There's a spectrum of liquidity from the instantly-tradable (a small position in a liquid equity) to the basically-impossible-to-get-rid-of (a controlling stake in a complicated asset). And there are many companies whose economics are basically tied to how many deals they can effectively do. The exchange business is tied to the liquid end of that spectrum, with its economics tied to how frequently people want to trade, and what data they'll pay for to trade more efficiently.[1] At the other end of the spectrum, there are service businesses that profit from chunkier transactions, either by getting a fee for M&A deals or by conducting such deals themselves.
In that model, London Stock Exchange Group is a barbell of a business. A few years ago, they were mostly focused on the eponymous exchange, but over time they’ve diversified, especially through their 2021 acquisition of financial data company Refinitiv for $27bn. Refinitiv's Eikon and Workspace products are second to Bloomberg in market share; this source says it had 20% market share in 2020, compared to 33% for Bloomberg, and was about 10% cheaper on a per-seat basis.
The market data business is very lucrative in some ways: customers are extremely price-insensitive, both because the product is the complement to very well-paid people, and because it's so rare for the cost of data to be the difference between successful and failed strategies.[2] And there's a natural way to expand within a firm: if the equities group likes the product, it's possible to get a meeting with the rates team and figure out what features would make them like the product, and to continuously iterate from there. At a high cost per seat, excellent customer service is affordable, which means it's possible to continuously solicit feedback. And since market data products get incorporated into the research process, they're sticky; no one wants to redo every single model that pulls in estimates or commodity prices from a data provider.
One problem, though, is that sometimes when the customers get asked "What would convince team XYZ to switch to us from Bloomberg?" The answer is something proprietary to Bloomberg; either exclusive access to a unique third-party dataset or some kind of first-party data advantage that continuously compounds as more users opt in. That makes the market data business one where it's much more rewarding to be the #1 player than it is to be #2—even if the #2 player is close to feature parity.
The space of possible datasets is vast, so every platform has some areas where it's behind. And the business has path dependence: if it's indispensable for one kind of trading, it tends to proliferate in that business, and gets more feedback from those kinds of users. So Bloomberg will be dominant in fixed income for a long time, because it's been the best source for data in that business over the entire career of almost everyone involved. Similarly, Capital IQ is great for data on acquisitions; if you need to figure out the typical EBITDA multiple for acquiring some niche business or asset, they'll have more comprehensive data, but they won't be very helpful for news and market data. And Refinitiv's Eikon tends to get treated as a slightly cheaper Bloomberg, but in commodities at least it's generally considered a better Bloomberg.
But why is it part of LSE Group? Why, in fact, is it most of LSE Group by revenue? In 2020, the LSE Group parent company did £2.0bn in revenue; in 2022, the first full year after the Refinitiv deal, it was £7.7bn. They had some data revenue before, but now the company is very much a financial data company with an exchange attached.
The exchange business has produced good results for investors over the last decade, with the big exchanges—CME, ICE, Nasdaq, CBOE—handily outperforming the market. One reason for this performance is that they, like so many other companies, have shifted from a more transaction-driven model to subscriptions, specifically offering data products. The economics of this are incredibly enticing. Converting per-trade or per-listing costs into ongoing revenue lowers the marginal cost of doing more transactions, and raising the price of data feed subscriptions forces the biggest liquidity providers to find ways to create even more liquidity to amortize the cost. Meanwhile, this liquidity provision makes the exchange a better place for real-money traders to trade, and that makes it a better place for companies to list. And with all that, the virtuous circle is complete, as liquidity begets more liquidity. Avoiding transactional revenue doesn't just make Wall Street happy by making the business easier to model and more predictable: it actually shifts incentives among market-makers, who supply a complement to the actual exchange business, encouraging them to supply more of it.
That model works very well when the data in question is directly related to the exchange. In particular, pricing connectivity has high bidder density (the topic of next week's Capital Gains), so the market-clearing price slowly converges on the amount of alpha a reasonably good trading firm should be expected to extract from slightly faster trading. But when the data is more general, it's closer to horizontal diversification than to a direct complement. There are some cross-selling opportunities, naturally, and the combined entity has already cut some costs, but the overall synergies are iffier.
There are good reasons for the LSE to diversify. Exchanges are a network effect businesses, and as companies globalize, national exchanges start to make less sense. The US has a disproportionate share of money managers, so in the end any company that elects to have its shares trade between the hours of 9:30am and 4pm Eastern time is catering to a large investor base. Anecdata abound:
Arm, one of the largest pending tech IPOs, is listing in New York rather than London ($, WSJ) .
- Plumbing equipment company Ferguson says it's happy with its year-ago move from a London listing to the NYSE ($, FT).
- Data company WANDisco was considering a New York listing as well, but has suddenly discovered accounting problems ($, FT) and will have to delay that.
- Building materials company CRH also announced plans to move its listing to New York ($, FT).
- British American Tobacco is being pressured to move as well ($, FT).
- There is good news, or at least there are instances where potential bad news doesn't materialize: Ashtead decided to stay ($, FT).[3] And there are data, too. In the 2021 IPO boom, US IPOs totalled $120bn, up 202% from 2019. The UK picture is less pretty:
Screen-Shot-2023-03-16-at-2.28.41-PM
Total IPO value on the LSE was $17.6bn in 2021, up 104% from 2019. And the biggest growth area was AIM, a junior market that's somewhere between what the Nasdaq was a few decades ago and what the OTC Bulletin Board is today—a place for companies that may have ambitious growth prospects but are also fairly new, fairly shaky, and with financials of uncertain accuracy.
The company is responding to this, in part through, yes, more deals: they recently signed an agreement with Microsoft in which 1) they agreed to tightly integrate Microsoft's cloud computing with their existing data products, and 2) Microsoft bought shares from some of their the PE firms who got a stake in LSE as part of the Refinitiv deal, waiving a lock-up agreement.
The Diff has discussed such deals before. The basic argument is that $1 of cash on the balance sheet is worth, at best, $1 of market cap, potentially with a small haircut if there's a risk that the company will misallocate, have difficulty repatriating, or just hold on to the cash. But signing, say, a ten-year deal where that $1 gets converted into $0.10 of annual cloud revenue is breakeven on a market cap basis even if the equity goes to zero. When a sophisticated financial sponsor is the seller in a transaction and the buyer, also sophisticated, has reasons to come out ahead even in the event of a capital loss on the transaction, it pays to be skeptical.
Of course, the deal sounds great other than that (big enterprise deals often do): they're connecting their data with Teams and Microsoft's office suite, connecting Refinitiv's data with companies' in-house data, and otherwise making the combined product stickier and more useful. But being #2 in a network effects business and tying that to another network effects business that's #1 in its country in a domain that's rapidly going global is a difficult place to be.
Disclosure: long Microsoft. And I’m an investor in Koyfin, a competing data provider.
Exchanges tend to see more growth in data businesses than in transaction businesses, but that's really just a subset of the subscription model where a seller can capture more of the total economic surplus by charging a fixed price in exchange for a lower marginal cost. The same fundamental economic force powers both DoorDash's Dashpass, where you pay a monthly subscription, get cheaper delivery, and consequently give DoorDash a larger share-of-mouth, and an exchange charging a high-frequency trader for colocation, which that trader amortizes by doing more trades and providing the exchange with more liquidity. ↩︎
The natural variance of finance, coupled with the industry's selection for self-confidence, means that even if the expected value of a Bloomberg Terminal is, say, $15k a year instead of $24k, there are plenty of people who will assume that they will do a bit better than that expectation and want to own the terminal. And there will almost never be a year when data costs make the difference between success and failure. ↩︎
Note that almost all of this coverage is from the FT. One of Britain's great exports is extensive pessimistic chronicling of the country's status in the global business world. ↩︎
Elsewhere
The CFO of regional bank PacWest sold puts last week to demonstrate confidence in the stock. The normal way to do this is, of course, to buy stock—a decent signal, although a noisy one.[1]
There are a few clever things about this trade. First, writing puts means betting on both a higher share price and lower volatility. Bank stock volatility has been elevated—PacWest's implied volatility right now is 202%, up from a 44% average over the last year—and naturally if the funding situation calms down, volatility will, too.
It's also a fun trade because of who the economic counterparty is. There are many reasons to sell a stock directly; someone might be shorting, but they might be exiting a long trade, rebalancing a momentum bet, moving away from equities entirely, etc. The direct counterparty in the options trade is, presumably, an options market-maker, but the natural buyer of a put option right now—the trader whose underlying demand sets the price around which the market-maker quotes—is someone betting that the bank will go under soon. It's exhilarating to bet against someone who expects you to fail.
And the last reason it's a fun trade is that it's such a perfect alignment between job description and financial incentive. The #1 job of the CFO of a bank is to make it a boring bank: yes, they also need to decide on buybacks and optimize the funding mix so it's as affordable as possible, but their most important responsibility is to ensure that the bank is never at risk of running out of money. Writing puts is a direct expression of both results of this, that the stock doesn't go down and that it doesn't do much.
More banks should restructure their equity compensation so senior executives are functionally or literally short puts. There are some investment banks that would have had a better time at various points in the last two decades if their head of risk were short puts instead of just long stock. Though there is one side benefit to letting executives do it themselves: it gives investors a real-time measure of their risk-management skills. The options in question were sold at a price of $1.23 per contract eight days ago. Yesterday, they closed at $11.40.
There's been a long-term trend towards more equity in PE deals; the classic model was a 5-10% equity (with outliers like Gibson Greetings with an alleged 2.5% equity, but that's moved up, both because lenders have decided not to give PE a cheap option on outperformance and because more buyouts focus on software and healthcare companies that can't support the same debt burden. And some recent deals are being done with 50% equity, or, in the case of Qualtrics, 83% equity ($, FT). A PE firm that raises a fund in good times can't necessarily deploy it with typical leverage once opportunities arise, but if they buy companies today, they can still restructure them with more debt and less equity in the future.
Audience capture is the phenomenon in which a content creator gets increasingly good at catering to a specific audience, and completely changes what they produce in response to those pressures. It's most apparent in single-creator social media enterprises, but it can apply on a different scale to the media. Fox News has historically dominated conservative cable TV news, a reasonably lucrative sector (an audience that skews older and richer is good for direct-response advertisers). But in late 2020 they were concerned that Newsmax, which was more right-wing than they were, was taking share ($, WSJ): Newsmax's primetime viewership went from 40k in Q3 2020 to 242k in Q4. Still well behind Fox's 3.47m viewers, but Newsmax grew over that period while Fox sank. Any time a media outlet carves out some opinion niche, they're also creating an opportunity for someone to do a slightly more extreme version. Someone who tried to create "centrist Fox" wouldn't really have a value proposition to offer—many media outlets want to be viewed as centrist, and none of those want to be compared to Fox. But they're always vulnerable from the other flank. Newsmax, as it turns out, was not able to retain most of that audience; this quarter they're down to ~111k, versus Fox's 2.12m. The disadvantage to the "Be like X, only more so" strategy is that X is already pretty good at being X, and has been careful about how X-y to be.
A commercial bank is a usually-not-too-tricky balance between maximizing returns and accepting some level of liquidity risk. An investment bank can have elements of that, but on the asset-light side there's a different kind of balance: retaining employees even in lean times, and avoiding a "talent run" where every executive departure makes the bank seem like a lower-status business that's less worth working with and less worth working for. Credit Suisse has, thanks to central bank intervention, avoided a run on deposits for now, but several senior members of their Asia equities team have left recently. Turnover is a natural part of the investment banking business, and a weak signal most of the time, but when there's a spike in it, especially in one group, it can impair that group's economics—and there's already a question of whether Credit Suisse is economically viable at all ($, FT).
The global capital expenditures boom is slowing; big companies’ capital expenditures in 2021 were ~20% higher than pre-pandemic, but are expected to drop 1% in real terms this year ($, Economist). Much of the rise in capex recently was demand-driven; 2021 was in many respects an inconvenient time to be building new factories, datacenters, and chip fabs, given shortages of equipment and skilled labor. But it was also a time when the perceived ROI was higher. Now, with those constraints slightly more relaxed and plausible discounted cash flow analyses pointing to worse real returns, companies are holding back. In the long term, economic growth is mostly tied to productivity growth, so it’s downstream from new technology and better ways to organize companies. In the short term, it’s really a function of demand. And demand-driven capex cycles are both a way to deploy the last round of technology and management improvements and a spur to finding the next one.
Specifically, when a company is going through a liquidity crisis, both the stock price and executive behavior are important signals. And if an executive thinks that spending, say, 10% of their annual compensation on buying stock gives the company a 10% better shot at survival, then there's a one-year payback on the investment. ↩︎