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Liquidnet's Merrin Wants Main Street to Dump Wall Street
Seth Merrin of Liquidnet Holdings, who is responsible for dark pools and the automated order management system, is trying to defy the odds to overturn investment banks' equity underwriting oligopoly.
Merrin first had an opportunity to assess the opacity, cost and inefficiency of the IPO process in 2008, when he went to take Liquidnet public. By the time the S-1 had been approved by the Securities and Exchange Commission that November, Merrin planned to use his own firm as one of the issuing entities, along with Credit Suisse, Goldman Sachs, J.P. Morgan and Sandler ONeill. But he wouldnt be able to learn how his firm would handle its own share distribution. In 2009, a year that saw only 50 IPOs in the U.S., the deal had to be pulled because of market conditions and a typically arcane patent lawsuit that still hasnt been resolved.SETH MERRIN WAS BORN IN 1960 TO A FAMILY WITH a history of entrepreneurship and philanthropy. His father, Edward Merrin, owned an ancient-art gallery on New York Citys Fifth Avenue that specialized in the pre-Columbian, Egyptian and Roman periods, while his grandfather owned a jewelry business. After graduating from the highly selective Bronx High School of Science in 1978, Merrin spent a precollege year in Israel as part of a program that exposed young people to various philanthropic and work projects throughout the country. Today, Merrin and his wife, Anne Heyman, are active in charities supporting everything from victims of the 1994 massacre in Rwanda to microfinance in Africa. EBay founder Pierre Omidyar tapped Merrin in November 2005 to chair the board of Tufts Universitys microfinance fund, which Omidyar had established with a $100 million donation. After his 1983 graduation from Tufts with a political science degree, Merrin went in search of employment, combing the restaurants of Columbus Avenue, near his home, looking to wait tables. I was rejected by every restaurant. The only job I could get was on Wall Street, he quips. Working his predigital network, Merrins father put in a call to fellow Tufts alum Nathan Gantcher, then co-CEO at Oppenheimer & Co. Gantcher put the new grad in a training program where he was rotated among the back office, trading, options and the floor of the American Stock Exchange. Merrin, who was learning a lot about computers and trading, rose quickly to become head trader of the risk arbitrage trading group at Junction Partners. At 24 the budding entrepreneur quit Junction to start Merrin Financial. He spent six months figuring out a way to automate the hallowed but inefficient manual process of equity trading. By 1987 the Merrin order management system was ready to go to market, just in time for Black Monday: October 19, when the stock market lost more than 20 percent of its value, exposing flaws in equity-trading systems. Ive always had really good timing, Merrin jokes. Around that time, Merrin met Michael Price, then president and CEO of Heine Securities Corp., investment adviser to Mutual Series Funds, sold to Franklin Resources in 1996. Seth recognized early that it was easier to track the order management book using computers, recalls Price, who became a board member at Liquidnet in 2000. Everything became scalable. But Prices firm was one of only nine Merrin customers in the first three years. Traders contended that to enter orders was a clerical task a common belief before PCs took over the world. And after the equity markets headed skyward following the recovery from Black Monday, people just werent interested in more-efficient trading and operations. The zeitgeist changed in 1990, with a push from Merrin. That year he hired a good salesperson and put more functionality into the OMS, and a shift occurred in the trading worlds mind-set. By the end of that year, an additional 18 systems had been sold. Today virtually every asset manager in the world uses an OMS. The entrepreneur tried his hand at two more ventures before founding Liquidnet. In 1996 he sold Merrin to Automatic Data Processing, which later sold it to MacGregor, which became part of Investment Technology Group. Even before Merrin left ADP, he had started his second company, a software firm he dubbed VIE Systems, in 1997. Two years later he sold VIE to New Era of Networks and began looking for a new opportunity. At first, Merrin took a detour backing a Silicon Valley entrepreneur in medical software, ultimately taking over as CEO. He ran the Palo Alto, Californiabased company for nine months before realizing it wasnt a good fit. I learned a lot out there, says Merrin, who had spent huge amounts of time away from his young family in New York. That was a very expensive lesson. In late 1999, Merrin had what he calls the epitome of an epiphany when he awoke in the night with the idea for Liquidnet. In the morning he sketched it out on his childrens drawing pad, then got serious with Eric LeGoff, the former CEO of VIE Systems, who had helped implement Merrins OMS at Prices Mutual Series Funds. Together they built a business that would allow large buy-side firms to trade many thousands of shares among themselves quickly and anonymously inspiring the moniker dark pool. Liquidnet started life in January 2000, at the height of the Internet bubble, when gobs of money were being hurled at start-up ventures. Merrin approached Price, Gantcher and Lawrence Zicklin, then chairman of Neuberger Berman, and they each gave him $1 million in start-up capital. That March he raised $10 million from Thomas H. Lee Partners, then started hiring people and building the system. A total of $19.5 million was raised before the opening, though it would be 13 months before the new firm would begin to generate revenue. The switch was thrown on Wednesday, April 10, 2001. As with the OMS, it would take several years for Liquidnets trading system to catch on. The dot-com bubble had burst, followed by the terrorist attacks of September 11, taking down the equity markets. Again, Merrins timing was off. Everybody placed bets on what our first days volume would be, he says. Nobody bet a low enough number: 4 million shares. We were all incredibly disappointed. The next day shares spiked to 17 million, then sank back to 10 million traded on Friday. It would take two years to reach 17 million again. Disbelievers called Merrins new company Liquidnot and Illiquidnet.
But in 2003, Liquidnet found its footing when Merrin asked his community of users to endorse a positive action rate using Liquidnet for 25 percent of the trade opportunities presented to them. A couple of months later, Merrin boosted the PAR to 50 percent, and Liquidnet entered its years of vertical growth.THE IPO PROCESS IS BULKY, EXPENSIVE and opaque, at least to those outside the investment banking world, which has had a lock on share issuance for decades. Thats because the syndicate of underwriters a small coven of investment banks, with one or two in the lead position are the gatekeepers of a system that apportions shares to favored customers at the expense, critics say, of the issuer. Once the company inks the contract, the banks decide how much to ask for the new shares, often underestimating by millions of dollars. In return for this money left on the table, issuers get price support for the new shares should the IPO not find enough buyers to meet its target price. Issuers have become beholden to the banks and their teams of research analysts, who drum up interest in a company through their reports, road shows and conversations with potential buyers, the media and others. But IPOs and capital formation itself have been under siege in the U.S. since the late 1990s (Institutional Investor, October 2010). Decimalization, online brokerages and intense competition set off by the rise of alternative trading systems have served to reduce the profitability of trading. And in 2003, following the collapse of Enron Corp. and other corporate financial scandals, former New York State attorney general Eliot Spitzer dealt a death blow to economic support for equity research, long a pillar of the capital formation process. That year the Global Research Analyst Settlement, created to protect small investors from misinformation generated by Wall Street analysts, prohibited the use of investment banking revenue to underwrite analyst research. One result has been a lack of economic support for small- and midcap companies. While analysts are still paid to follow large-cap businesses, the 50 percent of publicly listed companies with less than $350 million in market capitalization have become unloved orphans. Private companies get even less attention, leaving many of them without the ability to ever get IPOs. To date, the only real effort to disintermediate investment banks from new-share issuance was launched by William Hambrecht in 1999 after he sold his investment banking boutique, Hambrecht & Quist, to Chase Manhattan Corp., now JPMorgan Chase & Co. His new venture, dubbed OpenIPO, uses a Dutch auction to sell shares via the Internet. Since OpenIPOs launch only 30 companies, mostly in the technology or financial sectors including Instinet, Interactive Brokers, Morningstar and Overstock.com have gone public this way. Of those, only 19 were pure Internet IPOs, while others, notably Google, used a hybrid of auction and banks. A solution to the capital formation problem, at least as it applies to small companies, has been fielded by David Weild, head of the capital markets group at Grant Thornton in Chicago and a former Nasdaq Stock Market vice chairman: It calls for a new alternative stock market to be established by Nasdaq OMX Group, NYSE Euronext or any other entity willing to take it on. In this scenario a kinder, gentler nursery for small companies, harking back to the floor exchange days of market makers and specialists electronic communication networks would be prohibited from trading. Essentially, Weild wants to put economic incentives back into the IPO process. In his vision, a new exchange would have large commissions and wider trading spreads, so that traders could make money that theyre not making today because of the efficiencies of electronic trading like Liquidnets. Unsurprisingly, Merrin takes the opposite approach to solving the same problem. Liquidnet has long seen problems as opportunities. In 2006, after it started to feel the heat from block-trading competitors like ITGs Posit and Pipeline Trading Systems at the same time that share order size was falling, Liquidnet opened up the wholesale market to retail flow, including brokerages and exchanges, while staying true to its pledge of anonymity for its buy-side members. Dubbed H2O, this automated trading system allowed brokers and exchange partners to send retail orders to Liquidnet, a first step in turning the firm into a well-rounded agency brokerage that offered more than matched orders in a dark pool. Next came the algos. Until 2007, Liquidnet had the capability only to execute trades between two holders of the same companys shares; otherwise it had to send them elsewhere. Looking to bring in algorithmic trading capability, the firm acquired Miletus Trading, an agency brokerage that had been part of the H2O network. With the addition of program trading, the firms members had access to liquidity any way they wanted it. Despite challenges, the period from 2004 through early 2008 was a golden age for the block-trading firm. In 2005, after competing with other venture capital firms for the opportunity, Technology Crossover Ventures and Summit Partners each made a $125 million investment in Liquidnet. TCV, with more than 150 portfolio companies and 50 IPOs, had brought MarketAxess Holding, an electronic fixed-income trading platform, public the previous year (and would sell RiskMetrics to MSCI in 2010). The customer value proposition anonymous, electronic equity trading at a fraction of the cost, with zero impact was absolutely revolutionary and unique in the marketplace, says Richard Kimball, who founded TCV in 1995 to focus on technology companies. Id argue that no one with the ability to trade large blocks today has a solution that approaches Liquidnets. The new infusion of venture capital was used in part to allow early investors to cash out some of their investment, says Kimball, who sits on Liquidnets board. By 2008 other investors, including firm executives, were looking to monetize their Liquidnet shares. That November the firm completed documents for an IPO. For the first and last time, the public had a view of the companys revenues: $350 million at the end of 2007, more than double the $160 million at year-end 2005. Merrin planned to use his own company to distribute some of the shares to Liquidnets members. But the IPO, like so many at that time, was not to be. The crisis affected Liquidnet in other ways. In March 2008, after its clearing firm Bear Stearns Cos. went under, Liquidnet members became anxious about the trading venues ability to operate effectively. To smooth troubled waters as JPMorgan Chase was absorbing its quick purchase of Bear, Merrin persuaded Frank Bisignano, chief administrative officer at JPMorgan, to have CEO Jamie Dimon write a letter confirming Liquidnets strong position an essential document in those nervous times. During the financial crisis Liquidnet executives sat tight while the markets fought their way back to life. Then in 2011 six key executives left the firm, landing at Direct Edge, FXall, Pipeline, Portware, Pragma Securities and UBS Investment Bank. The Liquidnet pedigree is very good, says Jay Biancamano, the firms former head of marketplace and corporate strategy, from his new office at Pipelines downtown Manhattan headquarters. Biancamano was hired to turn around Pipeline (now the newly rebranded Aritas Group) after the once-respected block-trading venue was discovered to have been directing trades to its own broker-dealer rather than through its dark pool. Thats the sacred trust in these systems, says Sandler ONeills Repetto. You dont want to have your order exposed to other people. Pipeline, founded in 2004 by CEO Fred Federspiel and chairman and former chief executive Alfred Berkeley III, a former president and vice chairman of Nasdaq Stock Market, was fined $1 million by the SEC in October; the two executives were fined $100,000 each. When this betrayal shook the block-trading world, Merrin spent days on the phone reassuring Liquidnet members of his own firms continued commitment to fair play. Despite all the drama, Merrin is bent on convincing the corporate world that Liquidnet is an efficient and transparent venue for issuing shares. His message to the C-suite: Our members have $12 trillion worth of buy-side equity assets that wed like to potentially invest in your corporation. Grant Thorntons Weild believes that the changes in market structure may have improved Liquidnets ability to do so. He points to the fact that investment banking is no longer Goldman Sachs greatest revenue source. It got flipped; so much of the revenue has become trading revenue, he explains. People are automating trading. This in turn has created opportunities for new ways to issue shares: Were looking at equity issuance as if its a trade, says Weild. Thats especially true now that public corporations, with SEC approval, can issue new shares at will via so-called shelf registrations, including at the market and other follow-on transactions. If you can take out all the friction, then its a block trade, Weild points out. He contends that this is not a paradigm shift but a natural progression: Its all about getting stocks from companies into the hands of buyers without disrupting the markets something Liquidnet has been doing for years.
From this perspective, Liquidnets success may depend more on demand than on supply. I think the issue would be, does Liquidnets community want them to be in that space? says Larry Tabb, founder of financial advisory and research consulting firm TABB Group. Are they willing to buy new issues and follow-on offerings from what used to be a purely agency player? I think increasingly the answer is yes.LAST DECEMBER IN LIQUIDNET'S New York headquarters, near Penn Station, 20 investor relations and finance officers from U.S. corporations large and small filed into a conference room carrying coffee cups and plates filled with breakfast tacos and fruit salad. The seminar was the eighth in a series in Liquidnets ongoing campaign to introduce itself to the corporate world. A few years ago Merrin keynoted the National Investor Relations Institutes annual conference and set up a Liquidnet display booth there, which the equity capital markets team continues to do. Three years ago, when companies didnt understand what dark pools are, he pulled the blinders off our members, notes NIRI president and CEO Jeffrey Morgan. At Liquidnet headquarters Steven Greenblatt, Liquidnets head of capital markets, and John Adam, a senior member of the team, set out to give the corporate executives a brief history of the stock market: how it had arrived at a place where their companies share prices could move wildly throughout the trading day, seemingly without reason and how Liquidnets InfraRed sentiment indicator could show how potential trading was trending in a particular stock. First, Greenblatt explained how Liquidnet ties into the system on the buy side and operates like a Match.com online dating service for institutional traders. Guest presenter Tabb described how high frequency trading works. Then Adam took a turn to explain the new world order. In the past investor relations officers were trained to look at high-volume days as The market is happy or unhappy with our company. Today, however, unexplained volume could be emanating from a black box, an automated system that looks for certain patterns based on other trading activity and can therefore signal future activity all within milliseconds and take advantage of that. The most effective cure, said Adam, is getting your stock in the right hands, the core function of IR. Enter Liquidnet. Ahead of its share issuance initiative, Liquidnet developed InfraRed to bring corporate America to its doorstep. The sentiment reader, built from the firms data on the institutional marketplace, sits on the CEOs desk, consolidating and aggregating trading data that illustrates current sentiment on his or her company. In 2009, Liquidnet announced a partnership with the New York Stock Exchange to install InfraRed at 550 NYSE member companies. Now more than 600 public companies, including Nasdaq issuers, look at a Liquidnet product every day through a web application, on phones and iPads as well as computers. According to Jean-Marc Levy, head of global issuer services at NYSE Euronext, Liquidnets InfraRed is one of the most positively reviewed services at the NYSE, which offers tools and analytics through its private information portal. Nonetheless, making Liquidnet a corporate household name will be a long, slow build. The same way we had to educate the asset managers when we launched [Liquidnet], we have to do the same thing on the corporate side, knocking on peoples doors and explaining to them why were different and why were better, Merrin acknowledges. InfraRed is in front of their face 24-7, providing value before you ask for business. Thats something Wall Street doesnt do. Merrin has some human help with the door-knocking from TCVs Kimball, whose role is to provide introductions to C-level executives in Silicon Valley. Thats probably the best thing I can do for Seth, he says. There are early signs that Liquidnets efforts may be paying off. Jonathan Peisner, treasurer of KAR Auction Services, an auto auction company in Carmel, Indiana, has taken to InfraRed, which he found through his NYSE partnership. But Peisner is less certain about using Liquidnet for share issuance. KAR, with $1.87 billion in market cap and 12,000 employees, has 12 analysts following it. That places an investor relations officer in a bind, he says. The problem is, does it significantly sour the relationship with the sell-side firm that covers you? Maybe at some point theyll figure out a way to solve this dilemma. Microsoft Corp. treasurer George Zinn has similar doubts. You dont get fired for picking investment banks, says Zinn. In the trade-off between the leakage of millions of dollars by using expensive investment banks and the assurance of a successful deal, Im more worried about it going well than having to pay these very expensive prices. Zinn thinks Liquidnets approach may work only for secondary market share issuance. Accordingly, Liquidnet has made its first inroads in that market by partnering with Bank of Montreal and its real estate investment trust clients, which have ongoing capital requirements because of their frequent need to buy and sell properties. One is Palo Altobased Essex Property Trust. Liquidnet works with the bank when Essex needs large volumes of at the market shares. They will tell us when there is overweighted block demand, and depending on our match funding need, the stars and moons can align, says Mark Mikl, a capital markets and strategic planning executive at Essex. Since January 2012, Liquidnet has handled more than $1 billion in such transactions. Merrin believes this is only the beginning. When corporations have to buy back and issue more stock without Liquidnet, they have to take the word of their adviser that it is a good time to trade. But, Merrin says, the two pieces of information needed to execute efficiently are one, what do institutions think of your stock right now? And two, is there enough institutional demand to meet your objectives? If the issuer misses either one, costs come out of the corporation. Were the only people in the world who have access to that information, Merrin asserts. Nonetheless, Liquidnet is facing competition. The latest entry into this alterative capital markets space, Direct Markets, is a rebranded investment bank that has been building its own proprietary technology to cut out other banks. In January, Direct Markets lured former Liquidnet executive Lupowitz away from FXall, where he had been hired to run the show. Merrin sees this as less of a threat than a sign that his business model is viable. This has happened to me and my companies over and over again, he says. We do something new, and at first people say, Its not going to work; its not done that way. After the venture starts seeing success, he notes, people say, Why hasnt anyone done this before? Then we get competition. Last, he says, when we hit an inflection point, not doing it this way will seem absurd. He predicts that inflection point will occur in five years. Still, he isnt taking any chances, and hes started gearing up for a brand-new offering: private shares. Now that private companies take twice as long to go public think Facebook, Groupon and Zynga start-up intermediaries like SharesPost and SecondMarket Holdings have been dabbling in these shares for institutional investors and high-net-worth clients. In October, Merrin hired Kerner to help lead Liquidnet into private share trading; Kerner was acknowledged as the top private shares research analyst when he vacated the same role at Wedbush Securities, along with his associate Michael Silverstein, for Liquidnet. By late January, after he and Merrin had disagreed on how to build the new business, Kerner took off to start a fund that invests in private shares, while Los Angelesbased Silverstein stayed aboard Liquidnet. Merrin is hiring several other people for his new private shares group. But Kerner thinks Liquidnet may be at least a day late, calling the firms culture very challenged in an interview after he left.
Maybe so. But Merrin is determined to bring as much liquidity as he can, whether publicly or privately traded, to his 600 members. At the same time, he hopes to build a new group of believers in the transformative power of trading large blocks of stock anonymously even if that means launching the next Facebook.