Public markets are shrinking. The number of US listed companies stands at around half its level twenty five years ago. The rise and rise of private equity has played a role, plus US companies going to town on share buybacks. While it is more pronounced in the US, it is a global phenomenon. What are its long-term consequences?
This long-term trend of ‘de-equitisation’ has seen fewer companies becoming public and M&A activity and buybacks reducing the overall stock of equity. At the same time, there is plenty of capital flowing round private markets and companies have no longer had to subject themselves to the scrutiny of public markets to raise financing.
There are two main schools of thought on the phenomenon. One group fears the overvaluation in private markets. They point out that huge flows of capital have been directed towards private markets in search of higher returns. Prequin’s latest report shows the sector reaching $4 trillion in size. Private equity fundraising surpassed $500bn for the fourth consecutive year in 2019.
To this school, this is not an endorsement of private equity, but a clear sign of over-valuation. This has been self-reinforcing, as more capital has pushed up valuations, but at some point – they argue – the gravy train must end. There is too much money chasing too few deals and valuations looked stretched.
This view appears to be supported by the weak performance of a number high profile IPOs in 2019. Even where companies have a sound business model and strong growth, many have been unable to match their private valuation after listing: nine months on, Uber still trades below its listing price, Lyft at less than two-thirds of its launch price. WeWork shelved its IPO in the face of mounting criticism. Its IPO price was already around half of its private equity valuation.
Dr Paul Jourdan, chief executive officer at Amati Global Investors, believes listing provides a welcome ‘referee’: “In public markets, you can’t pull the wool over people’s eyes. If you don’t want the scrutiny, you don’t float. A reason to float is that customers will trust you.” He has seen the Aim market, a specialism for Amati, significantly improve in terms of the quality and maturity of the businesses. The weaker businesses are going elsewhere, often to crowd-funding.
The concept of the ‘referee’ has been widely discussed by Michael Lewis, in his podcast. He cites research on NBA referees showing how unfair calls have increased in recent years. However, at the same time, hard evidence suggests referees have become better at making good calls. There is a broader mistrust of the referees, not just in sport, but in financial markets as well. He argues that this is a damaging trend.
The other school of thought is that the trend is a result of the weakness of public markets. There is the expense and administrative difficulty of getting a listing in the first place. While they can get funding in private markets, many CEOs believe that time and expense is better spent on the business. Just a few years ago, there simply wasn’t enough capital in private markets to support companies through to billion dollar valuations. Today, unicorns can happily sustain a valuation of $2-3bn and higher in private markets.
Another argument is that the company has less control of its valuation in public markets, which are subject to a messy array of factors – from risk sentiment, to geopolitics to short-sellers. Witness Elon Musk’s ongoing battle with short-sellers and his (unrealised) threats to take the company private. This problem has become particularly acute with the money that has headed for passive funds (which surpassed $10 trillion in 2019). The influence of passive hampers price discovery and favours the largest companies, many of whom have the least need for capital.
Public markets have become horribly short-term in nature, benchmarked to quarterly or half-yearly targets. This is inefficient, encouraging companies to neglect long-term planning in favour of short-term boosts to the share price. It binds the hands of management, who cannot realise real value for the company because they are always jostling to meet the next round of quarterly earnings.
Private market apologists say it is difficult incentivise senior management appropriately in public markets. They are subject to the vagaries of remuneration committees, scrutinised by their shareholders and boards. Even if lofty salaries pass that scrutiny, can senior management really influence the share price for these companies? It is far more likely that they will be scrambling to meet short-term targets. In private equity, the management team can drive performance.
Equally, the public markets don’t really like the ‘growth at any price’ mentality of some private-equity backed companies. They demand a path to profitability, control of costs. Companies that stay private can focus squarely on revenue growth. This may be good or bad, but there is no doubt that it suits some companies.
For investors’ sake, it is to be hoped that this is not a permanent state and it is only a matter of time before the best models start becoming public. Private markets will eventually become more discriminating and investors will increasingly value the checks and balances they provide. There are signs that this is happening with the weak performance of recent IPOs. Private equity may become less tolerant of low profitability as a result.
This American LifeSource