Public markets are shrinking while their private equivalents grow. What are the implications for investors?
Recently there has been an increasing amount of discussion about investors moving away from publicly traded markets and towards private markets. We have been part of this shift for a long time, closely following the growth in private investment versus the shrinkage of its public equivalent. Curiously, investors have only recently begun to discuss the trend more widely, although it has been underway for many years.
Uncomfortably high public-equity valuations and low anticipated returns from traditional diversifying asset classes such as bonds have caused investors to seek diversification in different forms. They have increased their allocations to alternative investments, including private markets and private equity (PE) in particular.
Concurrently, the performance of actively managed public-market investments has often been disappointing. Alongside a guarantee of only marginally underperforming an index, the broad acceptance of indexation has allowed for significant savings on fees.
It's harder to measure the return drivers of private-investment managers however, as the markets they operate in are relatively opaque. As yet, there is no standardisation of relative performance measurement, attribution or benchmarking; private markets have not yet been fully 'institutionalised'. But so far, the returns these managers have provided appear to have satisfied their investors, and the call for more transparency hasn't been that great.
Investors have to approach the governance of their private-market investments differently than that of their public-market investments. Expectations for governance standards within private markets vary, too. For example, a small start-up company might need to scale up governance as its stakeholders increase in number. At the same time, investors in infrastructure have always had to obtain a so-called 'social licence' in order to operate, and have naturally taken environmental, social and governance issues into account. As investment in private markets grows, particularly in the burgeoning era of environmental, social and governance (ESG) considerations, these factors may need to be more formally accounted for. The call from various policymakers and regulators to open private-market investments to retail investors could help to push the issue of governance to the forefront.
The declining role of the public equity market and the dearth of IPOs
Public markets are getting smaller, at least in terms of the number of companies listed. As an example, the number of publicly traded US companies fell by 45% between 1996 and 2018, going from 8,090 to 4,397 over that period. Share buybacks have also added to the decline in the number of publicly traded shares available.
The availability of private capital, the cost of a public listing (7% for a mid-market company), and the arguably burdensome regulatory environment awaiting companies moving from private to public hands have led to a drop-off in the number of domestic companies listed on the US stock exchange (see chart 1 below). Share buybacks have also reduced the aggregate amount of publicly traded shares.
Chart 1: the number of companies listed in the US has dropped
Source: The Center for Research in Security Prices, Aberdeen Standard Investments
The voracious appetite of large firms to buy smaller ones has created a race to establish ecosystems rather than single-line business models. Between them, Google, Facebook, Apple and Amazon have bought over 500 companies in the last two decades. This appetite for acquisition also means that fewer companies are reaching public markets.
The private funding available to companies at the later growth stage has grown significantly during the past few years. Companies can stay private for longer – they don't need to access the public markets in order to fund their growth.
Private-market investors are therefore able to benefit from these companies’ growth stages (more of which are taking place in the private sphere). But this means public markets present fewer and fewer opportunities to invest directly in these growth stages. The wave of private capital currently available appears to be eroding the so-called democratisation of investing.
One reason for this is the poor experience of public-equity institutional investors during the technology bubble in the late 1990s. This led to a lack of appetite for further listings and a particular distrust of offerings led by PE. It also goes some way to explaining the decline in IPO issuance since 2000.
That said, IPOs have continued to occur, and the trend of the Unicorn listing has been strong in recent years. But of the companies that came to the market in 2018, only 17% had positive earnings – down from 71% in 2009 (see chart 2 below), a fact that seems to have reasserted itself recently in investor psychology. Despite this degradation in company fundamentals, many IPOs were well received by the market at the time of listing.
Chart 2: both the number of IPOs and the proportion of new listings with positive earnings have fallen
Source: Jay Ritter, University OF Florida, Aberdeen Standard Investments
Growth in private credit
Following the success of their PE investments, and in some cases having exhausted the ready supply, investors have been allocating increasing amounts of capital to private lending. Investors looking for income have also found this asset class increasingly attractive due to lower returns in fixed income markets.
Regulators and policymakers have deliberately encouraged these burgeoning markets. Following the financial crisis, one of their priorities was to scale back the big banks and encourage new entrants into the lending market.
Many alternative investment managers have embraced this opportunity. With the US Federal Reserve cutting interest rates, these markets have become even more attractive to yield-starved investors.
Private-lending investments are relatively new, and market-based lenders are yet to be tested by a recession. Accordingly, investors’ assumptions about risk, reward and correlation are working hypotheses and are likely to be subject to change.
Where a bank has multiple lines of business with a customer, a marketplace lender might only have one. This means that there are fewer levers to pull to make a borrower pay if something goes wrong with a loan. In addition, banks have teams of professionals whose job it is to work out non-performing loans. But marketplace lenders may not. While it might be possible to redeploy staff from lending teams, this may or may not work well in practice.
Marketplace lenders are well supported by regulators and policymakers and have generally used less leverage than banks did previously. So it seems unlikely that they will compound the problem when a recession finally comes. But the light-touch environment is very different from that in which a bank operates. During the next recession, the regulatory pendulum may swing back.
These markets have been quite opaque, so performing comprehensive analysis hasn't previously been possible. More data is slowly becoming available, however, as institutional investors demand it.
Asset allocation and return expectations
Although the move towards private markets and alternative investments allows investors to increase their portfolios' overall returns, many may not have enough invested to meet their portfolio's return target. It is clear that the current allocation to alternative asset classes is unlikely to be enough to help the average pension fund satisfy its return goal.
As an example, our current forecasts for PE returns are around 7%, rising to around 12% if one can invest with the top-quartile managers. This return profile is worth pursuing, being far in excess of our public-market forecasts, but it still falls well shy of the return necessary to make up the shortfall in required return generation left by public-market investments.
Perhaps the most likely outcome is simply that scheme members will have to reduce their pension expectations – or that scheme sponsors will have to increase their contributions.
Can investors increase their allocation to alternatives?
Although many investors aspire to allocate an increasing proportion of capital to alternative investments, including private markets, the size of the investable markets is still a fraction of the public markets. For most investors, achieving an average allocation of even 10% seems aspirational at this point – there just isn't the capacity.
It’s also difficult to replicate on a large scale strategies that generate returns above those of public markets. Looking at the larger PE managers, for example, average returns are lower. As PE has received more investment, the excess returns it generates have declined. The same phenomenon is occurring in venture capital, some forms of private debt, infrastructure, real estate and other asset classes.
Retail investors and private markets
Private-market investments are generally only available to sophisticated investors. For investors who can directly access private markets, asset allocation can be much more advanced, with a greater likelihood of getting closer to achieving the desired outcomes.
For those without access, return outcomes are limited. Only sophisticated investors can directly access private-market investments. Although there are opportunities to invest in listed versions of private-market investments (currently, there are around 200 listed companies with a market value of c. $375 billion), these are limited and don't necessarily offer the diversification characteristics or breadth of choice that an investor might want.
As individuals (typically unsophisticated investors) are now expected to be responsible for their own retirement planning, inequality in investment choices is likely to further exacerbate income inequality .
Some policymakers and regulators appear to recognise this, but the private markets still have a long way to go to become appropriate for retail investors to access directly.
Conclusions and further areas of research
The drivers of the shifts from public to private markets and from active to passive investments remain in place.
Index investing is an important component of asset allocation. The importance of active public-market investments in a portfolio continues as many of the new and large-cap listings are not yet subject to index inclusion.
However, access to the growth and lending opportunities that private markets can offer over and above those of their public counterparts is vitally important. While private-market investments are becoming increasingly expensive, public-market investment opportunities are shrinking and present high valuations and low yields. This adds further impetus to the argument for investing, in a selective way, into private markets.
RISK WARNINGThe value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.
The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.
Any data contained herein which is attributed to a third party ("Third Party Data") is the property of (a) third party supplier(s) (the "Owner") and is licensed for use by Standard Life Aberdeen**. Third Party Data may not be copied or distributed. Third Party Data is provided "as is" and is not warranted to be accurate, complete or timely.
To the extent permitted by applicable law, none of the Owner, Standard Life Aberdeen** or any other third party (including any third party involved in providing and/or compiling Third Party Data) shall have any liability for Third Party Data or for any use made of Third Party Data. Past performance is no guarantee of future results. Neither the Owner nor any other third party sponsors, endorses or promotes the fund or product to which Third Party Data relates.
**Standard Life Aberdeen means the relevant member of Standard Life Aberdeen group, being Standard Life Aberdeen plc together with its subsidiaries, subsidiary undertakings and associated companies (whether direct or indirect) from time to time.