Pantheon has published an informative research paper that examines the “phenomenon and causes of shrinking public markets.”
The research, “The Shrinking Public Market and Why it Matters,” is penned by Cullen Wilson, associate, and Brian Buenneke, partner. It warns in no uncertain terms that the number of publicly listed companies in the U.S. has roughly halved since 1996. Crucially, this trend has “spanned multiple economic cycles and has impacted countries across the globe,” the researchers explain, and as such they believe the phenomenon is likely to persist and have a significant impact on institutional investors.
Reasons underlying the trend of shrinking markets are numerous and various, but two of the clearest drivers include the “increased net cost of listing,” which has resulted in fewer initial public offerings bringing new companies into the market, as well as the fact that merger activity continues to remove companies from public exchanges far faster than they are added.
As Wilson and Buenneke lay out, “unprecedented access to private capital and a reasonable outlook for a healthy merger/acquisition activity” should allow this trend to persist. The result is that, for large-scale and long-term institutional investors especially, the public market “no longer offers the full breadth of opportunities historically available, and consequently investors may consider a broader basket of alternatives to access younger and more rapidly growing companies.”
The researchers then highlight the fact that the last four decades have brought tremendous amounts of new capital into the equities markets even as the total number of securities has sharply declined. Specifically, in 1976, Pantheon’s data shows mutual and index funds represented about $41 billion, growing to a whopping $10.7 trillion by 2016. It requires only a simple turn of logic to see the negative implications for institutional investor diversification contained in these numbers.
“The net effect of continued robust capital inflows and growth in market capitalization since the listing peak is that more investment dollars are concentrated in fewer, older businesses,” the researchers suggest. “The large increases in average age and market cap, the latter of which has grown by four-times in size, have coincided with a declining trend in year-over-year revenue growth in the S&P 500.”
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Pantheon’s analysis finds the shrinking number of public companies has not been for lack of new firms coming to be that could be listed.
“It is estimated that from the listing peak through 2012 both the total universe of firms and the number of firms eligible to list in the U.S. actually grew by about 7.5% each,” the researchers note. “Despite this increasing pool of candidates, the total number of listed companies today has roughly halved since 1996. Given that the total pool of firms eligible to list has not contracted, it is the propensity for firms to list that appears to have diminished. This is borne out by the data. Since 2000, IPOs have been dramatically depressed relative to levels seen in the 1990s … The propensity to list has fallen across all industries, so this is not a phenomenon limited to certain sectors, but a universal one.”
Wilson and Buenneke argue the increased cost of conducting an IPO, coupled with a broad array of growing alternative financing options, “which to an extent limits the benefit of listing,” mean companies are staying private for longer and are “pursuing their objectives outside of the public spotlight.”
“The median time from first venture investment to IPO has grown from about five years in 2006 to over eight years in 2016,” the research states. “The impact of this has been felt in the form of dramatically fewer IPOs since 1996, and so it is unsurprising that we have witnessed the subsequent aging of the average publicly listed company.”
At a high level, the researchers observe that, when public markets were the only source of capital at scale, emerging growth companies would typically raise between $50 million and $150 million to finance their businesses and pursue further expansion. “Only a fraction of this amount was available through private funding sources,” they note. “In 1996, the median amount raised prior to IPO was $12 million. However, with increasing access to capital in the private markets during the subsequent years, that figure has grown at 11% per annum to nearly $100 million in 2016, easily within the range of capital that public markets would traditionally provide.”
“We believe that access to ample levels of private funding effectively drives down one of the key benefits of going public, and allows companies to continue pursuing their growth and business objectives without enduring the costs and distractions associated with operating in the public spotlight,” they conclude.
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The Pantheon analysis closes with a section aptly titled, “Why does it matter?”
In short, Wilson and Buenneke explain, the public market “no longer offers the breadth of investment opportunities that it used to, and so public investors face the need to consider alternatives to access younger companies with the potential for more rapid growth. The dearth of IPOs since the listing peak in 1996 has reduced the refresh rate of new businesses entering the public market such that the average public company is 50% older and four-times larger than it was 20 years ago as mutual and index fund AUM has grown dramatically.”
Over the same period, according to the researchers, the number of companies in the S&P 500 growing at 20% or greater has halved: “No longer the promised-land for companies poised to grow, the public stock market is quickly becoming a holding pen for massive, sleepy corporations … The value creation that is occurring in pre-IPO companies is also difficult to ignore; traditional IPO investors are attempting to access these businesses in order to capture their growth potential—arguably what they used to achieve at IPO—and any investors without a means of doing so are likely missing out.”
The researchers point to Amazon, Google, and Facebook as “real-world examples of the impact that time to IPO and market capitalization at IPO can have on the potential for subsequent growth.”
“As these companies sequentially remained private for longer, by the time of IPO they had achieved greater scale both by revenue and market cap, and we believe the impact on revenue growth and potential for returns is apparent,” Wilson and Buenneke warn. “This is not a commentary on which of these businesses is superior—to the contrary, they are each market leaders and innovators in their respective spaces … However, the fact that Facebook was able to raise $2.84 billion of private funding and subsequently IPO at over $100 billion makes it inconceivable that an IPO investor in the company could replicate the returns of an investor in Amazon’s IPO.”
After all this analysis the conclusion for retirement plans is fairly straightforward: “Many core private equity investment strategies are direct beneficiaries of the trends driving the reduced public opportunity set. In the context of fewer new listings and longer private company life cycles, private equity can provide the capital that companies seek while operating as private businesses, and venture/growth equity managers often access outperforming companies long before the new cohort of pre-IPO investors do.”
The full analysis is available for download here.