What was initially seen as a healthy clearing of froth from one of the world’s fastest growing market has become a worrying and globally catastrophic nosedive. Over the past few months, China’s stock market has endured a roller-coaster-like trajectory. Recently, the Shanghai Composite index has hovered around $3000 per share, marking a loss of a year’s worth of growth. Investors from around the globe have watched as the Chinese government has fought, to arguably no avail, to artificially prop the market back up. Despite the government’s extreme policy measures, daily swings in the market have been extreme, peaking in a one day 8.5 percent drop known as “China’s Black Monday.”  While the changing global arena has lent for a correction in the Chinese market, the greatest change, however, seems to be in the mindset of investors themselves.

Due to extent of government intervention in its own market, many have come to see China’s market as a reflection of its own credibility and reputation. China has taken a more hands-on approach to controlling its market than any other economically significant country in the world. Preceding the crash, China’s state-owned media stations encouraged individual investors to make risky investments using borrowed money. In many cases, the aggregate of their investments exceeded the rate of growth and profits of the companies. In addition, the central government began to slowly loosen monetary policy, eventually lowering lending rates. As a result of China’s heavy involvement in the market, many investors found themselves in an arena rife with moral hazard. Investors were able to make risky bets with the cushion of the Chinese government stepping in to prevent crashing stocks. This “risk-free” environment was able to galvanize soaring levels of investment in the market, creating a bubble in the market despite economic slowdown. In one year, the Shanghai Composite had climbed more than 150 percent.

Once the market had begun to fall, China underwent extreme measures to stop the market from falling further. Despite president Xi Jinping’s expressed desire to make the Chinese stock market a more liberal and globally integrated entity, the Chinese government created and enforced an onslaught of restrictions on the market and its investors. In July, the China Securities Regulatory Commission imposed a 6-month ban of stock sales by major shareholders. In addition, officials threatened to arrest any investor found of short selling, a form of investing that essentially bets against the market. Shortly after, stock prices began to artificially rise again, only to result in China’s largest drop yet, known as Black Monday. Once again, Chinese officials searched for scapegoats to preserve their international reputation.  In less than a week, Chinese authorities arrested and questioned 197 people they blamed for “spreading online rumors” that “lead” to Black Monday.

Yet while China scrambled to defend its economy, the response of its citizens has revealed changing ideals. Although government has tried to artificially prop up the stock market and convince their investors of less volatility, the prospect of possibly losing life savings has put many investors into a state of panic. Nearly a third of the country’s individual investors (more than 20 million people) have fled the plunging stock markets. The number of investors holding stocks in the account fell from 75 million in June to 51 million at the end of July. Backed into a corner and scarred by losses, Chinese investors have looked for safer forms of investments. Many have realized that there is nothing stable to be found at home. As ZZ Xu, a Shanghai restaurateur, noted, most Chinese citizens have come to realize that they “can lose a lot of money very quickly.” With the second highest rate of urban household savings (51.5 percent), much of China’s citizens have begun to pour their money into foreign investment, specifically, real estate. Currently, Chinese investors are the leading foreign buyers of U.S. Homes, accumulating a record $29 billion dollars in annual sales. Similarly Australia’s foreign investment review body recently stated that China had overtaken the U.S. as the country with the largest investment from overseas, totaling roughly $19.6 billion dollars.  At the end of August, China’s monthly capital outflows peaked at a record high $141.7 billion dollars.

In some contexts, the increase of outward investment is no cause for panic. However, China’s current economic state leaves it particularly vulnerable to this flight. Firstly, this outpour inopportunely arises when China is experiencing slowing growth. As a result, many of the “post-economic boom” businesses that were funded through loans are already struggling to raise capital. Secondly, China is already using monetary easing to prop up its economy, and is thereby left impotent in defending its currency. It comes to no surprise that China subsequently devalued its currency, a common result of capital flight and a last-ditch attempt to strengthen falling exports. Thirdly, the imminent Federal Reserve rate hike will cause even more capital outflows, as investors will be given even more incentive to preserve their wealth in U.S. financial institutions and instruments. Lastly, volatility in Chinese markets and decreasing investor confidence has also scared away many foreign investors. On Aug 25th, shortly following China’s “Black Monday,” foreign investors pulled a record $19 billion dollars out of Chinese investments. At the end of the week, the outflow totaled $29.5 billion dollars, surpassing any weekly outflow during the U.S recession.

More broadly, the rise and fall of the Chinese Stock Market has stained the market itself permanently. While it has undoubtedly directly affected global equity and commodity prices, it is the indirect effect that will last for years to come. Unlike in other significant economies, institutional investors play a rather small role in China’s stock market. Rather, retail investors, of which more than two thirds didn’t even graduate high school, own around 80% of tradable shares.  As a result, China’s market is primarily driven by one force: investors’ confidence. With millions of individuals fleeing the market, even more are destined to follow the pack. This leaves China’s market subject to a downward-spiraling cycle. Retail investors are leaving the market because returns are poor and returns are poor because individuals are leaving the market. Moreover, the increase of capital flight will continue to damage Chinese businesses themselves. While China has already posed stricter capital regulations, and has sought to cut down on money smuggling, the flight continues to grow. As a result, the Chinese government will soon find themselves in a relatively impotent state to defend the market. With few institutional and state-owned investors to command and increasing capital outflows, their artificial stimulation will run out of steam.

“We’ve confidentially submitted an S-1 to the SEC for a planned IPO. This Tweet does not constitute an offer of any securities for sale.” With these words, on September 12th Twitter not so confidentially announced its decision to initiate the transition to becoming a public company. And ever since then, Twitter has appeared in financial news every day regarding its prospects about the IPO process. From talking about the slightest amendments made in the latest version of the S-1 sent to the SEC, or to the growing worry that Twitter is slowly losing user base, few news stories seem more prevalent than Twitter’s IPO.

However, in the midst of the Twitter fervor stands one man who is not necessarily all too hyped about the social media startup. Shai Bernstein, assistant professor at the Stanford Graduate School of Business, in his 2012 research paper Does Going Public Affect Innovation? notes that recent startup businesses entering public equity markets become, overall, less innovative as a firm. Specifically, he notes that post-IPO tend to pursue less-novel projects while experiencing high employee turnover (Bernstein).

According to Bernstein, measuring a firm’s level of innovation is a great proxy for measuring its success as well. Especially within industries where firms heavily rely on product differentiation and out-of-the-box creativity to ensure an edge over competitors, innovation plays an important role directing a company’s future prospects.

In his study, Bernstein compared two types of tech companies: 1) those that went public, and 2) those that were about to go public but had withdrawn IPO plans. What he found was that amongst firms of similar size, R&D spending, and in the same sector, the ones that went public significantly dropped in number of quality and original patents. For instance, he found that the average quality of those patents, as measured by how often they were cited, declined by about 40% in the 5 years after going public. By contrast, companies that remained private stayed on the same track as before (Bernstein).

In addition to patents analysis, Bernstein found that post-IPO firms experienced higher rates of management turnovers. He notes that many executives leave the firm after cashing out on their equity in the company because, and even worse, the ones that stay after the IPO become less productive (Bernstein). This caused a serious brain drain for many of the companies that went through with the IPO, and also led to the overall decrease in the firm’s internal innovation level.

Bernstein notes that there exists a complex trade-off between public and private ownership forms. While private firms are far more ambitious in its projects and innovative in its ideas, public firms have easier access to capital that enables firms to bring other innovative thinkers or are able to acquire small innovative companies (even though the public company itself might not be as innovative) (Bernstein). Certainly, the pressures from outside investors coupled with equity market conditions have a great impact on how companies behave after their IPO, which significantly affect its course of direction moving forward (Bernstein).

So what does all of this have to do with Twitter? Is Twitter going to become less innovative and experience significant decreases in human capital after the IPO? Probably, the answer is a no. Although I am not psychic, I think there are some points of considerations that allow Twitter margins of insulation from the potential harms of an IPO that Bernstein discusses.

The biggest difference is the fact that Twitter is a social media company that relies less on developing new innovative products. It is more focused on generating public recognition and usage. What sets Twitter apart fundamentally from the tech companies in Bernstein’s study is that Twitter is a benefactor of public attention, while for the latter it is a hit or miss. Whether Twitter receives good press or bad press from the media, the very act of public discussion about Twitter keeps its name relevant in the public domain. Twitter users don’t factor in the financial competency of the company to decide whether to use its products. Twitter does not require continuous patent developments to keep thriving; as long as it can provide the same level user experience for people then, for the most part, people do not complain. And as long as people are using Twitter as a medium of social media, then its business will stay afloat. Unless a major breakthrough in social media or changes in social norms of online communication strikes Twitter out of left field, the need for constant innovation is not a requirement for Twitter.

With this said, as Twitter prepares its IPO, scheduled for mid-November, Bernstein’s finding is nonetheless an important warning that Twitter should take heed. Especially in today’s day and age where new Apps pop up in iOS and Android on a daily basis, it is ever important to maintain knowledge of the changing industry and the key players involved.

 

Lots of money

In asset management, the first lesson is staying diversified. For the average household investors, the public markets are the place to put their money to work. Equity, bonds, commodities, and, for the more adventurous, derivatives are what one finds in most individuals’ portfolios. But for institutions with hundreds of millions in cash, whether it is college endowments or insurance companies’ pooled premiums, the investment options become more colorful. Private equity, hedge funds, and real estate are three examples of alternative asset classes that institutional investors often turn to in order to complement their public market investments.

The illiquidity and large capital requirements of the alternatives make them inaccessible to the average investor, which are also big risk factors that allow those with the means to invest in them to demand return premiums. While alternative assets behave differently from public securities and derivatives, they are by no means immune to the swings of the economy. Through the course of the financial crisis, institutional investors have had to face the challenge of reevaluating the role that assets like private equity and hedge funds play in their portfolios.

The relationship between risk and reward is frequently evaluated by asset managers when they perform due diligence on potential investments. For large investors, the excess returns that come with alternatives also bring along higher risk. For the managers of private equity and hedge funds, their losses in the crisis bought them an expensive lesson in investing, but most of the surviving funds maintain their fundamental strategies. For the institutional asset managers, their losses gave them enough of a scare that they had to rethink their asset allocation targets.

In the International Monetary Fund’s (IMF) September 2011 Global Financial Stability Report, it notes that “the empirical results and survey responses indicate that asset allocation strategies of private and official institutional investors have changed since the onset of the global financial crisis. Most importantly, investors are more risk conscious, including regarding the risks associated with liquidity.” It seems only natural that this risk aversion might divert interest from the riskier alternative assets. Yet, given the need to diversify and recover losses, there has actually been new interest in alternatives. For example, pension funds surveyed by the IMF increased their allocation in these investments from 10.9% in 2006 to 15.6% in 2010.

Looking at university endowments in the U.S., the amount of money invested with alternative fund managers has actually increased during the crisis. Based on the annual study on university endowments by the National Association of College and University Business Officers, in aggregate, endowments have increased their alternatives allocation from 35% in 2006 to 52% in 2010. This rise is most dramatic for the largest endowments (with $1 billion or more), from 40% in 2006 to 60% in 2010. Smaller endowments, with more limited resources, have expectedly smaller amounts invested outside of equities and fixed income. However, it may be premature to cite this evidence that the crisis increased the demand for private equity and hedge funds. This increase may simply be due to the fact that with the size of endowments decreasing and the illiquidity of alternatives, these institutional haven’t been able to adjust their allocations quickly.

One group in particular caught the attention of the media when time came for assessing damages post-crisis: Ivy League universities. The Yale Model, named after the university, was popular among investment managers of college endowments. It called for a significant allocation to “private- equity and real- estate funds or commodity-related assets”. In the past two decades, this strategy brought great returns to these endowments, especially those of Harvard, Princeton, and Yale. Yale and Princeton allocated 70% of their endowments to these assets, while Harvard had 57% of its money committed. From 1998 to 2008, “the Yale endowment gained 16.3% annually, while Harvard rose 13.8% a year and Princeton, 14.9%. The Standard & Poor’s 500 logged an average annual increase of just 2.9% in that span.” So how did the lauded alternatives fare in the crisis? While the jury is still out as the economy recovers, evidence from the few years after the crisis shows that they endured worse losses than traditional assets. Private equity, real estate, and commodity related investments took average write downs of around 50% (exact loss is difficult to determine as the returns on these investments are realized over the long term).

If the results from the Ivy League are any indication of overall financial conditions of institutional investors, it is hard not to be pessimistic toward alternative assets. They are a source of liquidity risk, and, as the crisis has shown, are not completely uncorrelated with the public market. However, with still large amounts of cash to invest, institutions need a way to include more return drivers in their portfolios. Currently, that means looking outside of the sluggish stock market and at private equity, venture capital, real estate, and hedge funds. It is not that the wound from the crisis is not deep enough to steer the likes of Yale and Harvard away, but instead the need to reenergize investment in companies means potential future benefit for those who have the money to fill the void. Institutional investors may provide the push that the economy needs to get back on track.