Andrea Auerbach
Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
It sure looks like it. The increasingly unforgiving nature of public equity markets, coupled with the continued evolution and growth of private investment markets, is making it easier for more companies to stay private, with some CEOs avowing to do so indefinitely. As a result, investors seeking to capture the full range of investment opportunities on offer across the US economy have little choice but to increasingly pursue private investments.
Over the past 20 years, the number of publicly listed US companies has been nearly cut in half, from a peak of 8,090 in 1996 to 4,331 at the end of 2016, with delistings outpacing new listings in all but one year over this period. About 60% of delisting activity was driven by mergers and acquisitions (M&A). Private equity’s fingerprints are all over that statistic, as the universe of private equity–backed companies able to act as strategic acquirers is on the rise. On average, about 7% of annual delisting activity is public-to-private (PTP) transactions, also overwhelmingly driven by—you guessed it—private equity. Private equity managers have the capital and the skill to execute PTPs and pursue them when opportunities present themselves, which is typically when public and private multiples converge or switch places. This skill was on full display in the record setting year of 2007, when there were 125 PTPs, and private equity fundraising peaked at $281 billion—not unrelated incidents in our view. In 2016, approximately 32 PTPs were completed. When public equity EBITDA multiples come closer to private EBITDA purchase multiples, watch for an uptick in PTP activity.
The decline in the number of public companies is being driven not only by delistings but also by the lack of initial public offerings (IPOs). Whether you favor active strategies or not, one cannot ignore the constant drumbeat of capital marching toward passive strategies, including index investing and exchange-traded funds (ETFs). Since 2007, overall inflows into index funds and ETFs have surpassed $1.3 trillion, compared to $1.7 trillion in outflows from actively managed funds. With passive strategies explicitly not participating in IPOs, the route to a successful public offering has become that much more challenging. IPOs peaked at 815 in 1996, during the original dot-com era. Subsequent to the “tech wreck,” equity underwriters and investors raised the standards for companies seeking a successful public listing, curtailing listing activity. Overlay Sarbanes-Oxley rules, public company information disclosure requirements, and quarterly earnings scrutiny, and private companies find going public means little except additional costs. The punchline? The number of IPOs in 2015 and 2016 did not breach 200, and 2017 looks to be more of the same.
While private equity– or venture capital–backed companies represent an average of around 60% of annual IPOs, the overwhelming path to exit for a private equity– or venture capital–backed company is via M&A. On a combined basis, our US private equity and venture capital benchmarks currently track over 17,000 unrealized investments, with an average of 1,800 investments realized annually. On an annual basis, IPOs represent less than 1% of all realization activity, on average. Thus, an overwhelming majority of private companies stay private, and the only way to access those returns is to have exposure to private investments in the first place.
Pursuing long-term corporate strategic goals tends to be easier in private, as companies avoid the quarterly incrementalist approach often favored by public market investors. We regularly monitor the progress of private companies held in private investment funds, co-investments, and direct investments, and the degree of change in company operations varies but there is most certainly change. This change is driven by a partnership between the often highly concentrated institutional ownership (usually one owner in private equity or shared ownership in venture capital strategies) and the management team. Common topics in our discussions of portfolio companies with private investment managers include replacing/upgrading senior executives, actively examining and pursuing optimized capital structures (including leverage for buyout strategies), new business development strategies, pursuing add-on acquisitions, funding new product development, seeking greater efficiency in operations, cutting over to Plan B when Plan A did not work, etc.
It takes time to effect this level of change. The average hold period for private equity– or venture capital–backed companies is six years, and the average fund’s life—the length of time from first investment to final exit—is ten and 14 years, respectively. Given the privacy to pursue value creation opportunities, the results are observable, with private equity–backed companies exhibiting average EBITDA margins from 250 basis points to over 600 basis points better than their public market comparables. The returns also appear to be worth the wait, with our US private equity and US venture capital indexes reporting 20-year returns of 12.3% and 25.4%, respectively, as of June 30—each representing significant value-add over public indexes measured on a public market equivalent basis.
The US public equity capital markets total over $27.4 trillion in assets, inclusive of all of those index and ETF funds discussed earlier, over 19 times the size of the US private equity and venture capital market, which we estimate to be at least $1.4 trillion. While this is a lowball estimate, as it does not take into account co-investment activity or direct investment activity, when the institutional private markets make up less than 6% of the public markets, there is clearly room for more to be done in the private investment arena.
In order to gain an advantage over their public competition, and to avoid public quarterly scrutiny of their growing pains, a look at the data shows companies are increasingly staying private. Now, it has always been true that investors needed exposure to private investment strategies to have comprehensive investment exposure to all sectors and tiers of an economy. It’s just (surprisingly) increasingly true given current US public market dynamics, and investors with the ability to accept the requisite illiquidity can reap the benefits for their programs.
Andrea Auerbach is Head of Global Private Investments Research at Cambridge Associates.
Originally published on November 7, 2017
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