The sale of company ownership through issuing shares of stock to the public is a cornerstone of our financial system, both for companies seeking capital and for investors looking for income and growth. In the last 20 years, however, the number of publicly-traded US companies has declined significantly and new companies issuing stock have also slowed. What might be the implications of these changes?
The number of listed firms in the US stock market peaked in 1996 at just over 7,300 according to the University of Chicago’s Center for Research in Security Prices; that number is now around 3,600, barely more than in 1982 when the economy was far smaller. At the same time, the value of initial public offerings in 2016 was the lowest since 2003 and less than 20% of the late-stage funding for technology companies in 2016 was from public offerings, with the majority from private equity. (Private equity is a larger investment in mature or established companies and is different from venture capital which invests in new or start-up companies.) The rate of company formation and total number of businesses has not significantly changed over the last 20 years.
A public offering creates an accessible market for investors and employees to sell shares and it may be the least expensive source of capital. But going public also carries greater pressure for short-term gains and may require more disclosures that could be useful to competitors. As an alternative, private equity funds have ballooned, reaching $2.5 trillion in 2016 and having nearly $1 billion of idle funds looking for investment opportunities.
In addition to private equity, some public companies fail to meet financial requirements and are “delisted” from stock exchanges. Other companies may be discouraged from going public by the specter of regulatory red tape. Mergers and acquisitions account for nearly half of the decline in listed companies as established companies look to boost growth by buying other companies. And even those companies that do go public are waiting longer thanks to the sea of venture capital that is willing to invest at higher prices than the earlier investors.
The slowdown in new public companies and the pace of acquisitions means the average market value of public US companies is three times as large as in 1997, even after adjusting for inflation. This means that the number of small and “microcap” stocks has fallen by half over that same period. The smaller number of companies has raised concerns that it has become harder for “stock pickers” to stand out from and beat the overall market and may have added fuel to the growing preference for index funds.
Those fears may be overblown. The 1,900 tiniest public companies combined are only 2% of the total value of the US stock market and many are so small that fund managers can’t invest in them anyway. Competing with big companies, which have become more nimble through technology and globalization, may be a bigger hurdle for small companies than regulatory costs.
There are a number of ways for investors to invest in vehicles that in turn invest in private companies but all have their advantages and drawbacks. Wealthy investors may be able to participate directly in private equity funds but these are illiquid and take a long-term view to allow them to maximize value. Many private companies either fail outright or fail to provide investors positive returns. Despite any hype or even past investment performance, these investments should always be considered high risk in return for their high potential returns.
Several of the major players in private equity are publicly traded, including Blackstone Group, the largest private equity firm, and Apollo Group, which just raised funds for the largest-ever separate private equity fund. But these larger firms have other lines of business such as hedge funds, real estate and lending so owning them is not a “pure” private equity investment. For example, private equity is only 25% of Blackstone’s total assets under management while private equity makes up even less of Apollo’s assets.
There is an actively-managed mutual fund and an exchange-traded that both follow the same investment manager’s methodology. They have between $200 and $300 million and expenses of 1.44% and 0.67% respectively. Both of these funds have investments in firms that have other lines of business, including Blackstone and Apollo, and their other holdings are fairly obscure or based overseas. A new actively managed fund takes a different approach and attempts to replicate the aggregate gross performance of U.S. private equity-backed companies. Its ten largest holdings do not include any private equity firms but instead invests in either firms that were initially funded by private equity (Amazon, Facebook, etc.) or that participate in funding fledgling firms through equity or debt investments (JP Morgan, Johnson & Johnson).
Business development companies (BDC’s) have gotten a lot of attention for their high level of dividends. BDC’s are publicly traded vehicles that provide a broad range of financing for small and medium companies. Their loan portfolio is often diversified across many companies and industries and no single loan dominates the portfolio. Still, BDC’s have significant credit and investment risk from the underlying companies and may employ leverage, or additional borrowed funds, which can amplify volatility. There is further risk from changes in interest rates and the BDC’s loans are usually long-term commitments so repositioning the portfolio can require raising new funds through selling additional shares.
Special purpose acquisition companies (SPAC’s), also known as “blank-check” companies, raise money by issuing shares to the public and then look for opportunities to make equity investments. There were 22 SPAC’s launched in 2017 alone, raising $6.9 billion. As the name makes clear, buying these SPAC’s before they make investments is a leap of faith in the SPAC managers, but waiting to invest in a SPAC means potentially paying more if the market has a positive view of their deals. A new SPAC is raising $500 million specifically to take a minority equity position in some of the 150 private US technology companies that are valued at $1 billion or more.
The fewer number of publicly-traded companies is not, at least for the foreseeable future, a sufficient reason to venture into new investment territory. If there is a part of your portfolio that is dedicated to “risk capital”, some of the new options for investing in growing companies may be worth consideration.