Off The Market
Why companies are choosing to stay private, and how venture capital is driving the trend
The trend of companies staying private for longer is here to stay. As a trusted partner to investment advisors, family offices groups, and UHNW individuals, Rokk3r Fuel ExO understands the importance of discussing the implications of this recognized shift in the capital market, and we want to ensure that our investors adjust their investment approaches and portfolio allocations accordingly.
While the media and investors continue to ride the equity rally and cheer each time a major stock index hits an all-time high, very few investors look under the hood and recognize the more serious problem of a shrinking and aging public market or understand the factors that encourage companies to remain longer under private ownership.
Over the past 20 years, the U.S. stock market has contracted — not in value, but in volume. Although the number of companies has occurred in relative slow-motion, slow to such a degree you may not even have noticed, the change is undeniable and quite dramatic.
The market today, with 3,671 listed companies, is only half its size at its peak, in 1996, when 7,322 companies were listed. The pool of public stocks has not replenished fast enough to make up for the number of companies that were removed through acquisitions, take-private transactions, and, less frequently, through delisting. In fact, the number of annual Initial Public Offerings (IPOs) has plunged sharply, from 600 in 1996 to 160 today. And we cannot attribute this decrease to a lack of new candidates. In contrast, both the total universe of companies and the number of companies eligible to list have risen modestly. The problem lies within the motivation for companies to join the public sphere. Weighing the rising costs against the diminishing benefits, more companies are shunning public markets and staying private for longer.
The rising costs of going public and being public
With the introduction of the Sarbanes Oxley Act in 2002, the costs of going public and operating as public entities have risen. To comply with regulations, companies have come to face more mandatory disclosures and regulatory requirements. The JOBS Act (2012) legislation relaxed some of those regulatory hurdles, but simultaneously liberalized private capital raising. Therefore, it blunted the legislation’s goal of spurring an inflow of new companies to the public realm.
In addition to the financial costs, less tangible costs also contributed to the dearth in new listing activities. In the public spotlight, decisions and actions in public companies are heavily scrutinized by investors, analysts, and the news media. Many public companies’ management are forced to focus on short-term performance at the expense of long-term value creation. The disclosures required of public companies provide full transparency into public companies’ inner workings, enabling competitors to reconfigure their own strategies and increasing the risk of shareholder activism.
Diminishing benefits of a public offering
The primary benefit of going public via an IPO is the ability to raise capital quickly to finance growth initiatives and expansion. However, that benefit has diminished as today’s companies have more options than ever to find private financing from different sources, in great amounts, and with flexible terms.
The world today is completely different, in terms of the amount of capital a startup company stands to raise pre-IPO, thanks to the development of the private capital market. The venture capital space, in particular, has caused a paradigm shift.
While 20 years ago the median amount raised pre-IPO was $12 million, that figure jumped to nearly $100 million in 2016, and the upward trend has held steady. The amount a unicorn (a company with a valuation greater than one billion dollars) can raise through solely private offerings is even more astonishing.
Before going public, Facebook raised $2.2 billion through private market channels over the seven-year period between 2005 to 2011. Over another seven-year span, from 2010 to 2016, Uber raised nearly $13 billion entirely from the private market. The abundance of capital in the private market has made a transformational difference in just a few years. Private sources of capital today can fulfill all of a private company’s needs, including achieving a dominant scale and acquiring smaller counterparts.
On the public side, American corporations are now sitting on $1.5 trillion, more than three times the amount that existed on balance sheets in 2000. Corporate behemoths in America have pulled back from R&D, leaving the creative economy as the source of innovation. They then use their full coffers to acquire any company that poses a competitive threat or that fills their gaps. The healthy supply of capital has supported the robust M&A environment and driven down another advantage of going public — to gain liquidity for a company’s founders, employees, and early investors.
To access liquidity, small companies actually prefer to sell to a larger firm rather than risk conducting an IPO and competing at a disadvantage with larger and more established peers. On the other hand, the growth of secondary markets and private share exchange programs have provided a means for the owners of private companies to monetize their shares before exit.
Diversification decreasing at the market level
As fewer companies issued IPOs, the remaining public companies in the United States are now larger, older, in more concentrated sectors (due to industry consolidation), and slower-growing, compared to the past.
Data show that the average public company today is 50 percent older and four times larger than it was 20 years ago. Over the same time period, the number of companies in the S&P 500 that have grown at 20 percent or greater has dropped by half. This is in stark contrast to the opportunities available now to venture capital investors. The Rokk3r Fuel ExO investment team invests in early-stage companies that post double-digit monthly growth rates or triple-digit annual growth rates. Our unique and disciplined process identifies and evaluates companies early in their life cycle and immediately de-selects any company that does not have the potential to achieve exponential growth and investor returns.
The aversion to public listing is not limited to select sectors but is a universal phenomenon. However, in terms of size, the deliberate avoidance is observed more commonly among microcap and small-cap stocks. Most small companies wait to go public later in their life cycles when they can amortize the substantial IPO costs over a much higher base of earnings and have enough scale to compete effectively. Given the diminished number of publicly traded companies and the maturities of those businesses, the public market no longer offers the full breadth of opportunity it once did. It means that investors need to embrace alternatives, particularly private and venture capital investments, to access younger and faster-growing companies in order to build as diversified a portfolio as before.
Value creation shifting from public to private
The current trend of delaying IPOs has benefited private market investors at the expense of public market investors — another hard truth. Most startup companies today have enjoyed a longer growth runway and built most of their value while still in private hands. Therefore, public investors face diminishing odds of buying stakes in early-stage companies, thus missing out on considerable gains as a result of significant early-cycle value creation.
Back in 1997, top technology companies, like Amazon, entered the public market very early. In Amazon’s case, the IPO came three years after the company was founded. At that point, Amazon’s market cap was still in the millions, and its revenue was humble. As a result, any public investor who was willing to take an early bet on Amazon at its IPO and hold his or her position until today would have a potential 1,475x return. That is 45% on an annualized basis — equivalent to a venture capital asset return. Both Google and Facebook remained private longer and only entered the public market after they had achieved much greater scale, compared to Amazon, both on a market-cap basis and by revenue. Going public later in their life cycles, both Google and Facebook have enjoyed most of their hyper-growth phase pre-IPO. Lower growth potential resulted in much lower returns of 27x and 4x to the IPO investors of Google and Facebook, respectively.
To match Amazon’s return since IPO, Google would need to reach a $44 trillion market cap and Facebook would need to reach a $163 trillion market cap. Because many successful startups in our current market plan to go public much later in their lifespans, if at all, we do not expect to see a repeat of an Amazon-like returns for Main Street investors.
The growth of the robust private investment market is the most notable development in the past three decades, and it has sent a shockwave effect through the capital markets. Companies have extended their time in private ownership because there is no longer a need to pursue an IPO and wrestle with the costs and public pressure to fund growth or access liquidity. Experienced investment managers have left the public market to take advantage of the rising opportunities along with the tremendous growth in private capital. Meanwhile, the private investor landscape has expanded to include nontraditional players such as corporate ventures, sovereign wealth funds, mutual funds, hedge funds and family offices. Even the SEC recently announced the plan to adjust the rule that allows more mainstream investors to participate in private deals and capture potential gain from early-stage investments for their retirement or other needs.
Rokk3r Fuel ExO expects that the decline of public equity will persist for some time to come, and we will see privately-held companies with an expanding role in a growing market. That leaves our investors with a decision to make. They can choose to either be left out, or ride the trend by increasing their allocations to private equity and venture capital investments to seek diversified exposure and potentially exponential returns.
This post was authored by Rokk3r Fuel ExO Partner and Chief Investment Officer Maggie Vo, CFA. Maggie is responsible for managing investment activities, leading due diligence for potential new investments and performing valuation analysis for portfolio companies.