Capital formation: It’s Still Happening… Somewhere.

Equity listed on public markets is the bedrock that underlies the valuation of many other growth assets, similar to the function sovereign debt plays for corporate bonds. It is also the focus of a huge amount of analysis (much of which is undertaken by CFA Institute members) and regulation. However, the significant decline in the number of IPOs and listed companies is well-documented. Although some do not consider this a concern, since capital formation appears to still be happening, albeit along different channels, there are possible downsides to capital formation outside public markets, such as the following:

• Existing listed markets could become overexposed to older industries and underexposed to growth industries. If this trend becomes extreme, then listed equity will cease to provide an appropriate benchmark for determining risk premia across asset classes, possibly reducing price discovery.
• Average savers are disadvantaged because only large funds and entities can efficiently invest in illiquid sectors such as private equity or infrastructure. Although savers could have access to such investment opportunities via pension schemes, it is typically developed-market, large, defined-benefit schemes that are most able to gain exposure to private, illiquid investments.
• The information asymmetry outside of public markets may cause investors to be locked into poorly performing assets over extended periods, without a liquid secondary market that could be used for price discovery.

This issue is currently a topic of research at CFA Institute, with a report on the issues affecting public markets due later this year. Recently, CFA Institute conducted a series of workshops in Hong Kong, Abu Dhabi, Dubai, and London, inviting CFA® charterholders, CFA® Society volunteers, and CFA Institute members, to determine the relevant issues affecting public markets.

Here’s a sneak peek at what will be discussed in the coming report.

What’s Going On?

Certainly, it is true that the number of US-listed companies has declined significantly in the last two decades. However, what is typically less reported is that this decline is relative to a peak that occurred during the dotcom bubble in the late 1990s. It is not obvious that this peak number of listed firms is a good benchmark to use.

Regardless of the benchmark used, the popularity of IPOs as a way to raise capital appears to be soft, and when combined with delisting activity, the number of listed companies is not growing as strongly as may be expected.

This Time It’s Different

One explanation offered for these observations is that new “knowledge-based” business models tend to be very asset light, meaning both that they require less capital investment to grow, and due to the low capital hurdles, that they are more susceptible to imitators, competitors, and disruptors. Both characteristics make it less likely that such companies will access the public markets in the first place, or remain listed for long if they do pursue an IPO.

Another argument posits that new ideas, growth, and innovation are now coming to the listed markets via existing listed companies (e.g., Alphabet, Bosch incubators and accelerators) rather than via the entry of new firms through IPOs. In this view, Alphabet thus becomes a self-contained “market” in its own right, and the public market thus becomes a market-of-markets.

Lack of Trust in the Flash Boys

During the workshops, several strong points were raised about the erosion of retail investor trust in public corporations and public markets. A typical middle-aged investor will have lived through the dotcom bubble, the Enron scandal, the 2008 global financial crisis, and the controversy surrounding “rigged” high-frequency trading markets. The retail-level optics of the public markets and public corporations have not been positive for a long time, even if those optics are more perception than reality.

We’re from the Government and We’re Here to Help

Often, the regulatory burden is put forward as the reason for a lack of interest from entrepreneurs in becoming public firms. This is a difficult concept to pin down because it is unclear which investor protection or market integrity regulations (enacted in response to demonstrably bad behaviour by market participants) need to be rolled back.

The main issue is that the market power of entrepreneurs, given relatively easy access to private market financing, is currently very high. We can see this in the lack of enthusiasm to engage in an IPO, as well as the increasing prevalence of dual-class nonvoting share structures among firms that do decide to take that path. How diluted would the investor protection and disclosure process of an IPO need to be before it is attractive relative to private market financing?

In addition to being put off by the perceived burdens of the IPO process itself, entrepreneurs may view public markets with scepticism because of the perception (possibly justified) of short-termism and excessive activist investing. Entrepreneurs would prefer not to dilute their ability to run their firms as they wish, and the alternative private market financing options enable them to act on that wish.

The Revenge of CAPM

The well-worn “passive versus active” debate also comes up in the discussion on capital formation. The seemingly secular rise in passive investment implies more and more money is not participating in capital formation at all. In addition, the immense fee pressure on active firms has been causing consolidation in that sphere; for the largest investment managers, participating in a non-unicorn IPO is simply not economically viable due to the small amounts involved, whatever the potential return.

Other aspects of market structure also seem to act against public market capital formation. Specifically, the rearrangement of investment bank activities and profit centres since the 2008 financial crisis has seen equity capital markets become less lucrative, with IPOs not necessarily generating much recurring fee revenue. Algorithmic market making has also made markets in the largest stocks extraordinarily deep and liquid, but the same is not true for any stock outside the very top tier. Sparse analyst coverage and illiquid markets feed each other in what seems to be a spiral of doom.

Between You and Me

It appears that private markets have become more popular because of what they are not (i.e., public markets) than because of what they are. Many workshop participants noted that investors in private markets tend to be more long term in their outlook, compared to the short-termist investors in the public markets. The absence of mark-to-market is considered a plus because of the muting effect it has on irrational fear and mood swings. Further, for institutional investors, private markets may allow for better oversight, transparency, and corporate governance reassurance, as the institutional investors are able to wield more influence among their invested firms.

Many practitioners have noted that the rise of private markets has been made possible in the first place by the post-crisis Quantitative Easing and low-interest-rate regime, which has seen accumulated corporate cash stockpiles chase yield in a low-yield world. Private markets, with their greater pricing inefficiencies, afford investors more opportunity to search for higher yields.

One question often posed in the rush to laud private markets is whether private market investments actually do generate superior returns. Some evidence suggests that private market returns arise from a few winners and accrue to only a few successful managers. While these success stories are highly visible, the countless failures are hidden from view.

There is also the issue of the scalability of private markets. Already there is a “dry powder” problem, that is, the phenomenon of private investors having insufficient investments in which to deploy their capital. This may be causing a “bubble” of private valuations where investors outbid each other to participate in the relatively few quality firms and projects.

The Future of Public Markets

Several workshop participants noted that they expect more public-market-like transparency and that disclosure will come to private markets, both for regulatory as well as market pressure reasons. Already, very large private firms have a level of publicity and disclosure not that far removed from public companies.

An interesting idea comes from a recent article in the Australian Financial Review, which discussed the possibility of the enormous superannuation pools in Australia necessitating the outright purchase of companies like BHP, by far the largest stock on the Australian market. It is possible to envision large private-equity and pension funds, having run out of viable private market deals, simply privatising the public market.

Summary

These and other issues will be investigated in the coming report. Stay tuned for our preliminary launch at the November European Investment Conference in Paris.