The sad truth is that we don’t yet know enough to understand how big of a problem this is, whether it is going to get worse in the future, or if it is even a problem at all.

Elisabeth de Fontenay

Associate Professor, Duke University

This interview, part of Clear Path Analysis’ series of one-to-one discussions with leading North American based asset allocators, economists and politicians, focuses on the decline of public in favour of private stocks. Issues covered include, what the statistics say for year-on-year activity; the nature of the shift from public to private for companies; impact of low volatility in the public sector; if regulations and platforms for private market investments are developing quickly enough, plus the impact buyout activities of technology giants such as Amazon and Google have had on the lack of start-ups going public.

David Grana: What do the statistics say for year-on-year activity in public market investment offerings versus private equity?

Elisabeth de Fontenay: The trends show a very clear decline in public offerings, which is especially large when compared to the tremendous growth in the private markets. Specifically in the U.S., there has been a 30-year downward trend in IPO's. The large number of IPO's during the dotcom bubble was an aberration and misleading of the long term trend. To illustrate, during the 80's and 90's, there was an average of more than 300 IPO's per year in the US. In the 2000's and 2010's, that number dropped to less than 100 per year. The largest decline in IPO's has been for small firms, which are down over 80%. And the decline among large firms is more than 50%. This isn’t just limited to the US, however; there have been declines in several other important jurisdictions around the world. The other half of the story is the major decline in the number of companies choosing to remain public. Plenty of companies that were once publicly traded have gone private or were acquired by another public corporation. When you put together the decline in IPO's and the increase in exits from the public markets, the result is a massive decline in the number of US public companies.

David: What was the nature of the shift from public to private for companies that have gone down this route?

Elisabeth: Some of them are just standalone acquisitions by private equity funds. But there were even more strategic acquisitions, where an already public firm acquires another public firm. Those could be horizontal acquisitions, whereby the acquirer effectively eliminates a competitor. Or it could be a vertical transaction, where a company has purchased a supplier. Many industries have become increasingly concentrated in recent years as a result.

David: What impact might this have on the investment side of the equation?

Elisabeth: This is the big question and, unfortunately, the answer is not straightforward. There is a lot of angst about these developments, and rightly so, because the changes are so large and rapid. If you put together all of the statistics I mentioned, the net result is that the age of public companies and their market capitalization has been increasing. In other words, public companies today are older, bigger and fewer. At the same time, promising firms are staying private for longer. These large, older public companies experience less growth than more dynamic, younger companies. But it isn’t entirely clear whether this situation is good or bad for public-market investors. On the one hand, the fact that we are getting companies in the public market who are out of their high growth phase might mean that public market investors are just going to have lower returns from here on out. On the other hand, this might also mean that these returns will be less volatile, because public companies today are safer and steadier. This point is up for debate. A few academics have argued that a lot of the small firm IPO's that have gone away in recent years involved bad companies that should never have gone public in the first place, so their view is that this is actually a positive development for public-company investors. But most worry that there may be less growth in the public markets, which raises concerns for public market investors.

David: Would you attribute the low volatility that we have seen in the market over the last 2 years to the fact that we have less publicly traded companies?

Elisabeth: The fact that we now have larger and older public companies may very well prove to be one contributor to the low volatility environment. Another piece of the story is probably the rise of indexing and automatic contributions to retirement accounts regardless of the performance of these investments.

David: Are regulations and platforms for private market investments developing quickly enough at the same pace as the decline in public market investments?

Elisabeth: I don’t think we are keeping pace in the private markets. Even though the private markets are rivaling the public markets in terms of capital-raising, they are way behind in terms of liquidity. And there are all kinds of hurdles to achieving this. There are exchanges for trading private securities, such as NASDAQ Private Market, but neither the institutional nor the legal framework is set up to deal with the amount of trading that we would expect for the huge amounts of money going into this area. For instance, disclosure practices in the private markets are entirely non-uniform, which means, for example, that every big unicorn does things differently. Most of them provide no disclosure at all, certainly not publicly. Ongoing disclosure—not just when the securities are issued– the key thing that explains liquidity in the public markets, and we just don’t have that on the private side. My guess is that we are going to continue to see relatively limited liquidity for private-company stock.

David: Where do we go from here? What are some of the next steps that might need to be taken to get us through this and see some form of solution to this new normal?

Elisabeth: The sad truth is that we don’t yet know enough to understand how big of a problem this is, whether it is going to get worse in the future, or if it is even a problem at all. If the number of public companies continues to decline rapidly, eventually we’ll need to consider whether to open the private markets up to individual investors. If this is the case, it can’t be through direct investments, because that would be throwing these people to the wolves. It will need to be intermediated in some way. Perhaps we could allow more mutual fund groups to make investments in late stage private firms, which would would have the benefit of putting pressure on the private firms about their disclosure practices. Regulators will also need to think really hard about what, if at all, they want to require in terms of disclosure from private firms, especially if they want to have any kind of liquidity in their securities.

David: Why is this happening?

Elisabeth: There are several different factors. Initially, the dominant view was that the IPO market was killed by increasing regulatory costs. The hypothesis is that Sarbanes-Oxley made it too expensive to go public, hence, more companies are staying private. However, the research suggests that this is only a relatively small part of the story. The downward trend in the number of public companies started before Sarbanes-Oxley was passed. In my view, the more plausible explanation is that this is largely the result of the deregulation of private capital raising. Over this same 30 year period in which IPO's have been declining, there has been substantial deregulation making it much easier to raise capital privately. For example, firms can raise unlimited private capital from institutional investors, and companies can stay private indefinitely by raising capital from massive venture capital and private equity funds, which only exist themselves as a result of deregulation. And these regulatory exemptions for raising private capital just keep multiplying.

David: What impact has buyout activities by tech giants such as Amazon and Google had on the lack of start-ups going public?

Elisabeth: This is yet another possible explanation for the decline in public companies. There is a theory that technological change and globalization have dramatically increased economies of scale and scope for firms. The implication is that it is actually incredibly difficult to survive as a small firm on your own today. As a result, there are huge incentives for these smaller firms to be acquired by someone larger. So instead of pursuing an IPO, these days promising businesses are simply being snatched up by larger firms in their industry.

David: What can investors do to adapt to this new type of market?

Elisabeth: For investors on the private side, there is a real question as to whether they need to band together and pin down what they want in terms of disclosure. There are still huge barriers to liquidity for private-company stock, by virtue of the fact that the disclosures and the means of trading of these securities are so non-uniform.

David: Thank you for sharing your thoughts on this topic.

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