The Long-Term Stock Exchange hopes to go live in September 2020. What is it, why was it launched and how will this impact capital markets?
by Paul Golden
While the backers of the Long-Term Stock Exchange (LTSE) describe it as an opportunity to move away from short-term thinking, many observers suggest the capital markets are working just fine as they are.
The LTSE was formally announced in October 2017 by American entrepreneur Eric Ries. It is expected that the exchange will go live by the middle of September 2020. Eric, who is the author of The lean startup, says in a blog post that the idea of a public market that realigns investors and companies around long-term value creation came to him when he was researching the book and kept hearing that short-term pressures were driving decision-making.
The ecommerce website Etsy is often described as an example of how short-termism can compromise a company's mission. The business was founded in 2005 with a commitment to social responsibility, demonstrated in its achievement of B Corporation certification.
Certified B Corporations are defined as businesses that meet the highest standards of verified social and environmental performance, public transparency, and legal accountability to balance profit and purpose.
However, following Etsy's IPO in 2015 a minority shareholder persuaded some of its largest shareholders to pressure the board into abandoning long-term projects. The company's 'values-aligned business' team, which was responsible for its social and environmental efforts, was dismantled.
The LTSE's listing standards state that companies should prioritise long-term decision-making, align executive and board compensation with long-term performance, and engage with their long-term shareholders.
Each company that lists on the exchange will have to develop and publish a policy consistent with these principles that will be verified by the exchange. Companies deemed to be significantly out of compliance with LTSE principles could be delisted.
"Investment is not about trading shares, it is about capital deployment within companies and the underlying process of wealth creation"
Eric explains that "with our long-term focused listing standards, the LTSE offers a public market option designed to shift the metrics of success from a quarterly drumbeat to a long-term perspective while providing flexibility and full liquidity".
Eric suggests that current public capital markets don't reward long-term thinking. This sentiment strikes a chord with Stuart Dunbar, a partner at Edinburgh-based investment manager Baillie Gifford & Co, who believes that the bulk of capital markets activity is oriented to trading in secondary markets in anticipation of what other investors are going to do in the short term.
"Investment is not about trading shares, it is about capital deployment within companies and the underlying process of wealth creation," says Stuart. "We are, therefore, supportive of any developments that better align investors and company management with this fundamental purpose."
However, he also accepts that it remains to be seen whether the exchange can force its listed companies to only think about long-term value creation.
Playing the long game
The challenge is to assess the consistency of company behaviour with long-termism as actions can be interpreted in different ways, according to Stuart. He says that moving away from the quarterly earnings cycle would be progress, and moving the reporting emphasis further towards long-term plans and "ambitions would probably help build constructive relationships with company management".
According to Jesse Fried, Dane professor of law at Harvard Law School and a consultant and expert witness on corporate governance issues, investors are happy to focus on the long term when there is a "compelling story" that the firm is likely to deliver value. He refers to the example of Amazon, which commanded a high valuation at IPO of US$438m and survived the bursting of the dot-com bubble and years of unprofitability because investors believed in its long-term prospects.
"If management cannot convince investors there is long-term potential, those investors will pressure management to change course, distribute cash, or sell the firm," says Jesse. "Since the investors are playing with their own dollars while managers are playing with somebody else's, investors are more likely to be right."
R&D World's annual global funding forecast 2019 finds that "US research and development spending continues to see annual increases". Jesse says “this suggests that capital markets are already functioning quite well”, and adds that the only way to get directors and executives to focus on long-term value creation is to implement compensation arrangements that reward them only if value is created in the long-term to minimise short-term temptations. “It is easy to tie compensation almost exclusively to long-term value creation, but I don't see any exchange – including the LTSE – trying to force companies to do that,” he adds.
Jesse says that a firm could go public on any exchange with a temporary dual-class structure or similar arrangement that would make it hard for activists to pressure management. Companies with dual-class shares have two designations of common stock, typically A shares and B shares, with the latter usually having more powerful voting rights than the former. In this case, investors would hold A shares, while management would hold B shares.
"But the LTSE will not require such an arrangement and very few firms choose to go down this route," he says. "In most cases, investors would not accept it because there is a high risk that management ends up entrenching itself and dissipating investors' cash."
Jesse is also sceptical about the benefits of LTSE's plans to prevent investors from placing orders without publicly revealing their intentions until the trade is executed, suggesting that minor tweaks to trading rules are not going to have any significant impact on how directors and executives think about business strategy.
"Immediate price reporting is widely accepted in equity markets and we already have terrific price transparency"
Chester Spatt, a professor of finance at Carnegie Mellon's Tepper School of Business and a former chief economist of the US Securities and Exchange Commission (who describes himself as a strong proponent of transparency in capital markets), is also dubious about the value of this practice. "Immediate price reporting is widely accepted in equity markets and we already have terrific price transparency," he says. "Additionally, the idea of mandating that market participants reveal their intentions raises huge challenges."
Examples of these challenges include:
- How would the accuracy of these disclosures of intent be evaluated?
- Would it be fraud if the investor altered their plans?
- Would a trader who changed their intent just be able to sell their stocks on the traditional exchanges?
"It is also difficult to evaluate whether the approach envisioned by the LTSE would benefit other markets without much greater clarity about what is envisioned and how the LTSE design would work," says Chester.
He takes issue with the LTSE's suggestion that the market needs an exchange that rewards long-term investment, rejecting the assertion that the current exchanges do not reward long-term commitment. "Our capital markets are precisely about rewarding long-term investments," says Chester. "Companies that have not made profits have been able to obtain extraordinary valuations despite huge losses because the markets are so forward-looking. Markets look to the long term in evaluating companies."
According to Chester, this is the only possible explanation for the current valuations given to firms such as Tesla (approximately US$277bn), Uber (US$57bn) and Lyft (US$9bn), as well as the past valuations of Amazon when it was a profitless retailer.
"These examples all illustrate the capacity of the capital markets to engage in long-term thinking and reward long-term investors," he adds. "Some of the basis of the criticism of the traditional markets is that valuations respond to short-term news and earnings, but that is because such information is an important indicator of a company's long-term prospects."
On the question of whether any exchange can really force its listed companies to only think about long-term value creation, Chester says some in the tech community criticise the current exchanges but have not highlighted how their approaches would significantly change the commercial incentives of the companies that they would list, or the investors in these firms.
Of course, the acid test of the LTSE's offering will be the number of listings it attracts. This will indicate whether companies agree that the capital markets are skewed towards short-term thinking or that the existing exchanges support the emergence of innovative companies building long-term value.