Public Market / Private Market
Capital Raising Goes Back to the Future
The universe of U.S. publicly owned companies has been shrinking since the turn of the millennium. Fewer companies are choosing to list, and those that are listed have been issuing debt to finance share buybacks at unprecedented levels since the financial crisis.
Public markets have also been getting less liquid. Regulation, in the form of Basel III and the Dodd-Frank Act, has made it much more capital-intensive for investment bank broker dealers to “warehouse” securities on their balance sheets. Those inventories are used to make markets and provide liquidity to clients as they buy and sell stocks and bonds; as they shrink, the liquidity of the public markets dries up and the potential for gaps in pricing and higher volatility rises. Brokers, alongside alternative liquidity providers such as high-frequency and algorithmic traders, have turned to providing more “risk-based” market-making, but this can turn out to be illusory liquidity that disappears during bouts of risk aversion, just when it is needed the most.
The opposite trends are evident in private assets. These are still most certainly long-term assets, but the secondary market in private-asset fund interests has grown and deepened rapidly since the financial crisis, bringing a completely new level of liquidity to investors. Meanwhile, as the number of public companies has declined, an increasing number of companies has been going private or staying in private hands indefinitely.
The flow of capital to businesses and individuals is privatizing and fragmenting in other important ways. The dominance of the banking system in credit flows is giving way to capital markets, private debt funds, crowdfunding and lending-platform technologies, as the same post-crisis regulation that has cut investment banks’ securities warehouses raises the capital-intensiveness of making loans. In some ways, the way savings flow into investments is going back to the 19th century, but with 21st century technology and legal structures.
The multi-generational, multi-skilled teams nurtured by the longest-established private equity firms are facilitating this shift of influence toward the private markets. These teams are able to take advantage of the opportunities opening up beyond the classic leveraged buyout transactions of the past, which used to represent 85% of the private equity industry and now make up just over one-third. As a result, the entire private markets ecosystem is deepening to include everything from direct lending and mezzanine financing, through secondaries and co-investment, to investing in the equity of alternative investment firms themselves. The breadth of this talent will be important as investor capital continues to flow into private markets and competition for assets rises.
For 200 years, we lived in an age of merchant banks, investment banks and public stock exchanges. The financial crisis may have marked the peak of that era, and capital raising may be going back to the future.
- Private Economy Expansion
- Private Debt Growth
Our Two Investment Implications
1. Private assets are becoming more essential—and more flexible
Globally, private investments may still account for just 2.5% of the world’s market capitalization. Nonetheless, the number of private companies exceeds the number of public companies, they are among the world’s fastest-growing businesses, and the probability that they are engaged in the important industries and markets of tomorrow is high.
As private markets represent a greater proportion of economic activity, investors will miss out on the full return opportunity if they do not participate in them. In fact, we would argue that private equity, in particular, is rapidly becoming an essential exposure to capture the true long-term equity risk premium. They tend to outperform, on average, because private equity investors have deeper access to information, more direct and transparent governance control, and the ability to create value through strategic and operational improvements. Because private equity managers are expected to spend months sourcing and completing investments, and can choose between trade sales, sales to other private equity funds and IPOs, they also benefit from a lot of flexibility around both their entry into and exit from positions. Moreover, the quality, as well as the liquidity, of listed companies is often overestimated: more than a third of the smaller U.S. companies listed in the Russell 2000 Index are loss making, for example, while broker dealers are less willing or able to use their balance sheets to support public market liquidity.
Private companies are very different from the larger firms that can cope with and thrive on the demands of public ownership. It is much more difficult for a company in an industry in transition or early in its growth cycle to thrive in the public markets, where investors increasingly demand more predictable revenues. We find many private companies do not have a publicly investable equivalent; they might not be engaged in a completely exclusive business, but at a public corporation they would very likely be small divisions generating a negligible proportion of overall revenue.
Private debt and equity are increasingly important for financing a broad range of companies of varying size across a broad array of sectors.
Investors used to focus on leveraged buyouts of low-growth, asset-intensive businesses at depressed valuations. Today, the opportunity set includes high-growth technology companies that used to go public at an early stage in their life cycles; examples such as Uber and Lyft show that some of these are now being financed privately up to multibillions of dollars, with billions in revenue.
While public markets grow smaller and less liquid, the private markets are becoming larger, more mainstream, more diverse and more liquid. Liquidity in private markets means secondary-market transactions in fund interests. Volumes were low before the financial crisis, but have steadily increased since. The first wave was fed by institutional limited partners who wanted to sell in order to adjust asset allocation or cut down on their general partner relationships. That has evolved into a more general liquidity-management tool for limited partners.
More recently, we have begun to see general partners taking advantage of the secondary market, too, working with dedicated secondary buyers to create offers to limited partners in older funds that hold locked-up, unrealized value in still-maturing assets. This enables investors to refresh their portfolios should they wish to, even as others alongside them elect to hold the assets. This is an increasingly useful service as funds hold onto companies for longer and longer periods—almost a third of private equity positions are now more than five years old.
Evidence suggests that reassurance that liquidity can be made available to those who want or need it actually lengthens private-asset owners’ investment horizons—indeed, this is one reason why investors are holding a greater variety of companies further into their growth cycles.
2. Diminished banks mean more opportunities for long-term investors
A combination of regulatory constraints on traditional financial intermediators and the appearance of technological solutions is reducing the role of banks, in particular, when it comes to lending to the real economy and providing liquidity to the financial markets.
Opportunities are growing for institutional investors to transfer risks from bank balance sheets, step in where banks are withdrawing from lending markets, and take advantage of higher volatility and market liquidity gaps as broker dealers hold smaller securities inventories.
Those opportunities are growing and varied. Institutional direct mortgage lending is increasing as high-quality borrowers, such as many of the self-employed, fail to meet new underwriting standards for bank loans. Private equity managers increasingly turn to private debt funds because, in addition to greater privacy, flexibility and timeliness, these debt funds now offer more certainty than banks. When a deal does need bank financing, providers of mezzanine and preferred stock financing as well as co-investment structures can help to build the lower layer of the capital structure that is often needed to get the leverage low enough for banks to be able to lend under post-financial crisis rules.
Beyond institutional direct lending we are also seeing the rise of disruptive platform-based lending and finance-disintermediation technologies for individuals and small businesses alike. These range from crowdfunding and non-bank payments systems to the utilization of blockchain technology to enable partial, “tokenized” ownership of illiquid assets by a broader group of small investors. Many of these enterprises are themselves funded through the private equity markets.
The new importance of private investing in the economy is not only about more and more companies being held privately and fewer and fewer being held publicly; it is also about more and more of the credit in our economy coming from investment funds and businesses backed by private equity.