Equities continue to represent the key driver of returns for many asset owners, with the average allocation to equities across the seven largest global pension markets in 2017 coming in at about 46 per cent.
Public equities have, of course, delivered robust returns in the post-GFC period, underpinned by the extraordinary scale of monetary policy support. In light of this, it is understandable that potentially far-reaching structural changes occurring in public equity and private capital markets have garnered less attention than merited.
The increasingly blurred line between private and public equity markets poses challenges for those institutions that continue to rely on public equities as the growth engine of portfolio returns.
IPO market evolution
Many will be familiar with the various statistics highlighting the changed nature of public equity markets in most developed economies, some of these include:
- The number of US listed companies has halved since its 1996 peak
- The average US public company is 50 per cent older and four times larger than 20 years ago
- Developed market net equity issuance is at historically low levels
While in 2018 we have witnessed an uptick in the number of US IPOs, the broader picture continues to be that of a significantly diminished flow of new equity issuers.
Indeed it has become increasingly rare to see IPOs of scale from beyond the portfolios of financial sponsors. The declining issuer flow has been variously attributed to factors such as the strength of M&A activity, investor short-termism and increasing economies of scale to being listed.
No matter the causes, the view that the “public market is quickly becoming a holding pen for massive sleepy corporations” expressed by Duke associate law professor Elisabeth de Fontenay appears to have increasing validity. In parallel with this development, private capital markets have witnessed explosive growth in the last decade.
This growth has been driven primarily by demand from technology-focused companies. Capital raised by US tech venture and growth investors has grown 25 per cent, year on year, since 2009.
There are now estimated to be 263 ‘Unicorns’ globally and at least 30 of these have valuations in excess of $5 billion. With venture-capital investment inherently difficult to scale, the categories of investors active in latter-stage direct private capital investment has grown markedly in recent years. Long-established crossover investors, such as Fidelity and T Rowe Price, have been joined by others like Baillie Gifford, and by strategics such as Google, Intel and Samsung.
Implications of these structural changes
There are a number of implications that follow from the observed shift in value creation from public markets. These include:
- Late-stage private capital markets in the US, and increasingly in Europe, resemble the heyday of the IPO market in the 1990s. The use of the IPO as a strategic lever to accelerate growth has become ever less common, with a listing of shares viewed by vendors and management teams primarily through a liquidity lens. Even if many high-growth private companies ultimately go public, this may only further spotlight the value capture question for those without adequate earlier-stage exposure.
- There are increased concerns about the diversification and growth properties of public-equity markets. Recent research prepared for the Norwegian sovereign wealth fund highlighted how the concentration risks for public market investors are rising rapidly, with many indices representing sectoral bets rather than exposure to the famed market portfolio. Meanwhile, private company investment is becoming ever more essential to the effective execution of thematic investment strategies as asset owners seek concentrated exposure to secular trends such as demographics, disintermediation and displacement.
- There are growing risks that the value of existing public equity portfolios will be adversely affected by the exponential growth in the size and capabilities of global private companies.
Asset owner response
While asset owners have been responding to these changes through increased allocations to private equity, buy-outs dominate the asset class. Preqin data shows that buy-outs accounted for more than 60 per cent of total private equity fund raising in the 2012-17 period, with 75 per cent of this flowing to large company buyouts.
While such allocations have a sound investment rationale, they do little to address the issue of private company value capture. Indeed, the creation of the Softbank-sponsored, $100 billion Vision Fund could be characterised as a response to this, as it seeks to take advantage of an absence of large global private capital providers.
A number of the largest global asset owners have reacted by increasing their latter-stage direct investments in high-growth private companies, with some going as far as establishing offices on the West Coast of the US to aid in sourcing opportunities.
It is particularly noteworthy that the California Public Employees’ Retirement System is considering the establishment of a direct investment program, which would include investment in promising companies in sectors such as life sciences, healthcare and biotechnology.
While latter-stage direct investment evidently presents risks and challenges, these can be overstated, given commercial validation is typically well established. Additionally, investments are de-risked through the use of contractual protections such as liquidation preference, anti-dilution and enhanced governance rights. As companies stay private for longer, necessitating greater equity rounds, governance and investor relations are becoming increasingly sophisticated and in many cases comparable to public market best practice. Finally, exit markets continue to be in rude health, with strategic acquisitions rewarded by public market shareholders.
It is evident that developed-world public markets are struggling to maintain their historic role in providing access to high-growth companies. This has implications for asset owners and may increasingly necessitate evaluating equity exposures on a more integrated public and private portfolio basis. However, this changing equity landscape is also creating opportunity. With private companies increasingly seeking long-term investors, asset owners globally are uniquely positioned to provide strategic equity investment, enabling greater capture of the unprecedented levels of private company value creation.
David Linehan has been senior investment manager at the Ireland Strategic Investment Fund (ISIF) since 2012. He recently left to join the private markets team of a London-based pension fund.