—of accurately timestamping data and figuring out the order in which to process it—seems to have deep applications beyond trading:
Because software and data are no longer in the same place, correctly calculating the order of the events that may be separated by feet or miles has become the dominant factor in the speed with which data can be processed.
“So much of our expectation about computing being correct depends essentially on knowing this order,” said Krishna Palem, a theoretical computer scientist at Rice University.
The thing about the elaborate meaningless tournaments of finance is that they give out large monetary prizes. So people have incentives to participate in them and work hard to do well. When the tournaments are about, say, who can read credit-default swap documentation most cleverly, they do seem rather socially wasteful. (Though not always!) But when they are about, say, who can best harness machine-learning techniques to evaluate masses of data and predict the future—or who can build the fastest communications infrastructure to connect far-flung places—or who can solve difficult technical problems of timing events accurately to the hundredth of the nanosecond—then they might have benefits outside of the financial tournaments. On its own it is perhaps a little bizarre that stock exchanges would need to sequence orders down to the hundredth of a nanosecond, but if that meaningless-seeming competition between high-frequency trading firms helps subsidize basic research to improve our understanding of time itself, isn’t that kind of cool?
There’s always a literature.
- Amazon.com Inc. could legally short the stock of pharmacy companies while it was secretly planning to buy an online pharmacy in a deal that would predictably hurt pharmacy stocks, and/or
- An Amazon employee who knew about the deal could do that.
I think the answers are “yes” and “no,” respectively. But readers wrote in to point out that there is a voluminous legal and financial literature on these questions. For instance, here is a 2001 paper by Ian Ayres and Joe Bankman on “Substitutes for Insider Trading”:
When insider trading prohibitions limit the ability of insiders (or of a corporation itself) to use material nonpublic information to trade a particular firm's stock, there may be incentive to use the information to trade instead in the stock of that firm's rivals, suppliers, customers, or the manufacturers of complementary products. We refer to this form of trading as trading in stock substitutes. Stock substitute trading by a firm is legal. In many circumstances, substitute trading by employees is also legal. Trading in stock substitutes may be quite profitable, and there is anecdotal evidence that employees often engage in such trading.
“It is difficult to get even good anecdotal data on the degree of trading in stock substitutes,” they write, but “our best guess is that low-level employee trading is common, but that large-scale corporate trading does not occur.” That last part is surely right—you’d hear about it if Amazon was actually shorting Walgreens Boots Alliance Inc. stock—but the first part is the interesting one: Is it in fact common for employees of one company to use material nonpublic information that they get in their work to trade their competitors’ stock?
The legality question is also hard: It comes down to whether the employee is “misappropriating” her company’s secret information to trade in a rival’s stock. My sense is that most companies have policies to the effect of “don’t use secret company information for your own advantage,” which would cover this case, but Ayres and Bankman “uncovered a few examples of companies that in the past have given employees explicit permission to trade in stock substitutes,” which I suppose would—bizarrely—make it legal.
Anyway there is other work on the topic, including a 1971 paper by Jack Hirshleifer on “The Private and Social Value of Information and the Reward to Inventive Activity,” which suggested among other things that shorting the stock of incumbents might be substitute for the patent system as a way for disruptors to profit from their inventions. (If Eli Whitney had, like, shorted wool manufacturers rather than trying to enforce his patents on the cotton gin, he’d have made a lot more money than he actually did.) Here is a formal model of that argument, “Speculative Profits, Innovation, and Growth,” by Vincenzo Denicolò and Piercarlo Zanchettin. And here is “Taking a Financial Position in Your Opponent in Litigation,” by Albert Choi and Kathryn Spier.
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