New Age Finance
I am teaching a course this semester in Advanced Corporate Finance. The traditional topics of such a course are the weighted average cost of capital (WACC), capital structure, debt and equity, risk management, projections and valuations. While those fundamentals still have value as a baseline, the truth is that with only that skill set it is unlikely that any person in the class would be able to make the necessary decisions to fund their companies in the current world. When I was asked to design and teach this course I thought hard about what would be most useful to the students. What I settled on was to spend half the course on the traditional basics with a specific view towards differentiating the financing of public versus private companies. Those practices have always struck me as radically different even though there is some overlap and there is certainly some convergence between the two as well.
I watched lots and lots of change in finance over the past fifty years since I first learned the basics in business school. The first thing that changed dramatically was the world of short term lending. This historically intermediated arena was the province of the banks, but as I entered the space it was already clear that the corporate world just barely needed banks anymore to fund themselves. The commercial paper market was allowing borrowers to sell their paper to end investors directly, thereby disintermediating banks except that investors required borrowers to have back-up lines of credit, which were only available from banks. The banks therefore were paid for this availability to money in difficult times, which was somewhat logical since they had access to the lender of last resort, the Federal Reserve Bank. In other words, government was a critical part of the world of private enterprise finance. But banks needed more ways to make money. Their large capital bases were designed to support lending not standby credit alone.
Meanwhile, the brokerage world was also undergoing plenty of change itself. While they picked up a few pennies in the servicing of commercial paper sales for companies, the advent of negotiated commissions (versus the fixed commissions they had enjoyed for years) meant that their bread and butter business of charging investors to buy publicly traded stocks was disappearing. It took its time to work itself down to zero as technology made the function an automated one rather than a people-intensive activity. Finance turned into a far more complex process. It used to be an agency function where people who could find and access pools of liquidity were paid well to get money for companies. The simple structures of debt and equity spawned many variants as borrowers and investors discovered features they wanted in these financing instruments. But once again, it was the intermediaries that drove that process. They hired the rocket scientists to design new high-powered products that sliced and diced risk and reward into whatever shape and characteristic that could be imagined. Their creativity began to outstrip the ability of either borrowers or investors to understand them or to want to operate through the exchanges where the instruments were traded. That meant that agents had to turn into bookrunners who acted at principals on more and more trades. At first this seemed alright since banks, as the primary intermediaries were well-capitalized and low-risk.
But then, the reality of intermediation is that it tends to have limitless appetites. Doing a few innovative transactions as principal and where counterparty risk is taken rather than direct lending risk is never enough. The wheels are turned and the risks mount up until there is a crisis that forces the government through its regulators to intervene and clean the slate for the next round of risk-taking and financing. I witnessed this cycle in the emerging markets as they opted to nationalize or abrogate every thirty or so years. Having lived through almost fifty years in the markets as a practitioner, I have seen the cycle take shape again and again in different environments and with different markets and instruments. I wanted in my course to somehow capture the ability for the students to understand the fundamentals and then have a window into the current state of change and perhaps at least one version of where it looks like finance is headed for the next cycle. It might be the only way to add value to them in the course of a semester. Without this approach, I saw no way to call this course “advanced” anything since it would be backward-looking in a world that is constantly moving forward.
The current state of affairs in finance is that the balance and distinction between public markets and private finance have changed and faded. The exchange-traded markets that have characterized the pinnacle of finance are decreasingly the best route for companies as that regulatory cost which is always only as far away as the next crisis begins to exceed the benefits of broad access to the largest of investors. Those investors fear that the transparency of regulated markets has been lost, or at very least relegated to a mediocrity of returns. For some time now the benefits of private market finance has grown to appeal to many of the largest and highest growth enterprises. The vehicles for investors channeling funding to these private companies have focused on private equity firms, venture capital firms (for the newest of companies) and hedge funds, who operate in the dark corners of public and private markets with the most vast array of complex instruments. But now there is a new cycle beginning that transcends these vehicles.
The advent of newer and newer technologies have combined with the oldest trends of disintermediation and complex contingent claim financing to present the markets with new opportunities and even newer risks. This has taken the form of what has come to be known as Fintech, and is combining with the newest and most radical of technologies, known as blockchain finance to create something being termed DeFi (decentralized finance). This represents the most radical transformation of finance and the access to funding that we have seen in the past century. It is a seismic change to the business world and like all radical shifts, it has come with simultaneous skepticism and enthusiasm depending on the side of the change spectrum preferred. But this new realm has already started to sing the siren song of riches that is being heard by more than the hobbyists. I recall as an early practitioner in derivatives wondering if the reduction would be of sustainable value. That was 250 trillion dollars of existing notional value ago.
While we are waiting for Fintech, Blockchain and DeFi to mature and take over the world of finance, the rest of the world is not content to sit idly by using the old vehicles. Instead, they have repurposed the uncomplicated SPAC (special purpose acquisition vehicle) and begun to use it all over the place to dismantle the walls between public and private finance once and for all. Today I have read that even Donald Trump has jumped on the bandwagon and is using a SPAC structure in an attempt to finance his latest new media venture, TMTG. I am teaching my students about SPACs just as they may be peaking as surely the Trump ambitions portend. Good thing we we will move on to Fintech, Blockchain and DeFi Finance as we move into the new age of finance.