Amid geopolitical turmoil, investors are increasingly wondering if central banks will once again come to the rescue of collapsing public markets.
They must also fear that the market fallout from Russia’s invasion of Ukraine will highlight what Mohamed El-Erian called a structural erosion of public market liquidity.
Compare and contrast with the position of private equity. Despite fears that companies backed by highly leveraged private capital would inflict losses on the banking system during financial crises, they have thrived and invested aggressively during the 2007-09 crisis and the current pandemic. Private equity benefits from an extensive safety net of global dry powder – commitments made by end investors that have yet to be disbursed – amounting to $3.4 billion.
Institutional investors continue to seek to capture an illiquidity premium in private markets. See how Calpers, the largest US public pension plan, decided last November to increase its allocation to private equity from 8% to 13% while investing 5% in private debt. Its global exposure to public equities is to be reduced from 50% to 42%.
This may seem suspicious as one more nail in the coffin of public procurement. Still, they could nonetheless be on the verge of making a modest comeback.
The starting point is certainly a bad omen. According to the OECD, 30,000 companies have delisted globally since 2005, an exodus that has not been accompanied by new registrations. And within the OECD club of nations, there has been a net loss of listed companies every year from 2008 to 2019.
A report by Michael Mauboussin and Dan Callahan of Morgan Stanley showed that today’s 3,600 U.S. public companies are about half the number in 1996, reflecting buyout activity, takeovers, and a low level of IPOs in stock exchange. Additionally, between 2009 and 2019, U.S. companies raised more money in private markets than in public markets each year – often significantly more.
Structural change in advanced economies is one of the drivers of the contraction of public enterprises, notably through the rise of the high-yield bond market, which facilitates takeovers; also by a secular decline in the intensity of the capital needed to produce goods and services. In the late 1970s, tangible investments in the United States were almost double those of intangible assets, according to the Morgan Stanley report.
Today, on the other hand, intangible assets are one and a half times more important than tangible investments. Unlisted tech companies, which often have the backing of savvy venture capitalists, don’t need capital to invest in physical assets.
If they come into the market, it is to offer an exit to their backers or to acquire currency – stocks – to pay for acquisitions or reward employees. Those that float may be subject to anti-competitive acquisitions by Big Tech companies.
Meanwhile, deregulation – such as looser limits on the number and type of investors allowed in a private company – has made easier to stay private. More buyout-backed companies in the US are now being sold to other buyout companies than finding a public exit. Disincentives to the IPO route include rising issuance costs and increased regulatory burden in the listed sector.
What cannot be overemphasized in all of this is how the extraordinary boom in private markets has been the product of ultra-loose monetary policy since the financial crisis. Central banks have started to reverse this trend.
And the crunch will expose leveraged buyout firms that have thrived on crude financial engineering whereby they load recipient firms with debt while extracting huge dividends, potentially destroying those firms’ balance sheets. Given the higher leverage of private equity more generally, rising interest rates will be a swing in favor of private equity.
At the same time, competition policy is getting tougher towards Big Tech in both North America and Europe. Acquisitions motivated by the desire to eliminate potential competition are in the crosshairs of regulators. This implies a potential reduction in radiation. Finally, private equity valuations have been driven so high by the weight of institutional money and accommodative monetary policy that the illiquidity premium sought by institutions may be close to disappearing.
It is undeniable that in times of rising inflation, variable rate private credit offers attractive protection against rising interest rates. But some of the shine can finally ooze out of private equity versus the public variety.