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The private equity threat

The rise of private equity highlights the fact that, for an increasing number of companies, a stock market listing is the wrong form of ownership.
The private equity threat
  • Cheap money and low valuations don't explain why private equity firms are buying UK companies. Instead, it's happening because dispersed ownership is increasingly inappropriate.
  • With investment opportunities among quoted firms shrinking, investors should consider private equity funds.

Private equity buyers are swooping for UK companies. Morrisons is the subject of a bidding war which means it will soon follow erstwhile stock market stalwarts such as Meggitt, Aggreko and St Modwen into private hands. This trend should worry equity investors.

The conventional explanation for why this is happening is inadequate. It says that private equity firms are buying because of cheap money; because UK shares seem cheap; and, adds Chancellor Rishi Sunak, because of confidence in the UK economy. But this is only part of the story. These factors should attract all sorts of buyers, be they other listed companies or institutional or retail investors. What’s so special about private equity firms?

Our answer starts from the fact that stock market-listed companies are in fact very rare. There are just 1645 UK firms listed on the main market and Aim. That’s less than one in 1800 of all companies.

To see why they are so scarce, imagine you thought that one of the companies in which you held shares could be better managed. What could you do? You could do in-depth research on management’s shortcomings and ways of improving them, and try to persuade fellow shareholders of your case. But this is a lot of time and trouble for a paltry reward because even if the firm were to become better managed its higher share price would add only a little to a reasonably diversified portfolio. Knowing this, you don’t go to that time and effort. And nor, for the same reason, do most other investors. The upshot is that there is inadequate oversight of management. This is a classic  collective action problem: individual shareholders pursuing their own interests fail to deliver the collective interest of all shareholders. Which has been known for decades. As long ago as 1848 John Stuart Mill complained that “the managers of a joint stock concern seldom devote themselves sufficiently” to running it well.

Of course, such lack of oversight can be mitigated by proper incentives (though these are difficult to design well); by managers’ professional pride; or by fear of losing their jobs if the firm is taken over. But the point is that there’s a tendency for dispersed ownership to contribute to inefficiency.

This isn’t always a great problem. If there are many projects that return (say) 30 per cent on capital it’s no disaster if managers pursue the fourth or fifth best rather than the very best. Instead, what matters is that the company has the capital to invest, and dispersed shareholders can provide this. This is why we saw stock market listings of tech firms explode in the late 90s, and so many mining companies come to the market when commodity prices rose in the 00s.

Which brings us to why private equity is rising and listed companies are shrinking. We no longer live in a world of abundant high-profit opportunities. Quite the opposite. And as Harvard University’s Michael Jensen wrote in a classic paper: “the public corporation is not suitable in industries where long-term growth is slow, where internally generated funds outstrip the opportunities to invest them profitably, or where downsizing is the most productive long-term strategy.”

In such industries, it’s important to control managers tightly. And private equity, being a more concentrated form of ownership, overcomes the collective action problem and achieves this. Such owners are sometimes criticized for taking cash out of companies. But if the business is in decline, this is just what they should do; you shouldn’t throw good money after bad. In such cases, what matters is the more efficient use of capital and labour. Which private equity can achieve. A recent study by the University of Chicago’s Steven Davis and colleagues has found that private equity buy-outs of listed firms often lead to productivity gains.

In a world of secular stagnation where investment opportunities are scarce we would therefore expect to see private equity supplant listed firms.

It’s not just mature, stagnant firms for which private equity provides better owners than dispersed shareholders, however. New biotech or IT companies can benefit from the expertise that specialist private equity investors can provide.

The upshot is that the number of stock market listings is being squeezed from both ends of the spectrum: they are inappropriate for both ex-growth companies and new specialist ones. Since 1999 the number of UK firms listed on the main market has almost halved. And Kathleen Kahle and Rene Stulz document how the US is seeing a similar trend.

Ownership, therefore matters. The right owners are often the managers themselves – which is the case for most of the UK’s three million companies. But sometimes they are customers: the Nationwide building society survived the financial crisis whilst the listed Bradford and Bingley and Alliance and Leicester did not. Sometimes, they are workers, as in most law and accountancy firms. Heck, occasionally the right owner might even be the state (a possibility which might explain why investors traditionally have paid insufficient attention to the question of who should own companies!)

Only in a minority of cases is stock market ownership appropriate – and it is a shrinking minority.

This means that it is increasingly the case that listed companies do not offer us a full range of investment opportunities. Instead, they comprise over-priced speculative plays, mature mediocrities or companies which knowledgeable founders have gotten out of.

Proper diversification therefore requires that investors consider private equity funds alongside their quoted equities.