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