Money Stuff: Private Markets Charge More

At a very high level, the job of the financial industry is to take customers’ money and invest it in economic growth. When the economy grows, the investors get a share of that growth as a return on their investment. 

How much should the financial industry charge for doing that job? It’s not an easy job. The financial industry has to figure out what companies will generate economic growth, and allocate capital to them, and monitor them, and do all the administrative and sales work of moving money from people who have it to companies that need it. A lot of people are working away in their garages trying to develop a cure for cancer or cold fusion or a quantum supercomputer or a really addictive gambling website, and the financial industry has to figure out which of them will succeed and give them money. That job, at a high level, is both difficult and important; curing cancer is not mostly a matter of getting the financing right, but that is part of it.

Still, you know, AI, computers, the internet, blah blah blah, maybe that job should have gotten easier over time? (Here is Warpspeed, “an AI superforecasting system for predicting clinical trial outcomes”: not exactly a computer telling you who will succeed at curing cancer, but kind of.) Thomas Philippon has a well-known 2015 paper finding that financial “intermediation has constant returns to scale and an annual cost of 1.5-2 percent of intermediated assets,” and that cost doesn’t seem to be going down:

I find that the unit cost of intermediation is about as high today as it was at the turn of the 20th century. Improvements in information technologies do not appear to have led to a significant decrease in the unit cost of intermediation. Explaining this puzzle is an active area of research.

So it is perhaps roughly correct to say that the cost of taking customers’ money, investing it in economic growth, and giving the customers back their share of that growth is about 1.5% a year or so. That might not be, like, the bare minimum cost. The financial industry might be collectively overpaid; there might be some structural reason that it can charge more than the actual cost of its services. But it’s a data point.

That said, you don’t have to pay 1.5% for your share of economic growth. The Vanguard Group will sell you an index fund representing the whole US stock market, and will charge you an annual fee of 0.04%. That index fund is not exactly an investment in overall economic growth, for a variety of reasons. (It’s limited to equity claims on corporate profits, not debt claims or returns to labor or other components of economic growth; it’s limited to the US; it’s limited to public companies.) But it does feel, in some rough directional sense, like that: If you invest in all of the stocks of all of the companies, you will get paid as the economy grows. And you can get closer by adding some bonds, some global stocks, etc., all of which are also available in fairly cheap index funds. You will not get exactly the total return to the economy by putting together a portfolio of index funds, but you can get reasonably close, and you’ll pay an order of magnitude less than 1.5%.

One way to put it is that the cost of financial intermediation — funneling the money to the good companies so they can cure cancer, etc. — is about 1.5% a year, but index funds can free-ride off of that work. Somebody else runs around to the garages evaluating inventors’ cold fusion devices or gambling websites, and picks the winners and allocates capital to them and gives them a valuation, and the index funds are just like “we’ll allocate capital to whoever everyone else picks.” That’s obviously cheaper.

Meanwhile everyone else is trying to pick the winners, at a total cost of 1.5% per year. Some of them will succeed, put all of their money into a startup that invents cold fusion, and get super rich. Others won’t. Collectively they will earn, more or less, their share of the growth of the economy. (Minus 1.5%.) Some will earn more (by picking winners) and others will earn less, but they will cancel each other out; their total net winnings can only come from economic growth. There’s no magic, no dark matter, no other source of gains. Everyone’s gains come from (1) economic growth and (2) other people’s losses. [1]

But everyone can’t index. Everyone can’t passively accept the return on overall economic growth, because overall economic growth depends on finance, on the allocation of capital. Somebody needs to go to the garages; somebody needs to monitor the companies and allocate the capital and all the rest. That costs money, perhaps 1.5% per year. The overall aggregate cost of funding economic growth and giving investors their share is about 1.5%, but the price of that bare-bones service — “here’s your share of economic growth” — is about 0.04%.

So the other main job of the financial industry is to charge more for that.

At some level, the rise of private equity and private credit and “alternative asset management” generally is about shifting ownership of the economy to vehicles that charge more fees. [2] You can own a share of all of the public companies for about 0.04%, which is not enough. But John Coates estimates that “now private equity controls between 15% and 20% of the entire U.S. economy,” and if you want to own your share of that slice of the economy, you’re paying more like 2% (plus 20% of profits). If you want to own your share of SpaceX — an outsized contributor to future economic growth, if you believe Elon Musk’s vision — you’ll pay even more. Similarly, private credit funds roughly compete with high-yield bonds, but are harder to index and can charge more. 

Anyway here is a Financial Times story about private-market fees:

Wealth advisers at banks and independent brokerages generated billions of dollars in fees by steering individual investors into private market funds, which many retail investors are now trying to flee.

Sixteen funds, including those managed by Blackstone, Blue Owl, Apollo and KKR, have generated more than $2bn in servicing fees for wealth advisers since 2017 even before lucrative upfront commissions, according to a FT analysis of regulatory filings.

The data shows how big banks such as Morgan Stanley, UBS and Bank of America Merrill Lynch and other independent wealth managers benefited from the boom in private funds targeting individual investors before it started to sour last year. …

“The advisers themselves are stuck in this incentive structure where their behaviour is going to be aligned with pushing clients into these products,” said Shang Chou, the co-founder of the multi-family office Dishmi Capital. “It’s not a surprise that this stuff has been over-allocated to the retail investor base.”

Right, the stuff that pays more, pays more.

One possible model is that most future economic growth will occur in private markets: Private-market funds do a better job of artisanal capital allocation, with sophisticated highly paid professionals working hard to pick the best companies and monitor them in the best way, while public markets are ghost towns dominated by shareholder lawsuits and passive investors and so do a bad job of capital allocation. The artisanal capital allocation costs more, but is worth it; you pay more for your share of economic growth, but you get more growth.

Another possible model is that financial intermediaries have some ability to decide at the margin whether economic growth comes in “private markets” or “public markets”: An asset manager can market a high-yield bond fund (public) or a private-credit business development company (private); an investment bank can advise a private company to do an initial public offering (public) or sell to a private equity fund (private). [3] That decision might be based on sound reasons of corporate finance and capital allocation. But it might also be influenced by fees.

Elsewhere: “Wall Street Brings Sophisticated Quant Trading to the Masses.”

Arguably Tesla Inc.’s original sin was going public with a single class of stock. Elon Musk is Tesla’s Technoking, chief executive officer, largest shareholder, and general animating spirit, but he is not exactly its controlling shareholder. [4] He owns only about 11% of the stock, and each share has one vote, meaning that he could in theory be ousted by disgruntled shareholders. He does not like that idea, in part because, you know, he’s Elon Musk and likes to control stuff, but also because he doesn’t “feel comfortable building a robot army” at Tesla without more voting control. Tesla is, in Musk’s thinking, a very important company for the world, and he wants to make sure it carries out his vision.

But he only owns about 11% of the stock, so there’s always a risk he might lose control and, like, Larry Fink will take over his robot army. To prevent that — only to prevent that?!? — last year Tesla granted him a stock pay package with a headline value of a trillion dollars, contingent on him hitting certain valuation and operational milestones. The point was not to reward him for good work with a trillion dollars — he is already super-rich and there’s not much else he could buy with a trillion dollars — but rather to reward him for good work with 25% voting control of Tesla, which is the only thing his heart desires and the only thing he can’t buy.

I understand that this sounds fake, but it really is what both Musk and Tesla said. Tesla board chair Robyn Denholm told the Financial Times “that the special committee set up to design the pay package … explored whether there was a way to give Musk the voting rights he wanted without the vast payout”:

“There wasn’t an instrument that you could use that could do that,” she said. “We searched high and low for it, but so we ended up using restricted stock, which does have economic rights.”

If they could have given him more voting rights without also giving him a trillion dollars, they would have. But stock exchange rules don’t allow public companies to create new super-voting stock, so the only way to get him more votes was to give him more stock. The extra trillion dollars of contingent compensation was just an unfortunate accidental side effect of giving him what he really wanted, the voting rights.

Musk’s other giant company, SpaceX, doesn’t have that problem. It is not public. It plans to go public soon. But it can avoid Tesla’s mistake by going public with dual-class stock. It will, the Information reports:

The prospectus indicates that SpaceX will adopt a dual-class share structure that would give Elon Musk super-voting Class B shares, in which each share is worth 10 votes, according to a person familiar with the matter.

Musk’s total ownership stake and voting control wasn’t immediately clear. The document says that the dual-class structure “concentrates voting control with Mr. Musk and other shareholders of our Class B common stock.”

Yeah, look, terrific. There are people who complain about dual-class stock giving founders too much control, but none of those people are Elon Musk fans who want to own SpaceX. Obviously the Elon Musk Complex has to be controlled by Elon Musk, and it is silly for him not to have super-voting shares. Fine. The article goes on:

SpaceX also gave Musk a similar type of ambitious stock award that made him one of the world’s richest people from his leadership of Tesla.

The company approved a plan last month that would award CEO Elon Musk 60 million additional shares if the company’s market capitalization climbs from $1.1 trillion to as high as $6.6 trillion, and completes an ambitious plan of building data centers in space to supply compute for AI developers. The stock vests as SpaceX increases its market cap in $500 billion increments.

The document says that the shares vest if the company’s space data centers can deliver “100 terawatts of compute per year,” which is orders of magnitude more than peak power consumption in the U.S. ...

The award was on top of an earlier goal SpaceX’s board of directors set for Musk in January. He would get up to 200 million additional shares if the company hits stock-price targets and establishes a Mars colony with at least 1 million inhabitants.

On the one hand, sure, look, if he does a series of wild sci-fi things, give him a wild sci-fi amount of money. On the other hand, this is purely economic compensation. The rationale here can’t be “I don’t feel comfortable building a galactic space army at my Mars base without control of the company,” because his control of the company is permanently established with super-voting stock. The rationale here can only be “if I take over Mars I want to get paid.” Which, fine, so would I, but in this scenario he would probably be a multi-trillionaire without the new stock award. He just wants more.

Also:

One risk factor the company notes in the SpaceX prospectus is that shareholders may not be able to pursue certain legal claims because of a “requirement for mandatory arbitration.”

We talked about this idea last year: Now companies can basically forbid shareholders from suing them, by requiring all shareholder claims to be brought in mandatory arbitration. As far as I can tell, no one has done it yet. Now SpaceX might. SpaceX is sort of obviously the best company to do it: Elon Musk is going to do a bunch of wild stuff that does not meet traditional standards of corporate governance, and that’s what shareholders are signing up for, and if they don’t like it they shouldn’t buy the stock. SpaceX is a gamble that the entirety of Musk — the visions of space data centers and Mars colonies, the energy, the wild flouting of governance norms — will pay off for shareholders, as it mostly has in the past. Quibbling about the governance norms is stupid.

But if SpaceX does it and it works, then 100 companies that are not run by Elon Musk are going to try.

I feel like a decent heuristic in much of the world is that, if you run a normal business doing normal stuff, and one of your normal suppliers sends you an invoice for a normal service, and the invoice is like “$100,000 payable in Bitcoin,” then it’s probably fake. Someone is probably impersonating your supplier. Normal trade tends to be denominated in dollars, or in other national currencies; lots of people, for lots of legitimate reasons, use crypto, but your typical widget supplier probably has a bank account somewhere and can handle being paid in dollars. A North Korean scammer might have a harder time opening a bank account, and might accept payment only in crypto. (This is an imperfect heuristic and please do not email me to be like “my totally legitimate business only accepts crypto,” it’s fine, I believe you.)

On the other hand, if someone sends you an invoice like “we have kidnapped your chief financial officer, please remit $100,000 in Bitcoin to get her back,” that might be real. Or it might be fake! Crypto is useful both for real kidnappings and for fake kidnappings. Real kidnappers, and also fake-kidnapping scammers, might equally have a hard time with traditional banking.

Similarly, if the Islamic Republic of Iran sends you an invoice payable in crypto for safe passage through the Strait of Hormuz, that absolutely might be real. Iran, for reasons, is pretty cut off from the US dollar system of international trade, and really is charging ships fees, payable “in yuan or stablecoins,” to transit the strait. But it also might be fake. Coindesk reports:

Shipowners are receiving fraudulent messages from scammers posing as Iranian authorities and demanding bitcoin or USDT payments for safe passage through the Strait of Hormuz, according to Greek risk management firm Marisks.

Marisks said it believes at least one vessel fell victim to the scam and was fired on while attempting to transit the strait, which has been largely blocked by Iran since late February amid a U.S.- and Israel-led war.

Yeah the risk of falling for this scam is not only that you are out some Bitcoin but also that your ship gets blown up.

In 2024, Global Tetrahedron LLC, the company that owns the comedy website The Onion, tried to buy Alex Jones’s conspiracy website Infowars out of bankruptcy. For reasons that never made sense to me, the court rejected the purchase, and Infowars remained in a weird limbo and apparently controlled by Jones. But the New York Times reported yesterday that “The Onion has re-emerged with a new plan: licensing the website from Gregory Milligan, the court-appointed manager of the site.” And The Onion reported that “At Long Last, InfoWars Is Ours,” and lays out its plans:

Such is the InfoWars I envision: An infinite virtual surface teeming with ads. Not just ads, but scams! Not just scams, but lies with no object, free radical misinformation, sentences and images so poorly thought out that they are unhealthy even to view for just a few seconds. The InfoWars of old was only the prototype for the hell I know we can build together: A digital platform where, every day, visitors sacrifice themselves at altars of delusion and misery, their minds fully disintegrating on contact.

Sounds cool. As of noon today, Infowars still seems to be controlled by Jones. It has a headline saying that “The Onion Has Fraudulently Claimed AGAIN That It Owns Infowars!!!” Two points here:

1. I often write about questions of who controls a company, but I will say that the answer to the question “who controls a website” is pretty much the person with the password to change the website. So, points to Jones, so far.
2. If the Onion does falsely claim that it owns Infowars, is that “fraudulent”? The Onion is, after all, a satirical site. “Pelicans-Kings Game Ends After Neither Team Able To Recover Tipoff” is another recent Onion headline, and not true. If The Onion was pumping and dumping stocks, would that be protected satire?

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