Capital Formation: The Evolving Role of Public and Private Markets
The statistics on public market participation by corporations over the last two decades make grim reading in developed markets. The headline number of firms on US listed-equity markets is significantly lower than in the past: The United States had 14% fewer exchange listed firms in 2012 as compared to 1975. Compared to the peak year of listed firms — 1996 — the number of listed firms had dropped by half as of 2012.
Outside of the United States, the number of listed firms globally has not experienced a dramatic drop since the late 1990s, although the United Kingdom and the Euro Areahave seen stagnation or smaller declines. On the other hand, the number of Chinese listed – companies has increased dramatically. Hong Kong has more public companies today than in 2000 — the number has gone up every year, possibly at the expense of Singapore, which has seen its listings fall.
Public markets and public corporations are intrinsically linked, so it is not surprising that changes in the nature of public markets are causing changes in corporations, and vice versa. In particular, the pressures on public corporations have grown, due, for example, to increasing corporate disclosure requirements, listing standards, and governance practices. A frequent complaint is that being a public corporation is increasingly or excessively onerous.
Though some of these issues are longstanding, the difference today is that the market power of entrepreneurs in accessing capital for their businesses has increased to the extent that avoiding public markets entirely has become feasible. Newly deregulated — and in cases such as Initial Coin Offerings (ICOs), largely unregulated — private-capital pools combined with large amounts of deployable capital searching for higher yields in a near-zero interest rate environment are giving entrepreneurs more options.
Further, the new business models frequently found in highly developed markets are often characterized by high intangible asset investment. This has important implications for public markets because companies based on intangible asset development
- tend to scale very rapidly and with relatively little capital;
- prefer to deal with fewer but larger investors to retain ownership and control; and
- over easily copied intangible assets for as long as possible.
Private Markets:A Growth Story
Private markets have grown rapidly over the last 20 years, with private equity funds (buyout and venture capital) commanding the bulk of assets under management, and real estate and private debt funds vying for second place. Notably, all asset classes have experienced barely interrupted growth since 2000. Although ICOs have taken a large amount of mind share among media and investors, in aggregate they are still a tiny proportion of global capital formation.
Private markets typically have higher expected returns because of the illiquidity premium involved in owning these securities, as well as structural advantages that benefit institutional investors. These advantages arise from financing efficiencies, the ability of institutional investors to time their exits, and operational value creation. Realised private market returns tend to outperform their benchmarks, but by low single-digit percentages; these private market returns may nevertheless offer a better risk-return trade-off than public equity funds that tend to underperform their benchmarks. Private market returns are noticeably dependent on good manager selection. At the same time, manager skill appears to show little persistence when successor funds are examined in the literature. This is all to say that although private markets do likely offer higher expected returns, those returns are by no means guaranteed.
There is no obvious regulatory solution to making public markets more attractive to new businesses and entrepreneurs whose nature seems intrinsically better suited to private markets and/or acquisitions by existing public firms. One can see this in action in the long list of acquisitions of tech start-ups by incumbent tech giants and existing corporations. The lowering of public market disclosure standards would only erode investor protections and reduce the attractiveness of public companies, and thus, would be unlikely to result in additional public listings.
Separating the cyclical from the structural is important when considering any policy response. Although private funds currently face supportive financing conditions, it remains to be seen whether this (excess) demand will inflate private company valuations to an unsustainable level. If so, might we see expected returns fall, making public markets relatively more attractive again even without regulatory intervention?
With the global move toward self-funded retirement, it is not credible to leave an entire generation of retail investors with only diversifiedpublic market exposure to generate retirement returns, while institutional investors crowd into innovative business models that offer potentially higher returns but unknown potential systemic consequences.
We believe the correct set of policy responses is not to weaken the integrity of public markets in a likely vain attempt to attract more activity, but instead to improve access of smaller investors to private market investments responsibly, via professional intermediaries such as collective defined contribution vehicles. The policy priority should be to ensure social support for the corporate sector by better integrating the private markets into the existing “social compact.” For example,regulators should
- encourage better disclosure and transparency standards in the private markets (while acknowledging that they can never be as transparent as the public markets);
- improve access to private market investments by pension savers through professional intermediaries;
- view access to private markets for pension savers as a way to create broad-based public support for private markets, rather than as a way to necessarily increase returns;
- keep strict investor protections and limits in place because the evidence suggests that, although private market returns are higher than public returns, those returns are very dependent on the period being considered and typically are for the best-performing funds. These high-performing funds do not demonstrate persistence in performance.
Finally, regulators should monitor the rise of private markets for evidence of growing systemic risks. Although some commentators argue that no systemic implications exist because private institutions, in the event of a downturn, would simply absorb private losses, such reasoning may not tell the full story if it transpires that sovereign wealth funds, government plan sponsors, pension systems, and retirees are heavily involved in the burden sharing.
Image Credit: © Klaus Vedfelt