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Multi-class share structures create a 'significant long-term cost': Goldman Sachs

One of newly public firms’ favorite tools to boost executives’ control may also be a long-term liability, according to Goldman Sachs.

Many of the “unicorns” – or companies privately valued at more than $1 billion – making their initial public offerings this year came to market with a multi-class share structure.

With this, companies offer a class of common stock to retail investors offering few to no votes per share, while management and early investors hold shares granting a higher potency of voting rights. These firms have leaned on the tiered stock structure as a means of keeping their executives in the driver’s seat when it comes to making major company decisions.

That concentration of authority doesn’t come for free.

“Using multi-class voting to insulate management from its own shareholders comes at a significant long-term cost,” Goldman Sachs strategist David Kostin wrote in a note. “Firms restricted from joining major indices will not fully benefit as capital flows into passive funds that now represent more than 50% of total U.S. mutual fund and ETF assets.”

‘Extraordinary flow of capital’

S&P Dow Jones Indices announced in July 2017 it would bar newly public companies with multiple share classes from joining the S&P 500 Composite 1500, an index that also includes the S&P 500. Existing constituents with multi-class stock – including Facebook (FB), Google-parent Alphabet (GOOGGOOGL) and Berkshire Hathaway (BRK-ABRK-B) – were allowed to remain.

Around the same time, the FTSE Russell said that firms with multi-class share structures would need to have at least 5% of their voting rights lie with unrestricted public stockholders in order to be included, and that existing constituents would have until September 2022 to make changes to comply. (Meanwhile, MSCI – another index fund provider – said in October 2018 that it would not exclude companies that had unequal voting structures).

And indexing – or having a portfolio contain all the equities in a select market index – has only grown in popularity as of late. In August this year, U.S. equity index funds reached $4.27 trillion in assets, surpassing actively managed funds with $4.25 trillion in assets for the first monthly reported period on record, according to Morningstar data.

This means that newly public companies that have elected to divvy up voting rights unequally among their various stakeholders are missing out on one of the primary ways retail investors are putting capital to work in equity markets.

“Firms restricted from joining major indices will not fully benefit from the extraordinary flow of capital that continues to surge into passively-managed funds,” Kostin said.

“This year, U.S. passive mutual funds and ETFs have experienced $114 billion of inflows, while active mutual funds have sustained outflows of $193 billion,” he added, with emphasis his.

The number of companies going public with multiple classes of stock has increased in recent years. (via Goldman Sachs, FactSet)

That hasn’t stopped some of the biggest companies in this year’s IPO market from offering multi-class shares. Lyft (LYFT), Zoom Video Communications (ZM), Pinterest (PINS), Tradeweb Markets (TW), Chewy (CHWY), and CrowdStrike (CRWD) all offer unequal voting shares for their stakeholders. Lyft’s and Pinterest’s Class B shares provide 20 votes versus one vote per Class A share. The others offer Class B shares with 10 votes apiece, versus one vote per Class A share. WeWork’s parent company, before announcing plans to shelve its IPO on Monday, had planned to come to the public market with an unconventional triple-class stock structure.

But these companies could get around index providers’ restrictions by adding sunset provisions to their corporate governance setups, or by phasing out their high-voting stock a certain number of years after the IPO, Kostin added.

A handful of companies that have listed in the past several years, including Twilio (TWLO) and EVO Payments (EVOP) have already incorporated these clauses, making them eligible for index inclusion once the high-voting shares expire.

And while investor advocacy groups have criticized the disproportionate democracy of multi-class stock structures, the arrangement isn’t without some benefits.

“Advocates of multi-class voting structures argue it allows management to focus on long-term strategy and shareholder value creation without the potential distraction of short-term oriented activist investors,” Kostin said. “There could be some merit to this argument. From a recent return perspective, the 15 multi-class IPOs completed in 2019 have dramatically outperformed the 71 single-class IPOs.”


Emily McCormick is a reporter for Yahoo Finance. Follow her on Twitter: @emily_mcck

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