Investment Insights: Public or Private?
By Cliff Aque, CFA, Investment Strategist
The number of listed companies in the Unites States declined steadily from a peak of 8,090 in 1996 to a low of 4,102 at the end of 2012. As the world recovered from the Great Financial Crisis, many expected to see companies return to the public market through initial public offerings (IPOs), but this has not been the case. At the same time, listed companies have been getting steadily larger, crossing $30 trillion in market capitalization last year. The 10 largest companies in the S&P 500 make up 26% of the index as of this writing. Why has this happened and what are the implications for investors?
Selling shares in an IPO used to be a sign of success and was an important way for companies to raise capital, but this is no longer the case. Rather than ring the opening bell at a stock exchange, many companies are opting to remain private longer. Part of the reason is that going public is expensive. In its 2017 Business and Finance Outlook, the OECD found that the average underwriting fee in the U.S. from 2000 to 2016 was 7%.1 Bigger companies can negotiate lower fees between 3% and 5%, but few can negotiate down to 1.1% as a large social media company did in 2012.
Companies can now tap private sources of capital more easily as private markets have seen continued deregulation. The start of this can be traced back to the 1996 peak, when Congress enacted the National Securities Market Improvement Act, which made it easier to sell ownership stakes to qualified purchasers. In 2012, Congress raised the number of investors allowed in private companies from 500 to 2,000 and in 2013 the Securities Exchange Commission (SEC) relaxed its ban on advertising for private placements. Interest in private capital continues to grow; Preqin, a firm that collects private market data, stated that dry powder (capital looking for an investment) grew to $2.1 trillion by June 2018, up 18% from the end of 2017.2
Private equity has moved far from the “greed is good” corporate-raider image of the 1980s and 1990s. Today many private equity firms are run by sophisticated investors that offer a partnership model, helping with senior staffing, providing strategic relationships, and, most importantly, understand the company’s business model. Public companies are subject to public investor’s focus on short-term results from quarter-to-quarter, whereas private investors often share a longer term view and can offer multiple stages of capital funding. Uber is a great example of a large company that remains private because it is easy to raise capital even though they just had their first profitable quarter. They have had eight rounds of funding since February 2016, with the last in August 2018 when a large automaker invested $500 million, which valued Uber at $72 billion.
This brings us back to size, because not only are public companies are bigger, but private companies have become bigger, too, using technology to increase their scalability and speed. Digital companies may lack profitability, but because they offer value through their intangible capital, they often make interesting acquisition targets for other firms. Large technology companies have acquired hundreds of companies which may have otherwise gone public over the past ten years. Global merger and acquisition has been strong over the last five years, with the total value hitting $3.9 trillion in 2018.3
The Kaiser Family Foundation counted almost 7.4 million companies in the U.S. at the end of 2017, of which 1.86 million had 50 or more employees. Public investors may not be able to invest directly in these, but as bigger public companies acquire smaller private ones, investors can indirectly get exposure by owning those public companies. Private markets also continue to become more democratized through feeder funds that can offer accredited investors access. Public investors who have not invested privately before need to carefully consider the illiquid nature of private equity which can require investors to lock-up their capital for long periods of time. Additionally, picking the right private equity funds is crucial as the range of return outcomes can be extremely wide.
The markets may have shifted to a greater emphasis on private markets, but that is not necessarily a bad thing. Before the NASDAQ exchange, IPOs were usually reserved for more established companies and perhaps we will see a return of that as some of these still-private, but large companies mature. Public investors can still indirectly invest in private companies through individual securities, mutual funds (which can have up to 15% exposure to private companies), or through private equity vehicles that are becoming more accessible. We should recognize the importance of participating in this vast opportunity.