The downside of companies staying private

By Felix Salmon
March 22, 2011
conversation with TED today on the implications of the fact that fewer companies are going public.

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I had a pretty involved Twitter conversation with TED today on the implications of the fact that fewer companies are going public. We’re both agreed that from a corporate-finance perspective, the trend makes perfect sense: the all-in cost of private equity is lower than the cost of going public. (For reasons why that might be the case, see here or here for starters.) But broadly speaking, from a public-policy perspective, is this a good thing or a bad thing? My thesis is that it’s a bad thing.

There are a few different reasons for this, but they basically boil down to the idea that it’s a good idea for stock ownership to be as broad as possible. What we don’t want is a world where most companies are owned by a small group of global plutocrats, living off the labor of the rest of us. Much better that as many Americans as possible share in the prosperity of the country as a whole by being able to invest in the stock market.

I’m not saying that individual investors should go out and start picking individual stocks. But I am saying that equities provide bigger returns, over the long term, than other asset classes. And that therefore it’s not good public policy for the ability to invest in an increasingly large part of the equity universe to be restricted to an ever-shrinking pool of well-connected global plutocrats.

Historically, this wasn’t much of an issue. Yes, there were private companies, but once they reached a certain size, they generally went public. Even after private-equity firms started becoming important players, those firms were largely funded by pension plans which were ultimately invested on behalf of relatively small individuals.

Nowadays, however, things have changed. There’s much more equity capital available for investment in the private markets than there has ever been in the past — which means there’s much less need for private companies to go public. On top of that, most of us aren’t invested in big pension funds and never will be: the country has moved from that model, based on defined-benefit pensions, to a model of defined-contribution pension plans where individuals invest their own money for retirement. And those of us with 401(k) plans or IRAs don’t have any real way of investing in private equity: our mutual funds and ETFs invest only in public equity and debt.

This is one of the important ways in which defined-benefit plans are better than defined-contribution plans: they give individual investors access to the kind of sophisticated pension-plan managers needed to be able to invest in private equity successfully. I’m not a big fan of the idea that middle-class individuals should be encouraged or allowed to invest directly in private equity — the risks and fees are too large, and invariably the real money ends up getting made by someone else. As for TED’s suggestion that we should just buy stock in Blackstone — well, for one thing Blackstone is a public company, not a private company, so it suffers from all the same problems of high correlation with other public stocks. And for another thing it’s pretty obvious that there’s a world of difference between buying a stake in a publicly-owned asset manager, on the one hand, and buying a stake in a privately-owned company, on the other.

My point here is one that Michael Kinsley has been making for a while:

Look. Small businesses are businesses like any other, and small business owners are people just like others—except that they tend to be wealthier…

There is an anthropomorphic fallacy here. Big businesses are not owned by big people, and small businesses aren’t necessarily owned by small people. The typical shareholder in a big business is a worker in some other big business whose pension fund has chosen to invest in that company. Or a retiree who has bought this stock as his or her nest egg. Or it’s somebody’s 401(k).

Broadly speaking, there are two ways of building wealth: returns to labor (work hard), and returns to capital (invest wisely). If you work for a company with a defined-benefit pension plan, then it will invest wisely on your behalf. If you’re stuck with a defined-contribution plan, however, the onus of investing wisely is on you — whether you’re qualified to do that or not. And the universe of asset classes that are available to you significantly smaller than the universe available to pension plans. As a result, defined-benefit investors outperform defined-contribution investors significantly (by about 3 percentage points per year, if I recall correctly; my internet connection right now isn’t good enough for me to get the exact number).

So American workers are facing a double whammy here: they’re losing access to private equity at exactly the point in time where private equity is becoming a very large and important part of the international capital markets. Meanwhile, it’s the rich foreign clients of Goldman Sachs — the global rentier class — who are getting that coveted access to equity in Facebook.

It’s not just Goldman Sachs, either. SecondMarket (a private company itself) now has a platform designed to match buyers and sellers of private equity in more than 12,000 companies; the company has also registered some 55,000 participants who are qualified to take part. Needless to say, those participants are not exactly representative of middle-class America.

So how do we put the brakes on this trend? Should we force companies to go public when they reach a certain size? Should we allow individual investors to have much more access to private equity and venture capital than they have right now? No: both of those are bad ideas, I think. The reasons for staying private are good ones, and the reasons for restricting investment in illiquid private companies are also good.

How about making a public listing more attractive by relaxing rules like Sarbanes-Oxley? Again, I’m not a fan: the literature is far from compelling that Sarbox was a significant contributor to the decline in public listings.

Indeed, I’m not putting forward any policy prescriptions at all here. I’m just pointing out a problem, while noting that it doesn’t seem to be an issue in the rest of the world. Maybe this move will just be an extra nudge pushing American investors out of the US market and into more international diversification. Which might not be a bad thing after all.


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If the problem you describe is real, isn’t the answer simply that we need an effective way to bring private equity access to the common investor? There’s a number of ways this could be set up but basically you’d need some sort of aggregator/intermediary between the retail investor and the PE funds.

But if it’s better for the companies and better for the investors… I’m really not sure there’s a problem here.

Posted by right | Report as abusive

1) Plutocrats can own big public companies as easily as they can own private companies. A small percentage owns the vast majority of public equity.

2) Stocks have often returned more than bonds. They are expected to return more, but there are no guarantees. Look at Japan equities over the past decade or so.

Posted by 3oosion | Report as abusive

I had a brief conversation with Jack Bogle about this a few years ago, he was in town speaking at an event celebrating the 50 year anniversary of the S&P 500. Some mega-PE buyout must have prompted me, and I went ahead and asked Jack Bogle whether he felt public markets were becoming irrelevant and whether the best businesses were being taken private. It was a few years ago, and I don’t recall exactly how he phrased it, but in essence he said that there had always been great privately-held businesses, and there had always been great publicly-held businesses.

At the time I didn’t buy the argument, but I’ve since reconsidered. The trajectory of every business is different. There have always been phenomenally great businesses that are closely held. For example as an investor in public markets, I would love to have a piece of Ikea, Cargill, Hermes or Mars at a reasonable price. They are all great businesses and very attractive. And there are great businesses that are organized as public companies. Similarly, there are very poor businesses that are privately held (banks which were nationalized decades ago) and very poor ones which are public (nationalized banks when they first list on public markets).

All capital intensive businesses will, sooner or later, approach the public markets for financing and offer up either debt or equity in return. And at some point, every large privately held company (including Facebook) will have a majority of owners who want it to be publicly listed, and it will be. It might take many years and multiple generations of owners (UPS) or a very talented and opportunistic buyer (see Louis Vuitton and Bernard Arnault). And at some point either during their public or private lives these businesses will be available at an attractive price (usually not at the IPO). As either private or public market investors our job is to recognize and take advantage of the opportunity when it presents itself.

I would argue strongly against the blanket assumption that equity returns (public or private) will exceed bond or cash returns over every long-term investment time-frame. As Derman points out, every investment strategy works at the margins and you could argue that there is a lot of dumb money floating around again, convinced by various professionals that stocks always outperform other investments. There is also a lot of institutional money that now believes private equity necessarily outperforms other types of investments (and you can’t hold Swensen responsible for that).

That said, Jack Bogle is one of the few good guys in finance and a personal hero, it was a real pleasure to meet him. He’s very unassuming and humble, there was a line of limos for every other executive there, Jack was probably the one most people came to see and a couple of us helped him hail a cab. As an aside, he said then and has said publicly since that his personal portfolio is split between stock and bond index funds, following the “(100-age) = percentage in bonds” rule of thumb.

Posted by The_Governor | Report as abusive

I have an example of a little-known manufacturer based in New England, with over a billion dollars annual turnover, that has funded healthy growth entirely internally. Its shares are held by a few members of the founding family, and it throws off enough cash (around $100 million a year) to keep those shareholders satisfied. There is absolutely no reason for them to go public.

You are describing a very different situation – where companies need or want external funding, yet can get adequate valuation and investment without having to trade. *That* is what has changed. But while you name a couple of high-profile examples, are they the rule or the exception? You haven’t answered that question yet. If they are the exception, then there’s no problem. Yet I don’t think what you described is broad-based enough to be the rule yet. You tell me.

Posted by Curmudgeon | Report as abusive

The reason most people cannot invest in private companies is that we have paternalistic securities laws and regulations, going back to the ’33 Act and ’34 Act, which were passed in the wake of the Great Depression. It’s not worth the effort for private companies do deal with the mandatory disclosure requirements that would come with selling to anyone who is not an accredited investor (or otherwise exempted under something like an intra-state sale law – and then you have ongoing efforts to make sure to stay in compliance with the exemption, too).

Most companies wouldn’t choose to be a ’34 Act reporting company and not avail themselves of the public market via a ’33 Act public offering, but I guess FB may prove to be an exception.

What would be interesting would be to look at the underlying economics that would allow a private company to raise that kind of capital (hundreds of millions of $) without giving its investors an exit event through either a public market or a merger. Is the private market for the securities going to become large enough to give the VCs and similar investors a good enough exit event? Maybe for a FB, but I can’t see that happening for a large swath of companies – at least, not without the SEC sticking its nose in to see how to mess it up.

Posted by Gimlet | Report as abusive

Also, I think you’re underestimating the incentive-skewing effect of SOX and other recent regulations: ssorbainbridgecom/2011/01/impact-of-sox- on-the-ipo-market.html

Posted by Gimlet | Report as abusive VC

It seems in principle like a good idea; I don’t know how well it’s carried out in practice.

I do object to any implication that having a defined-benefit plan obligates one to live paycheck-to-paycheck until the final vesting date; of course savings outside of retirement accounts is prudent regardless of your retirement plans. Indeed, saving is more important to building wealth than achieving a particularly good return is. This weakens, rather than refutes, your broad thesis, though.

Posted by dWj | Report as abusive

“If you work for a company with a defined-benefit pension plan, then it will invest wisely on your behalf.”

You are joking, right? I recently calculated my retirement account returns from 2005-2009, and my returns beat the average DB plan in every single year by a (annualized) average of 5%. (Admittedly a period during which my risk aversion has served me well.)

DB = “stupid money”. Many of them simply index. It is quite possible that your average DC participant is even stupider, but suggesting that DB plans “invest wisely” is simply silly.

Posted by TFF | Report as abusive

Amen. A transaction tax would reduce shareholder turnover, improve management incentives, and decrease the need for draconian compliance regimes to make up for dead hand holders not keeping boards/managements in line.

Posted by Derrida | Report as abusive

This would be less of a problem if all the nations of the world agreed to impose sufficiently progressive taxation that the wealth of the plutocrats was also funding a proper social safety net, including a defined benefit pension along the lines of that thing Matt Yglesias was talking about ( 2/they-could-call-it-social-security/ ).

At a fundamental level, if there simply weren’t enough people with sufficient wealth to fully fund significant sized companies — if the ONLY way to raise IPO-scale amounts of money was to ask for money from the top 10% richest, because there just wasn’t enough wealth available from the top 0.1% — then more companies would IPO.

Posted by Auros | Report as abusive