Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
Uncovering the Roles of Participants in Capital Markets (S1 E5)
Prepare to have your perspective on the U.S. capital markets revolutionized as I, Edward Finley, sometime professor and Wall Street investor, unveil the misconceptions and truths behind our economic engine and those who drive it. In addition to the three common participants in our economy, we'll add financial intermediaries, who play a key role in how markets work.
In understanding the role of firms in the economy, we'll challenge the notion that small businesses are the bedrock of the US economy, and instead, shine a light on the might of large firms—the real heroes in job creation and business revenue. As we dissect the life cycles of firms, you'll understand why young startups bet on equity to drive growth, but as they mature, they pivot to using retained earnings or debt to fuel growth. The fierce competition among firms doesn't stop when they reach that level of maturity, and we'll discuss the risks to mature firms.
You'll also gain insights into perhaps the most important participant in our economy: households. The odyssey of that journey -- from borrowing in our youth to saving for the golden years -- we'll see how our spending habits ultimately fuel capital markets.
Government, the third player in the economy, ever the voracious consumer of capital, orchestrates funding for ambitious long-term goals, and uses capital markets to skillfully redistributing resources for the public good.
Finally, we'll explore the fourth participant in financial markets -- intermediaries -- and discuss the important distinction between the buy-side and sell-side.
It's a thrilling expedition into the intricate ecosystem of our financial markets, and you're invited to join the voyage.
Notes - https://1drv.ms/p/s!AqjfuX3WVgp8uGa7L0VEg_eXnxlG?e=yvfnsh
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Hi, I'm Edward Finley, a so Time Professor at the University of Virginia and a veteran Wall Street investor, and you're listening to Not Another Investment podcast. Here we explore in markets and investing that every educated person should understand to be a good citizen. Welcome to the podcast. I'm Edward Finley.
Edward Finley:Well, we've spent some time so far talking about what the different capital markets are in the US and the role of those capital markets. I'd like to turn our attention today to the roles of participants in capital markets. Economists typically think about three participants in most financial markets firms, which are sort of business enterprises, households you and me and others like us and governments. We're going to introduce a fourth category in talking about participants in financial markets, which are financial intermediaries. It turns out financial intermediaries play a crucial role in the proper functioning of financial markets. Let's start with firms. Generally speaking, when we say firms, we mean business enterprises that participate directly in the production of goods and services in the economy. They are broadly net demanders of capital, but that varies individually with the particular point in the life cycle of a firm that we find it. We're going to talk a little bit about that more later. What I want to point out here, though, is that the conventional story in the US is that our economy is built fundamentally on the backbone of so-called mom and pop businesses, and it turns out that's not entirely accurate. So when we say firms here, we're going to speak very specifically about business enterprises that are organized with limited liability. Recall our earlier discussions about one of the key features in capital markets that make them function efficiently and properly is limited liability, and so I want to distinguish here first, business enterprises like mom and pops that are not firms, and firms, business enterprises that are organized with limited liability.
Edward Finley:In the US, firms employ most labor and they account for most business receipts, and the majority of firms are really quite large. Let's take that apart. So about 134 million Americans were employed in 2020, and the vast majority of them worked for a firm. Only about 10% were self-employed. 90% were employed by a firm. Of the 116 million or so Americans that were employed by firms, most were employed by a fairly large firm, that is, more than half. 54% were employed at firms with more than 500 employees. That's a substantial firm. About 30% were employed at firms with between 20 and 500 employees, and only 6% were employed at firms with fewer than 20 employees. So let's just recap that for a second 90% of Americans were employed in 2020 by firms. Those firms were predominantly very large more than 500 employees but 80% of them had more than 20 employees. Only 6% were firms with fewer than 20 employees.
Edward Finley:So where does it come from? Where does this mythology come from that American economy is built primarily on small enterprise mom and pop operations? Well, here's where it might come from. It might come from the fact that firms account for only 27% of all businesses. So when you ask Americans if they're engaged in a business, only 27% of those businesses that file tax returns every year are firms. 73% of them are not. 73% are small mom and pop operations. So, certainly to a politician who cares about voters, it's the vast majority of businesses that are mom and pop businesses. But firms employ most Americans 90% and firms earn the vast majority of all business receipts. In the US, 96% were earned by firms. So we have a kind of notion here that American businesses really built primarily on mom and pops, and that's true if we were just taking a headcount. But it doesn't account for where most Americans work and it doesn't account for where most business receipts are earned.
Edward Finley:Young firms have to rely on equity and debt markets to grow, while mature firms can continue to innovate and grow off something called retained earnings. Retained earnings just means that after the firm accounts for all of its expenses and it pays dividends to its shareholders, the remaining amount of money is retained earnings, and that creates some interesting incentives and behavior in terms of how and when firms access capital markets and how market participants determine the value of a firm's shares. Let's start by thinking about young firms first. Young firms are in a highly speculative, exponential growth phase in their earnings and it's subject to great swings. This, of course, leads to very highly volatile prices. Management of young firms keep very little cash, in fact, if they're profitable at all. Instead, these firms experience large increases in expenses, mostly capital and labor, as they grow. In order to fund those expenses, firms will access capital markets several times along the way to becoming a mature firm.
Edward Finley:Recall our discussion earlier of venture capital and growth equity categories. That really roughly tracks the life cycle of a firm. Investors will have the least information on which to base their decisions about the prospects of a firm with young firms and the risk of predicting future changes in the capital structure that could affect the value of their shares. Let's contrast that with mature firms. Mature firms' growth is still positive and it's in line with, or for very successful companies, maybe even larger than, broad economic growth. But mature firms grow by using retained earnings, so they rarely access capital markets, except maybe for acquisitions. The share prices of mature firms tend to be more stable and grow at lower rates, but at the same time, mature firms are less likely to fail. Investors have much more information on which to base their decisions about the prospects of a mature firm and there is therefore less risk in predicting the future value of that firm.
Edward Finley:The risks for mature firms are present in the disruption of their business model, entrance of new competitors and management missteps that can destroy value very quickly. A simple example to bring this to heart is Blockbuster Video. For those of you old enough to remember, before there was streaming, we all rented first videotape, videocassette tapes and then DVDs. Blockbuster was the place to rent these movies. With the introduction of the internet, and then, soon after that, Netflix, Netflix utterly disrupted the business model of Blockbuster, ultimately leading to Blockbuster's bankruptcy.
Edward Finley:Let me say a few words about the role of debt and equity in funding firms in the economy. When firms raise capital. They of course have a choice. They can choose either or both. Equity is the typical way for younger or fast growing firms to access capital because of the very special mix of burdens and benefits that equities present. So first, if you raise capital by issuing equity, you have no obligation to pay dividends. Recall our conversation about equities from earlier no obligation to pay dividends or to repay the capital, for that matter. It means that raising equity capital presents a very limited strain on a company's cash flow, which is crucially important at the earliest phases of their growth. Equity owners have to share future profits and perhaps even control. But because these firms at their youngest stages are so highly speculative, a firm doesn't have to part with nearly as much of the enterprise to raise the necessary capital. And since young firms use capital to fund their expenses, it's very useful that if the business fails, there's no need to repay the capital.
Edward Finley:Let's think about debt. In contrast, Debt is the more typical way for mature firms to access capital because of its unique mix of burdens and benefits. Firms that are mature have more reliable cash flows and that makes it easier for them to pay interest on that capital. It also makes it easier for them to ultimately repay the principal at some point in the future rather than sharing their profits, and that can be very useful for a firm that's not expected to grow very rapidly and wants to maintain as much of the economic benefits to themselves as possible. Interest on debt is tax deductible, which is very useful if you have profits, but it's not terribly useful if you don't have profits. It's in contrast to paying dividends. The same excess profits of a firm that one could use to pay dividends or to pay interest are given very different tax treatment, and it's much more useful to pay interest if you have profits that are taxable.
Edward Finley:Bond repayments provide a predictable value at which the borrower can terminate the relationship. This is in stark contrast to raising capital via equity, where once you take on an equity owner, short of buying them out, you have no real way to exit that relationship. But lenders who lend money in the form of debt capital put restrictions on some of the non-core business activities of the firm, and they also insist often on certain promises about some financial metrics that could limit a firm's ability to run the business freely in the way that they'd like to. For example, lenders often want to see very low debt to equity ratios. That just simply is a fraction of the amount of debt over the value of the firm's equity capital, and so it might insist that before you borrow money, you raise some equity capital. As I say, the mix of debt and equity can be specific to a firm at its particular lifecycle. It's going to be a mix depending on the benefits and costs to the firm at that moment. There's also something interesting to note here, and that's a blend of equity and debt, something called convertible bonds.
Edward Finley:Convertible bonds are a way for both young and mature firms to raise capital. So what are convertible bonds? Convertible bonds are bonds in any other way that you might imagine, except that the bond holder has a right to convert that bond into equity at a predetermined ratio, unilaterally. So it's bond, but the bond owner can convert it into equity. Convertible bonds are very, very useful for a company with poor credit rating, If, let's say, it's a mature company. It can be useful for a company in the middle of its lifecycle where it can afford some interest expense, but it can't afford, perhaps, the interest expense that it would have to pay the market for pure debt. Why is that? Well, with convertible bonds, because the capital provider is permitted to convert it into equity, the interest rate on those bonds will be lower and it makes sense. If I have an ability to convert the bond into equity when the firm is being successful, then I probably demand less money in interest during the first period. The upside is shared only if the company does well, assuming that the bond holder converts into equity. The firm retains control because when they issue the bond they don't dilute their equity ownership in the firm until it's converted. It's interest payments, not dividends, so it's deductible if the firm has taxable profits, and while it does contain restrictive covenants that are more restrictive than traditional loans, it can be somehow more flexible. Alright, so that's firms.
Edward Finley:What about households? Households fundamentally provide labor and earn income for it. They make decisions about present consumption that lead the households to save, and they too have a life cycle. In the early years, a household savings is typically negative, that is to say they borrow to fund their lifestyle and expenses. In their middle years, savings is positive, that is, they're building a portfolio for future use. And in their later years, household savings become negative again, that is, they're no longer earning income and adding to their portfolio. Instead they're spending their portfolio.
Edward Finley:Overall, households are net suppliers of capital. Now it's interesting to note that with changes in American demographics there's begun a shift, with more of the US population increasingly having negative savings. And one should think very carefully about what would be the implication for markets where households are not increasing the amount of capital available for risky use. What are the implications where markets are global and US households are not savers but other countries are? And when we think about those questions, we realize that in a market economy where households are really the only providers of capital, it's very important to know whether the source of capital is expanding, static or declining. Because in a world in which the source of capital is expanding, that will put a natural limit on the increase in prices of securities, but where it's contracting, that will necessarily put upward pressure on prices, All right. So firms are net demanders of capital. They're the engine of producing goods and services in the economy. They employ who, they employ households. Households are fundamentally the providers of capital in our capital market.
Edward Finley:Last of the traditional categories is government. Now in the US we have to differentiate because of course we have two kinds of government. So let's start with the national government. The national government in the US is a net demander of capital. It borrows both long term to fund its programs and it borrows short term to fund gaps in their cash flow. Recall we talked about treasury bills short term borrowing just to fund gaps in cash flow and treasury bonds are longer term financing to finance the national debt. Well, that long term borrowing and, to some extent, taxation are the ways that the national government demands capital from the market. And what does it do with that capital? It reallocates that capital to public use. So there are sort of three main categories in which the way the government allocates capital to public use once it's demanded from the market.
Edward Finley:First, it lessens the burdens on the productive economy. So what does that mean? Well, if we lessen the burdens on a productive economy, it provides more efficient ways for firms and for households to engage in economic behavior. Some examples well, the provision of healthcare to the elderly or to the poor, the provision of subsidies for food or housing for those who are poor, and the subsidies to other governments like states subsidizing state programs for the poor or state unemployment insurance. All of these things allow for a more fluid economy, and a more fluid economy means a more efficient economy.
Edward Finley:So the first object of why the national government demands capital is to lessen the burdens on the productive economy. The second reason is to provide what economists call public goods. Public goods are important goods think highways, defense spending but they wouldn't be provided by the market, and you can see why not. It doesn't take an economics degree to figure that out. If you need defense from foreign invaders, how can the market provide that? Which is to say, how can someone only get that defense if they pay for it? The answer is really can't. If you're going to defend the country from foreign invaders, the truth is you have to defend everyone, and if you're defending everyone, no one has an incentive to pay for it.
Edward Finley:This is a classic public good. The national government provides important public goods and they demand capital from the market to supplement their tax revenues. Third and last are what are sometimes called quasi-public goods. Quasi-public goods are not exactly public goods in the sense that someone could pay for it and would derive benefit from paying for it, and often these are things that are so very speculative in the future that private investment is not allocating sufficient capital to those exercises which we might all agree are very useful, and in that case the national government can promote research and investment in areas that they believe are critical to the public good. A great example of this was the invention of the internet, largely funded by the government, and more recently, the Biden administration has passed a bill, with Congress's help, to provide funding for alternative energy sources. These are all quasi-public goods. The national government is providing important funding to begin the process of creating something innovative, one that might not get created by private enterprise, with the expectation that later, private enterprise and capital would do the job itself.
Edward Finley:The national government can also be a provider of capital via the Federal Reserve's monetary policy. We know, for example, from headlines phrases like quantitative easing and quantitative tightening. Those are two examples of the Fed. Either, in the case of quantitative easing, providing capital that is to say, they are buying treasuries from the market, and that's putting capital in the hands of the public or quantitative tightening is when the Federal Reserve is selling treasuries or other securities to the market. They're removing capital from the capital markets.
Edward Finley:How about state governments? Well, state governments in the US also demanders of capital, but for a very, very different reason. They're required to balance their annual budgets, so any expenses that they might incur for things like the public goods that we talked about are quasi-public goods or lessening the burdens on the productive economy they need to fund with tax revenue. State governments are demanders of capital from capital markets, typically for large long-term capital projects Think building airports, building highways and they borrow from capital markets to fund long-term liabilities here think about state public employee pensions. Unlike the national government, they don't have the power to create capital. State governments will only ever be demanders of capital.
Edward Finley:Let's discuss now the fourth member of our financial market financial intermediaries. Financial intermediaries operate to bring together suppliers of capital namely households typically and demanders of capital, namely firms and government. They operate in primarily two ways. The first is called the sell side. Well, firms, typically that are accessing capital, they're net demanders of capital. They seek to sell securities to the public. They either need to sell equity to the public to raise equity capital or sell debt to the public in order to raise debt capital. Typically, they need advice on which type of security they should use, whether they should use either or both. What market should they raise it in? Should they raise it on an exchange? If so, what exchange? At what price? These are the kinds of things that firms have to decide before they raise capital in markets. Investment banks our first financial intermediary advise firms on those decisions, and when they do that, they're operating in what's called the sell side. Sell side because they're advising firms that are selling securities to the public. Investment banks, however, also market these securities to investors by selling them to large institutional investors or to the general public. Recall our discussion, for example, of underwriters in the IPO market. So investment banks here not only advise firms, but they can also undertake to sell those securities to the public.
Edward Finley:What's important to understand about investment banks is that they do not stand in a fiduciary relationship with their client. They have a relationship, of course, and I'm not suggesting that they would ever do anything illegal or untoward vis-a-vis their client, but, as you'll see in a moment, it's very, very different from the other category of financial intermediaries who do stand in a fiduciary relation with their client. What I mean to suggest here is that investment banks are engaged in an economic transaction with firms that are either raising equity capital, raising debt capital, retiring equity or debt capital or some other action in capital markets, and they do so not as a fiduciary, but as simply someone providing a service to those firms. Okay, so that's the sell side. What's the buy side.
Edward Finley:The buy side are those financial intermediaries that take responsibility for investing client assets in securities markets, ie they buy securities on behalf of their clients. Think pension funds, insurance companies, endowments, mutual funds. All of these are pools of assets that are held to be invested in securities markets. The pooling permits a pension fund or an insurance company, say, to broadly diversify its risks. It also permits them to attract and retain someone with expertise specific expertise in a type of security, in order to increase their efficiency or to reduce costs or increase scale. Investment companies that pool assets for investors are those that then invest in the securities markets. So investment companies tend to execute on a specific kind of risk. For example, it's not unusual to find an investment company that invests in US large cap stocks, but it does so in a way to provide diversification of any individual firm's risk.
Edward Finley:Some investment companies own different types of securities and diversify across lots of different risks in order to achieve a certain goal. Here there are things like target date funds, where you put your money with an investment company and they promise to invest it with the idea of providing for your child's college education in a certain year or for your retirement in a certain year. They'll invest across a multitude of different securities not any one and by diversifying across the different securities they help achieve the goal. Households can gain access to different types and greater numbers of securities that would be otherwise very difficult to buy directly. Recall our discussion of some of the advantages of creating money market funds. This is the same concept but applied broadly across all securities.
Edward Finley:As I mentioned before, investment companies develop expertise and they reduce trading costs by having scale, and some investment companies specialize in owning very different or alternative risks. One example might be hedge funds, or investing in non-public equities, like private equity, or investing in non-public debt, like private debt. All of that we'll discuss in much more detail in future episodes when we talk about asset classes. The thing to take away here, however, is that the buy side firm always stands in a fiduciary relationship with the client. That means the buy side can never put its interests ahead of the client's interests. They always must put the client's interests first, and that introduces a whole host of protections that make it very difficult for firms on the buy side to pursue a project or to pursue a strategy that would intentionally injure the client. Well, that's it for this episode. Thanks again for listening. Have a great day.
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