Private vs Public Markets - Capital Formation and Implications for Investors

Increasingly, well-funded private institutional investors are leading a shift in capital formation away from public markets. This may have profound implications for retail investors, according to new research from CFA Institute, the global association of investment professionals.  At the same time, they find that there is no need to offer regulatory shortcuts to make public markets more attractive to new businesses seeking funding.

The report, Capital Formation: The Evolving Role of Public and Private Markets, suggests that the increasing ability of entrepreneurs to access private capital has encouraged a shift from public market capital-raising, which carries fewer regulatory burdens and typically enables them to retain greater control over their businesses. A combination of readily available private capital in search of higher returns in a low interest rate environment, as well as less capital-intensive new business models, has served to give new businesses more funding options than ever before.

The report also finds that firms are staying private for longer and raising more capital privately than in the past. To illustrate these trends, it is estimated that the median time to IPO for US companies has risen from 3.1 years in 1996 to 7.7 years in 2016. While firms are still privately held, they are also able to raise more capital: a median of US$12.2 million was raised prior to IPO in 1996, compared to a median of US$97.9 million raised prior to IPO in 2016. Related to these findings is the stock buyback phenomenon – over US$3.6 trillion more was spent on repurchases than the amount raised from equity issuance between 1997 and 2015. Whilst these trends are most pronounced in the United States, other developed markets, including the UK and the euro area, show similar shifts.

With firms pursuing IPOs at a later stage in their development (or simply exiting the private markets via a trade sale to a large public company), individual investors are seeing fewer IPO opportunities and could miss out on the returns provided by rapidly growing new businesses whilst they are kept in private hands. And, what does eventually become public often has much of the value already extracted.

The paper makes the following policy recommendations to ensure fuller market transparency and to level the playing field for individual investors where possible:

1. Better disclosure and transparency standards in the private markets are needed: Supranational regulators should investigate the systemic implications of the boom in private markets. 'Dry powder' – the amount of capital available in private equity funds – has increased in recent years, and there is a growing perception that valuations are high with no discount for the illiquidity of the underlying investments.
2. Stringent investor protections should remain in place: regulators should not try to lower regulatory and financial reporting standards for listed markets in order to attract IPOs.  Doing so would not address entrepreneurs’ preference for private markets and would likely make public markets even more risky and less attractive for investors.
3. Access to private market investments by pension savers should be enabled through professional intermediaries: Pension savers should be afforded a means to participate in private markets via a professional intermediary such as a pension fund.

Sviatoslav Rosov, CFA, Director, Capital Markets Policy at CFA Institute, commented:

“Individuals are being told to save for their retirements by investing in the public markets at a time when companies are increasingly preferring to avoid or defer a public listing. This may deprive savers of the ability to participate in high-growth business models and further promote the sense that markets are being operated for the benefit of ‘insiders’. We believe the solution is to allow savers to invest in private markets through their pension funds or a similar professional intermediary, subject to appropriate and explicit acknowledgement of the relatively illiquid nature of the underlying investments and the obligation to have a relatively longer-term investment horizon for this subset of their savings, which must be segregated from any daily liquidity (switching) constraints.”