One thing that sometimes happens is that a small startup needs some money to keep the lights on, so it finds an investor who is willing to put in $100,000 but wants 10% of the company in exchange. The startup says yes, because (1) without the $100,000 the lights will go off and there won’t be a startup anymore, and (2) $100,000 for 10% of the company — a $1 million valuation — seems pretty generous, given that the startup has no revenue and can’t keep the lights on. The investor is putting up real money that the startup needs, and getting back nothing but a share of the startup’s very uncertain future success.

And then the startup invents some fundamental world-changing thing like cold fusion or AI or the “like” button, and it becomes a $100 billion company, and the investor’s $100,000 investment is worth $10 billion. And then:

1. Everyone high-fives the investor, who becomes a venture capital celebrity for getting in early on a huge success story.
2. At some theoretical level the startup’s founder should be annoyed, because she gave up 10% of her company — now worth $10 billion! — to the investor for only $100,000 in cash.

But she is probably not that annoyed. For one thing, she is the founder of a $100 billion company and has made many billions of dollars for herself, so it seems greedy to want more. More fundamentally, though, she is a venture-backed startup founder and is acculturated into a world that understands these kinds of bets. She understands that she got to where she is today — $100 billion — not only through her own skill but also because she had access to capital along the way. She understands that investors are constantly writing checks to small startups in exchange for equity stakes, and that a lot of those stakes turn out to be worthless, and some turn out to be kind of meh, and a very very few turn into multi-billion-dollar paydays. And you, as a founder, want to be one of those multi-billion-dollar paydays. The investor only makes a lot of money in states of the world that are also very good for you. Your interests are aligned.

On the other hand, we talked the other day about Financial Technologies Partners, a boutique investment bank that advises emerging financial technology startups in exchange for 5% to 20% of their equity. Or, not quite. FT Partners takes its fees in the form of long-term contracts promising it 5% to 20% of the proceeds of various future deals for the company, including sales of the whole company. These future fees are not actually equity; FT Partners does not own stock. But an arrangement like “if you sell your company we get 10% of the proceeds” is economically pretty similar to “we own 10% of your company.”

It is emotionally different, however. If you sell 10% of your company to a venture capitalist in the early days, you think of that VC as a partner on your journey, you are all in it together, and eventually you rejoice in the shared success of selling your company for $100 billion. If you hire an investment banker in the early days, and then later your company is worth $100 billion and the banker comes to you and says “$10 billion please,” your natural reaction will be to say “no” or “who are you” or “man you did not do $10 billion worth of work for us.”

And so in fact FT Partners is involved in litigation against several of its clients who do not want to pay it fees that are, in hindsight, ridiculously huge. And there is something sympathetic about saying “you did a little investment banking work for us a decade ago, and it’s ridiculous that you now expect to get a billion dollars for that.” Whereas “you gave us a little cash for our stock a decade ago, and it’s ridiculous that you now expect to own a billion dollars’ worth of stock” does not get much sympathy. Everyone understands that if you buy stock in a small company, and then it becomes a giant company, you get back much more money than you put in. Form matters; getting a 100x return on your actual equity is normal, but getting a 100x return on your equity-like-but-not-really-equity claim rubs people the wrong way.

We talk occasionally around here about the classic dorm-room financial question, “what if people could sell stock in themselves?” There are some real businesses that do versions of this — paying upfront for a share of people’s future earnings — and often they specialize in young athletes. Sports prospects often need money but don’t have much, and they have a venture-capital-like return distribution: Most minor league baseball players or junior tennis players will never make much money, but a few of them will make hundreds of millions of dollars. So if you found 100 promising players and gave them $500,000 each for a 10% stake in their future big-league professional earnings, (1) a lot of them would take the deal, (2) probably without a lot of adverse selection against you, [1] (3) 90 of them would end up repaying you $0, (4) nine of them would have nice careers and pay you a few million dollars each and (5) one of them would be a superstar, make $500 million of lifetime earnings, and return your entire fund.

As I have written before, though, there is a technical problem with this sort of thing. As a dorm-room question, “what if you could sell stock in yourself” is terrific. But of course you can’t. You’re not a corporation; you don’t have stock. [2]  You can sign a contract that is the approximate economic equivalent of selling stock in yourself: You can sign a contract saying “I will give you 10% of my lifetime earnings,” which is pretty close to selling a 10% ownership stake. [3]  But it is not the same as selling a 10% ownership stake.

So if you sell someone 10% of your lifetime earnings for $500,000, and then your lifetime earnings turn out to be hundreds of millions of dollars, you might say “you gave me a little cash a decade ago, and it’s ridiculous that you now expect me to pay you tens of millions of dollars.” Again, a startup mostly wouldn’t say that to a venture capitalist that bought its stock, but you are not a startup and nobody actually bought your stock.

One more technical point. Nobody bought your stock, because you are not a company and you don’t have stock. But somebody did give you money, and you signed a contract promising to give them money later. What was that money, if not an equity investment? What would you call that contract? Your first instinct might be to call it a “loan.” It is an unusual loan — instead of paying back a fixed amount with interest, you agree to pay back an amount that varies depending on your future income and that could be zero — but I don’t think it is crazy to characterize it as a loan. 

This is a problem, because there are consumer-protection rules requiring disclosure of loan terms, and many states have usury laws capping the interest rate on loans. If you get $500,000 from an investor for 10% of your future earnings, and then end up making $500 million and owing $50 million to the investor, that is going to work out to an annualized return that is way way way higher than the usury cap. And the investor will say “no, see, I was taking equity-like risk on a portfolio of athletes, and this was the only one that worked out, and it’s not a fixed rate of return at all.” But you might say “nope, technically a loan, you can’t charge me more than 16%.” And this can work: We talk from time to time around here about transactions that are characterized as roughly equity purchases, but that then get recharacterized as loans and subject to usury rate caps.

Anyway:

San Diego Padres outfielder Fernando Tatis Jr. filed a legal complaint Monday against Big League Advance Fund and Big League Advantage, LLC (BLA), a company that offers players upfront payments in exchange for a percentage of future MLB earnings. Tatis owes millions to BLA after agreeing to a deal with them in 2017.

The complaint, filed in the Superior Court of California, County of San Diego, seeks to hold BLA accountable for “exploitative, predatory business practices, which shamelessly push illegal loans on young, vulnerable athletes — most from economically disadvantaged Latin American countries,” according to a press release from Tatis’ legal team.

Tatis, who signed a 14-year, $340-million deal with the Padres in 2021, initially praised the agreement with BLA, telling The Athletic’s Ken Rosenthal in 2018 that he signed the agreement because he needed the money to hire a personal trainer, rent a better apartment and buy better food. At the time, Tatis was a prospect in the minor leagues and said he wasn’t worried about the BLA bill that would come if and when he made it to the big leagues. …

That thinking has apparently changed. According to the release, the suit alleges that “BLA has for years run an unlicensed lending business that evades legal oversight and siphons millions in earnings from California workers.” …

The money BLA gives players is not a loan, per se. If a player doesn’t reach the big leagues, he owes nothing. If he does reach the major leagues, however, the price — a portion of pre-tax major-league earnings — can be hefty. 

See, if Tatis was a promising but cash-poor startup in 2017, and he sold 10% of his equity to an investor to raise cash to pay for rent and food, and four years later he was worth $340 million, then (1) the investor would get $34 million and (2) everyone would be happy about it. But that’s not quite what happened. What did happen? One possibility is “Tatis got a $2 million loan and now has to pay back $34 million,” which, when you put it like that, can sound a bit predatory. 

One possibility is that private credit will eventually trade in a more or less open liquid market. Another possibility is that it won’t. I tend to bet that it will: On a long enough horizon, everything ends up trading in a more or less open liquid market, and there are very powerful forces — forces like “leveraged buyout exits are delayed and limited partners are antsy for liquidity” and “everyone wants to sell private credit to retail investors, who need liquidity” — that are pushing private credit to become tradable. And so you see plans for private credit trading desks and marketplaces, and exchange-traded funds that presume liquidity.

But the view that private credit won’t trade is also quite respectable. The argument there is that the main selling point of private credit is that the borrower can have a long-term relationship with a single lender, or a carefully chosen handful of lenders, rather than with whoever decides to buy its debt on the market each day. [4]  Private credit, in this theory, charges borrowers higher interest rates, but in exchange gives them a better and more comfortable relationship. If the borrower runs into trouble, it will call one or two or five people whom it knows, and they will work out some reasonable accommodation. It won’t wake up one day to find out that all of its loans are owned by a vulture firm looking to take over the company. Companies — and particularly private equity sponsors who run a lot of leverage — are willing to pay for this sort of flexibility and stability. Freely tradable private credit would be oxymoronic; it would defeat the purpose of private credit.

And so private credit agreements generally say that the loans can’t be transferred without the permission of the borrower, which (1) protects the borrower’s interest in having its debt owned only by people it knows but (2) makes trading kind of tough. If you agree on a trade and then the borrower says no, you have wasted your time; it’s hard to get excited about a market where each trade has only a slim chance of going through.

Still, it is also respectable to bet that private credit will become more tradable, which means that people really are setting up trading desks to trade it. They don’t always have much to do. Here is a funny report from Bloomberg’s Ellen Schneider and Carmen Arroyo about the tumbleweed blowing through JPMorgan’s private credit trading desk:

It’s become something of a running joke in the world of private credit.

About once a month, JPMorgan Chase & Co. traders send out a list of dozens of loans they’re looking to buy and then, on most occasions, fail to get their hands on a single one. It’s not about the price. They’re willing to pay up. The problem is almost no one in private credit is willing to sell, let alone to a Wall Street bank.

The us-versus-them mentality is so strong that the lists, known as runs in the lingo of traders, often get no more than a perfunctory glance inside some private credit shops—just long enough to know what JPMorgan is trying to buy. The bank's struggles are evident, money managers say, in the lists themselves—full of outdated pricing and repeat requests to acquire the same loans—and in the follow-up calls its traders make to reiterate and push the purchase offers. …

Of the more than 20 private credit shops Bloomberg News spoke with for this story, including many of the biggest firms in the industry, none had ever sold a direct loan to JPMorgan. What's more, several of those money managers, who asked not to be identified discussing internal deliberations, said they never will.

One problem is the borrower preferences I mentioned above:

In the world of private credit, the borrowers, their private equity owners and the lead lenders typically have to sign off on trades. This essentially gives each of them veto power over every single transaction.

The owners, known as sponsors, often push back the hardest. For one thing, they like to limit the group of investors who have access to sensitive financial information about their companies, and loan trading would suddenly put those numbers in the hands of more people. More importantly, trades carried out at declining prices could expose stress in their companies and, in extreme cases, drag down the value of their equity stakes.

Another problem is that liquid trading markets create accurate mark-to-market valuations, which is maybe not what private-market managers want. This is what Cliff Asness calls “volatility laundering”: If your assets never trade, then you never need to mark them down, so your returns look less volatile than public-market returns. Schneider and Arroyo write:

[Private credit funds] fear that if JPMorgan, or any of the other banks following in its footsteps, is successful in creating a vibrant trading market for the loans, it could shatter the perception—or mirage, as critics would argue—of price stability that they’ve spent years selling to investors. The value of the loans, the pitch goes, won't ever get whipsawed around, and dragged down, by the vagaries of the broader markets because they are privately held assets. But if they trade regularly, price levels get marked, day after day, and private credit suddenly doesn't look all that different than its public market counterparts.

Sure. I assume that every new trading business starts like this, and that part of what makes a good trading pioneer is the ability to call every potential seller every day even though they never trade and laugh at you. Eventually it will become a booming business, or it won’t, but not for lack of effort.

Also here’s a wild non-trade:

The trading push has led to some embarrassing moments for JPMorgan. Like last summer, when its traders sent out a run that included price quotes on loans made to educational software company Pluralsight Inc. The run pegged going prices at above 90 cents on the dollar. But Pluralsight, it turns out, was so mired in financial trouble at the time that it was restructuring that debt. Some creditors had marked its value all the way down to 50 cents.

Okay okay okay, fine, you are a private credit fund, you do not want to sell your loans to JPMorgan because that sets a bad precedent, I get it. But you are in the middle of the Pluralsight restructuring, you have already marked your loans down to 50, and JPMorgan lobs in an unsolicited bid to buy whatever you’ve got at 90? [5]  And you say no? Really? I would have been very tempted to call them back and say “hey guys, guess what, today is your lucky day.”

We talked yesterday about a proposed exchange-traded fund that would split Microsoft Corp. stock into two parts. One part would be a claim on the stock’s stream of dividends; the other part would be whatever’s left, its capital appreciation. I thought this was nifty, but several readers pointed out to me that Americus Trust got there decades ago. In the 2020s, the way you do any sort of nifty financial structuring idea is through an ETF, but in the 1980s, the market was very different, and the important thing then was to find a good acronym for every new product you did. Americus had PRIMEs and SCOREs:

The Americus Trust program, a derivative security innovation of the early 1980s, provided a means of splitting the return of dividend paying firms into its two basic sources. For about five years, stockholders in 27 large companies had the opportunity to tender their shares to the Americus Shareowner Service Corporation in exchange for a new security known as a unit. The certificate for each unit was perforated and divisible into a prime (Prescribed Right to Income and Maximum Equity) and a score (Special Claim On Residual Equity), each of which traded separately. Primes gave investors the right to the firm’s quarterly dividend income plus a fixed termination value, on or before a stated termination date. A prime closely resembled a corporate bond, especially when the stock price exceeded the termination value. Scores represented the right to a stock’s capital gains, that for Americus Trusts are the excess of the underlying stock’s price over the termination value. Scores, that shared the primes’ termination dates, were much like long-term call options. 

I have to say, I arrived in derivatives structuring in the 2000s, just after the golden age of giving acronyms to everything, and I was keenly aware that I was living in a fallen world. I did my share of “mandatory convertible units,” which is what we called them in my day, but I would see precedents from the days when giants strode the earth and called them FELINE PRIDES. [6] Reading about PRIMEs and SCOREs really took me back. Now it’s just “dividend certificates” and “asset certificates,” whatever. 

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