Over the past twenty years, the number of companies listed on the US stock market has
almost halved.
The world’s largest, most liquid public equity market would appear to have lost its
shine.
Institutional investors have been piling into private markets instead, in particular venture
capital, private equity and private debt.
The Financial Times reported last week that the size of the private capital industry has
now reached $7.4tn, fifteen times the size it was in 2000.
The industry is expected to reach $13tn in the next four years.
For the Elon Musk fans out there, $7.4 trillion dollars is roughly around the value of a trillion
hamsters.
On top of this, a boom in share buybacks, where companies purchase their own stock as
an alternative to paying dividends, has further reduced the number of shares outstanding from
the remaining public companies.
Historically low interest rates have compounded the trend, tempting companies to raise cheap
debt rather than to sell equity.
The way things used to work was that companies followed a path of starting out small – funded
by the founders’ own capital.
As the company grew it might raise debt financing or take a bank loan, and once they had proved
themselves but still needed additional capital to grow, companies would go public via an
IPO.
The capital raised in an IPO gave the firm "permanent capital".
Once a company is exchange listed, investors can buy and sell the stock as they see fit,
and shareholders receive any distributions (or dividends) paid out by the company.
If the company needs more equity capital at some point in the future, being exchange listed,
they can simply issue additional shares in what is known as a secondary (or follow on)
stock offering.
Exchange traded companies allow retail investors to own a piece of fast-growing businesses
and to share in a nation's economic growth.
Even if you don’t have your own brokerage account where you invest your savings there
is a good chance that you have a retirement account that is invested in the stock market.
This type of investment should grow your savings faster than other types of investment like
bonds or real estate.
This model of how companies raise capital to grow has been disrupted over the last twenty
years where we have seen some of the fastest growing tech companies, reaching multi-billion
dollar valuations, while remaining privately owned.
The financial press refer to these billion dollar plus valued private companies as unicorns.
In the past it would have been close to impossible for a company to grow this large while still
remaining private, as back then Private Equity firms were too small to fund operations on
such large scales.
Tech Unicorns like Palantir which was founded in 2004 spent sixteen years in the Private
Equity Enchanted Forest before going public in 2020 with a 16.5 billion dollar valuation.
Long waits like this can frustrate venture capital investors, who typically look to exit
investments within 10 years and who view high-profile IPOs as reputation-building events.
Employees at these firms who hold stock options that are nearing their maturity dates have
also pushed some companies to go public, such as Airbnb which went public in December 2020
after twelve years in the enchanted forest.
So, what happened in markets to change the way that companies raise capital?
Well, overall a number of government actions dating to the mid 1990’s made it easier
for start-ups and private backers to raise capital, by reducing the application of anti-fraud
rules governing share sales and increasing the number of investors allowed in private
market funds.
A study published by the NBER found that these changes played a significant role in changing
the going-public versus staying-private trade-off.
One of the best papers on this topic was written by Steven Davidoff Solomon at The University
of California - Berkeley and Paul Rose.
I’ll put a link to their paper in the description.
Solomon and Rose put forth several theories explaining the disappearance of small company
IPOs.
The most prominent one relates to increased federal regulation, in particular the Sarbanes-Oxley
Act of 2002.
The cost of going public has always been significant, but the new regulations in 2002 caused these
costs to skyrocket.
Compliance required hiring additional personnel, outside consultants, and required numerous
systems improvements within firms.
On top of this, the regulations imposed significant new responsibilities on directors and officers,
increasing their exposure to personal, civil and criminal liability, making it more costly
for public companies to recruit and insure their directors and officers.
The market structure theory builds on the regulatory explanation adding that shifts
in market structure set up economic barriers to small company IPOs.
Finally, there is the argument that IPO’s have disappeared due to shifting economic
conditions where there are simply new and better sources of capital than an exchange
listing provides.
The idea being that it is more attractive for founders and managers to remain private,
provide limited transparency to investors and crucially for technology firms to provide
limited transparency to competitors.
The regulatory explanation achieved prominence a decade ago, which then led to the JOBS act
of 2012 which was supposed to unwind regulation and lessen its burdens on growing companies.
The JOBS Act was primarily a response to the regulatory theory, but it also took aim at
some market structure issues by loosening restrictions on research analysts.
Other features of the JOBS act were that it expanded the number of private shareholders
that companies are permitted before being forced to release public financial reports,
this of course allowed private companies to keep their finances hidden for longer and
prevented them from running into shareholder limits, like Facebook did before going public
in 2011.
The JOBS Act overall had no effect on encouraging new IPO’s
It’s worth noting that Mutual fund managers, are also permitted to include small holdings
of private companies in their public-equity mutual funds.
Across all venture capital-backed IPOs in 2016, 40% had raised money from mutual funds
prior to going public.
These private company investments can be used bump up reported returns and reduce reported
volatility for mutual fund managers.
This is because there are no observable market prices for these investments, they get marked
to a model valuation.
This is not necessarily good for mutual fund investors, Neil Woodford, a UK based fund
manager, was forced to close his fund back in 2019 after big losses in illiquid private
investments, which included an investment in a company that claimed to violate the laws
of thermodynamics by making clean energy through cold fusion.
If there is one piece of investment advice that I can give, it is that investments in
businesses that violate the fundamental laws of physics mostly don’t work out…
So, what exactly are private equity firms?
They are, as their name suggests, private — meaning they’re owned and invested in
by their founders, managers, or a limited group of large investors — and they are
not available for the general public to invest in.
These firms buy or invest in companies that they decide have growth potential, or have
steady cash flows that can be leveraged.
They then try to repackage them, speed up their growth, and — theoretically — make
them work better.
Then, they eventually sell them on to another firm, take them public, or find some other
way to offload them.
Generally, an ordinary investor isn’t able to put their money directly into a private
equity fund.
These funds are available to institutional investors — meaning pension funds, sovereign
governments, and endowments — or accredited investors - who meet a set of criteria that
allow them to make riskier investments.
Basically, rich people who can afford to lose their investment and don’t need or want
the protection of securities regulators.
So, are these private investments providing better returns than investments in publicly
listed companies?
Well, according to Bain & Company, over the last thirty years, private investments have
significantly outperformed the S&P500 by around 5% per year, but they point out that over
the last ten years returns have converged where private investments have similar if
slightly lower returns to public market investments.
This convergence should probably be expected - as the private investment industry has grown,
there is more competition to invest in every available deal, so the deals today are more
picked over than ever before.
In addition, a lot of the legal and tax efficiencies historically exploited by private equity firms
have disappeared.
The Financial Times reports that right now, the private capital industry has almost $2.5
trillion committed to funds by investors that has yet to be deployed.
This amount of money on the sidelines highlights how ferocious the competition is right now
for attractive deals and might lead you to question what returns might look like going
forward.
Not only does Private Equity appear to have outperformed historically, it also seems to
have had much lower volatility than an investment in the S&P 500.
This obviously has an appeal for institutional investors, who might face investor redemptions
during market drawdowns.
Unfortunately, this low volatility is more of an illusion than reality.
Private equity portfolio companies are usually valued on a quarterly basis so there is no
daily time series.
In addition, the valuations are usually conducted by external appraisers using business plans
from the private equity firms.
If private equity firms valued their portfolio companies on a daily basis using public market
multiples, volatility would be much higher and more reminiscent of the S&P 500.
It might surprise you that the average private equity fund according to Cambridge Associates
claimed to be up 11% back in 2008 when many of their portfolio companies were at the brink
of collapse and the stock market was down 38%.
I’ll allow you to decide for yourselves if they had actually picked the best companies
to invest in or if they simply refused to write down the value of their illiquid investments.
Let’s think a bit about what you get when you invest in one of these funds.
An investor in a US-focused private equity fund will get exposure to mainly US-based
companies just like they would by investing in a stock market index.
Private equity funds have no short positions, no unusual investments like cryptocurrencies
and they don’t trade in and out of investments the way hedge funds do, there is no reason
to expect any unusual diversification opportunities.
Investing in private equity is basically a long-only bet on a leveraged portfolio of
companies with high fees of two percent of assets under management and twenty percent
of the upside above a hurdle rate taken out.
Nicholas Raebner at Factor Research constructed a portfolio in 2018 of small cap, low valuation
and levered stocks – the type of company these firms typically invest in.
He found that this portfolio of public equities that anyone can invest in outperformed the
US Private Equity Index over the last thirty years while providing daily liquidity, requiring
minimal initial due diligence and not requiring any ongoing management or monitoring.
I’ll put a link to his paper in the description.
This (of course) is great news for retail investors, as it means that you don’t have
to be an accredited investor to access this type of returns stream.
Unfortunately for you though you won’t get to pretend to be up when the market is down,
as all of the stocks you have invested in are priced daily in the market.
The upside of that though, is that you will be able to sell your holdings whenever you
want to.
Now that companies are able to raise capital relatively easily in private markets, how
has it changed the world of investing?
Well, in recent years we have seen a shift in the type of corporate governance typically
seen in public equity markets.
Listing rules often enforced market norms regarding shareholder voting rights, and the
ability of shareholders to control management.
Many of the privately held, as well as the more recently IPOd technology companies in
recent years have structured their equity offerings such that Company Founders can’t
be outvoted or ousted by common shareholders.
A good example of this is the way that, Facebook went public with a multiple share class structure.
The Founder shares had 10 times the voting rights of the shares that were offered to
the general public.
Investors generally agree that multiple share class structures are not a good corporate
governance practice, but at the time of the IPO, Facebook was considered to be such an
exceptional asset that they "got away" with imposing an unfair structure upon their public
shareholders.
Five years later when Snap (who bizarrely claimed to be reinventing the camera) went
public, they issued non-voting shares to public shareholders, giving these shareholders no
rights to vote on management compensation, anti-takeover policies or even the composition
of the board of directors who supposedly represented them.
Public shareholders essentially had no control whatsoever of the company’s management.
The Founders and early Venture Capital investors sold ownership in the company while maintaining
full control.
Typically, you would expect investors to avoid investing in companies like this, or to demand
a discount for non-voting shares, but it doesn’t appear to have happened in these cases.
Shortly after the Snap IPO the FTSE Russell index managers and S&P Dow Jones announced
that companies that offer virtually non-existent voting rights to public shareholders would
not be eligible for index membership, effectively drawing the first line in the sand on poor
corporate governance proposals for new tech IPOs
It is an interesting idea that today because companies (in particular tech companies) go
public so late in their lifecycles, an IPO is no longer a means of raising capital for
a new startup, it is instead an exit for venture capital investors and a liquidity event for
company founders.
This is part of the reason that the NYSE is pitching the idea of direct listings as an
alternative to the IPO process.
It might be, that certain investors like private investments, because they are illiquid, they
never get marked down in market dips, and you are unable to panic in selloffs and dump
your position at the market low.
Investors in public equities who are prone to panicking in market dips could possibly
take away the lesson that making a well-researched investment and sticking to your investing
plan throughout a market cycle might deliver superior returns in the long run.
If you want to learn more about how private equity works, here is a link to a one-hour
class I posted on YouTube about a year ago that covers the topic in greater detail.
Like, Subscribe, and see you guys later.
Bye