Commentary on Political Economy

Thursday 20 July 2023


Tri­umph of private equity is rede­fin­ing pub­lic coun­ter­parts

The rise and rise of private equity and debt is reshap­ing pub­lic mar­kets with con­sequences we are only begin­ning to under­stand. There is now some $12tn of private equity and debt invest­ments in busi­nesses, real estate and infra­struc­ture.

The growth has been driven by mul­tiple factors. On the sup­ply side, there is abund­ant cap­ital from fam­ily offices, wealthy indi­vidu­als and insti­tu­tions that are sac­ri­fi­cing liquid­ity in hopes of higher returns and exclus­ive early access to prof­it­able deals.

On the demand side, private cap­ital is attract­ive due to the high cost of pub­lic issues such as ini­tial list­ing expenses and ongo­ing reg­u­lat­ory com­pli­ance.

Other factors include fewer oner­ous report­ing oblig­a­tions and less rigour around related-party trans­ac­tions and expenses. Some founders also avoid pub­lic mar­kets because of fears about loss of busi­ness and oper­a­tional con­trol.

For ven­tures that have low fund­ing require­ments, founders and ori­ginal investors can max­im­ise their profits and retain con­trol longer by delay­ing rais­ing pub­lic equity.

Asset man­agers have facil­it­ated the pro­cess by broad­en­ing their remit to increase assets man­aged and col­lect higher fees than on con­ven­tional invest­ments. Favour­able reg­u­la­tions, such as a US expan­sion of the num­ber of per­mit­ted share­hold­ers allowed in a private com­pany, have helped. But there are col­lat­eral effects of private invest­ing.

First, pub­lic mar­kets are becom­ing more a mech­an­ism for allow­ing private investors to mon­et­ise gains, exit hold­ings and obtain trade­able stock as acquis­i­tion cur­rency rather than rais­ing new growth cap­ital.

Second, as private investors cap­ture a greater share of returns prior to going pub­lic, pub­lic investors may suf­fer over the long run, as evid­enced by the poor post-IPO per­form­ance of many private investor-owned com­pan­ies after adjust­ment for mar­ket move­ments.

Third, diver­gent valu­ations of com­par­able busi­nesses make rank­ing of invest­ment choices dif­fi­cult. In recent times, val­ues of privately held busi­nesses have not fallen by as much as cor­res­pond­ing pub­lic ones.

The dif­fer­ence is the valu­ation mod­els used and the abil­ity to defer adjust­ments in val­ues. Not­ably, private valu­ations derived from suc­cess­ive fund­ing rounds often prove optim­istic.

Private com­pan­ies have lower report­ing require­ments, mak­ing informed dis­cus­sions more dif­fi­cult.

Fourth, the inter­ac­tions between the two mar­ket seg­ments also can become a source of poten­tial fin­an­cial instabil­ity trans­mit­ting shocks across mar­kets.

With fund man­agers hold­ing a higher level of illi­quid private invest­ments, they have to sell down more trade­able pub­lic mar­ket hold­ings to gen­er­ate cash when needed, some­times irre­spect­ive of value con­sid­er­a­tions. This can hit pub­lic mar­kets in moments of tur­moil.

Fifth, with many busi­nesses choos­ing to stay private for longer, pub­lic mar­kets risk becom­ing nar­rower, lim­it­ing diver­si­fic­a­tion oppor­tun­it­ies.

Sixth, small investors and some pen­sion funds have lim­ited access to private invest­ments due to size or man­date issues. Obtain­ing expos­ure, where pos­sible, neces­sit­ates the use of mul­tiple inter­me­di­ar­ies, incur­ring addi­tional fees and costs. This raises the risk of groups of investors becom­ing con­fined to dis­ad­vant­aged pub­lic invest­ments, with select insiders enjoy­ing more luc­rat­ive oppor­tun­it­ies.

Finally, private mar­ket groups increas­ingly resemble closely held Japan­ese, South Korean and Indian con­glom­er­ates. Heavy on fin­an­cial engin­eer­ing, these new groups lack trans­par­ency and often do not have the com­pens­at­ing longer-invest­ment hori­zons, greater research and devel­op­ment fund­ing and close gov­ern­ment rela­tions of their Asian coun­ter­parts.

Private mar­kets risk evolving into a self-con­tained shadow eco­nomy in which asset man­agers can bypass many reg­u­lat­ory require­ments and the greater scru­tiny of lis­ted assets.

With large amounts of cap­ital under con­trol, such a scen­ario would rep­res­ent an unwel­come return to the late-19th cen­tury era of rob­ber bar­ons and priv­ileged invest­ing.

In his 1958 book The Afflu­ent Soci­ety, John Ken­neth Gal­braith high­lighted grow­ing private wealth and pub­lic squalor. The rise of private mar­kets is an unanti­cip­ated post­script to that pro­cess.

If bene­fits from busi­ness activ­ity accrue primar­ily to a few wealthy parties, then it may under­mine the legit­im­acy of the sys­tem that allowed it in the first place.

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