There are many ways for companies to raise capital; going public is only one of them. The generational move lower in interest rates over the past 30 years has made it easier for companies to raise capital as investors have sought alternative sources of returns. As risk appetite has increased, options in both equity and debt markets have emerged, with private investments amongst some of the most popular. For a quick but pointed stat, in 2017, US$2.4-trillion was raised privately in the U.S., versus the US$2.1-trillion raised publicly.
To be sure, there are many reasons a company may prefer to turn to private investors over more traditional public markets:
- Less regulatory oversight, including fewer disclosure requirements (no need for those quarterly conference calls!);
- Fewer investors to deal with, and the flexibility to partner with like-minded investors;
- More privacy and control; and
- A final point – which was recently reinforced by Ron Shaich, founder of Panera Bread – in some cases, the pressure on public companies from shorter-term oriented shareholders may impede a company’s ability to innovate, invest, and remain focused on a long-term vision.
But as more companies choose private funding when they need to raise capital, what are the implications for investors in public markets? What should we be aware of? And what, if anything, are we doing about it?
Implication #1: Fewer options for public investors
Perhaps the most visible manifestation of the rise of private investing lies, ironically, with initial public offerings. IPOs in the U.S. have been on a downward trend for the last three decades and the number of listed companies has halved over the past 20 years. Businesses that are asset light, cash flow positive, don’t require an infusion of capital, and small amount of debt, may have little need to bother going public. Since these companies elect to stay private for longer, that means fewer options for those investing in public markets.
For small cap public equity investors in particular, it has become more difficult to find new ideas because companies stay private through the small cap phase and then IPO (initial public offering) as mid- or large-caps. For example, last year Snap sold 200 million shares at US$17 for its IPO. And while Snap did not meet our investment criteria, nor is the type of investment we seek to make for our clients – we have not seen any evidence that it earns its cost of capital—even if we had wanted to invest in it, our small cap portfolios never had a chance given that it IPO’d at a US$24-billion valuation.
Snap highlights another trend in the IPO market, especially in the current tech cycle: we are seeing more “unicorns” limping across the finish line, nursing haircuts, thirsty for cash. The playbook for many private equity companies that buy or provide funding to companies not yet publicly listed frequently involves optimizing the business they’re invested in. While “optimizing” seems like a term with positive connotations – and it often is, if it means materially improving a company’s operations – more often than not, optimizing is simply a financial exercise of squeezing costs, underinvesting in the business’s long-term prospects, and taking on debt to maximize profitability in the shorter-term in the hopes of selling the investment at an attractive price – often through IPO. This compounds the problem of fewer public options in that there are also fewer high-quality options that meet our criteria of well-run, wealth-creating business that are attractively priced.
But while it is true that many freshly IPO’d businesses do not meet our investment criteria, some of them are worth a look. In some cases, we’re able to identify business models with high potential that simply need time to deleverage their balance sheets and reinvest in their businesses. But we’ll almost always wait to see evidence of progress before investing.
Additionally, some of the publicly listed companies that we own in our portfolios are themselves investors in private markets. Brookfield Asset Management is one of the more prominent examples. Brookfield has benefitted from the shift in capital allocation toward private investments, and as discussed on our podcast, is one of the best globally positioned companies to take advantage of the many opportunities available to private investors. For one, Brookfield raises capital from other investors to invest alongside them. The company benefits from the privatization trend because they also generate investment management fees. And, as investors themselves in the businesses they buy and operate, if they can buy good assets at reasonable prices and then run them effectively, they’ll generate an attractive return on their own investment.
Implication #2: More competition
The rise of private investors has meant there is a lot more capital competing for investment opportunities. Private equity companies, pension and sovereign wealth funds, and acquisitive companies are all far more influential than they were a few decades ago. And they have a lot of money to infuse into the system. Of the US$2.4-trillion private equity raised last year, about US$1-trillion is sitting as dry powder, still waiting to be put to work. As the old saying goes, there’s too much capital chasing the same assets.
The obvious implication here is that the mechanics of supply and demand have contributed to the rise in asset prices, and that valuations have become expensive. In order for a company like Brookfield to continue generating attractive returns on their investments, it’s no longer as easy to find outright bargains today as it was 10 years ago.
We own a number of acquisitive firms we believe have the attributes to effectively compete with private investors for opportunities and that have the discipline to adhere to their capital allocation strategy. One example is Constellation Software. Constellation Software has made numerous acquisitions over the years and most of them have been relatively small (about $3-million). But taken together, the company now has a market cap of over $18-billion – quite an accomplishment considering the initial $25-million investment that started the company. Much of its success can be attributed to its founder, Mark Leonard, who has proven to be an outstanding allocator of capital. We continue to have confidence in Mark and his team as they have resisted the temptation to lower their hurdle rates despite a more competitive environment, and have embraced a decentralized structure in order to gain better flexibility to scour for opportunities.
In this increasingly competitive environment, a focus on good management teams is perhaps more important than ever. It is key that management teams don’t lose their discipline.
Implication #3: Illusion of safety
Because private equity investments aren’t listed on an exchange, they don’t have to report in public market terms. In fact, most are not required to provide ongoing public disclosures at all. And they don’t have a publicly-listed stock price that is updated every microsecond for investors to agonize over. While the intrinsic value of their business may fluctuate daily in some theoretical sense, there isn’t a public listing subject to the whims of greed and fear that acts as a temperature gauge. And since management has significant discretion in the way they value their investments, this can lead to private equity being presented as less volatile than public equity markets. To some, less volatility means less risk – but this is absurd! As illiquid investments with limited oversight and reporting requirements – not to mention that many have yet to make a profit at the time of investment – private equity probably shouldn’t be considered any less risky than public equity investments. Both are equity stakes.
For asset owners looking to “decrease risk” – or at least the appearance of risk – this thinking has perhaps provided a perverse incentive for further investment in private versus the public market. As discussed in past blogs, we don’t view risk as the daily volatility of stock prices; rather, we view risk as the permanent impairment of capital. For all investments (for example, debt/equity, private/public), we believe that is a much more appropriate lens through which to consider investment risk. The presence or absence of disclosures or of a daily thermometer do not alter this view, and we would urge some caution for private investors who feel they are obtaining equity-like returns for less-than-equity-like risk.
This piece isn’t intended to be a gavel pronouncement on whether private equity is “good” or “bad.” There are valid points to be made in favour of private equity investing and as an alternative source of funding for companies. As mentioned, we invest in solid businesses that participate in private markets. However, there is no question that private investments have limited our opportunity set, either through limiting the number of high-quality options or through increased competition. Investors should be aware of the nuances around private equity.
Rob Campbell is Institutional Portfolio Manager at Mawer Investment Management