The private paradox

No, this is not the opening salvo of a press release from the desk of a private equity house touting its book. It’s the honest assessment from one of the most level-headed and cute investors in the business: Scottish Mortgage Investment Trust (SMT). 

As a stockpicker, its star has been burning a little less brightly in the past six months as it endures a rare period of underperformance versus benchmarks. But that’s largely because of the global rotation from growth into value, and the collapse in once-mighty Baidu, not because of the unquoted stocks. 

Having first dabbled in the opaque waters of unquoted companies in 2010, the return of all the stocks that SMT initially owned in unquoted form, some of which have now listed, has been 445.3 per cent, versus 341.4 per cent for Scottish Mortgage overall. Investment returns are increasingly happening in private. This is not a good thing for your average investor.

Despite some very well publicised initial public offerings (IPOs) in 2019, fewer companies are coming to public markets and there are now a lot fewer companies on the stock exchange. Primarily this is because young, growing businesses can find more appealing ways to raise capital. Persistently low interest rates make debt financing more attractive than going through the rigmarole of listing on the stock market. Issuing shares also incurs costs that you avoid by staying private and issuing debt. 

So, since the financial crisis and the unleashing of highly accommodative monetary policy by central banks, the universe of listed stocks has declined sharply – by about half in the US and by around a quarter in the UK. The picture among small-caps is even more stark. The number of stocks listed on Aim has halved in the past 12 years, down from 1,694 in 2006 to a meagre 882 by the end of September 2019. Simply put, today there are better and easier places to source capital than public markets.

All quiet on the IPO front

The number of IPOs in London is falling. Just four IPOs were logged in the third quarter of 2019, with two on the Main Market and two on Aim. Deal activity has not been this low since the financial crisis a decade earlier, according to the EY IPO Eye report, which comes out every quarter and says things are “unusually quiet” in IPO land.

There were 24 IPOs, raising £4.8bn, in the first nine months of 2019, less than half that during the same period last year, when 53 IPOs raised £5.2bn. Aim has seen the most dramatic drop, with a 71 per cent fall in the number of IPOs year on year versus the 36 per cent decline on the Main Market.

It’s not only a UK problem (don’t blame Brexit). According to EY (formerly Ernst & Young) again, IPO activity globally is lacklustre. The number of IPOs worldwide coming to market in the third quarter was down by about 25 per cent from a year ago. EY points to economic and political uncertainty in the UK and globally, but increasingly these trends appear more structural than cyclical. The tectonic plates of global capital markets are shifting.

Funding secured

Tesla (US:TSLA) boss Elon Musk famously tried to de-list the electric carmaker, goading short sellers with the now infamous tweet: ‘Am considering taking Tesla private at $420 (£326.56). Funding secured’. Of course, it wasn’t, and Musk got a slap on the wrist from regulators in the US. 

Nevertheless, it highlights am important point: there is a strong appeal in taking companies private and we are seeing more cases lately, hinting once more that business leaders are happy in moving away from the glare of public markets. 

The value of private equity (PE) deals taking UK-listed companies private has more than trebled to £14bn in 2018-19, up from £3.8bn in the previous year, according to accountancy and business advisory firm BDO LLP. 

And the targets are getting bigger as private equity appetites grow. US private equity giant KKR has just tabled a $70bn (£54bn) bid to take Walgreens Boots Alliance into private hands, which would it make the largest ever take-private deal in history. 

Taking a company private is not straightforward. “Some PE firms are put off by the extra compliance burden of acquiring a listed company, which means dealing with the Takeover Code and its strict timetable,” explains Jamie Austin, head of private equity at accountancy firm BDO. 

But valuations are making it appealing. Mr Austin argues that listed companies are attractively priced compared with private companies. Money is cheap and private equity has built up a lot of cash on the sidelines. When listed companies are trading at a discount, it would seem to make perfect sense to go for a private equity buyout.

“For management teams, the immediate reduction in regulatory, compliance and reporting burdens also makes public-to-private transactions an attractive proposition,” he adds.

So the public equity markets are facing a war on two fronts – fewer IPOs as companies eschew issuing shares in favour of debt; and more public companies going private, because share prices are cheaper.

The trouble with public markets

Scrutiny of public companies has increased, from more stringent corporate disclosure requirements, to tougher listing standards and governance practices, argues Sviatoslav Rosov PhD, CFA, in a recent CFA Institute report. These pressures undoubtedly make remaining private more appealing, when you don’t have to raise capital by issuing shares.

Tim Martin, the ever-vocal chairman of JD Wetherspoon (JDW), recently weighed into the debate on corporate governance, specifically on non-executive directorship tenure and how rules actually “institutionalise” short-termism – a bugbear for many a founder who’s gone public and subsequently felt like taking their business private again.

“There can be little doubt that the current system has directly led to the failure or chronic underperformance of many businesses, including banks, supermarkets, and pubs,” says Mr Martin, adding: “In summary, my view is the UK CG system [the UK Corporate Governance Code] is up the spout – and is itself a threat to listed companies – and therefore to the UK economy.”

Corporate governance is a double-edged sword – just look at the freedom Adam Neumann enjoyed at WeWork. A balance is to be struck, but there is something in what Mr Martin advocates.

Private markets are also not subject to the same rigorous scrutiny from requirements such as releasing quarterly earnings updates – something the likes of JPMorgan chief executive Jamie Dimon and Berkshire Hathaway’s (US:BRK.A) Warren Buffett think creates a short-termism in public markets. They may be right: listed companies may benefit from not having to report earnings every three months. Investors can be easily spooked by a bad quarter when the overall picture remains bright. For investment-heavy technology companies, returns for investors may be years in the making. Going public can be a risky proposition if the commitment to investment wanes and shareholders press for returns.

Of course, the point about all this scrutiny is that companies must report audited numbers on the ongoing health of the business. By releasing regular reports investors can benchmark against known criteria and compare with previous years. This becomes much trickier with an unquoted company.

Dangers of investing in private companies

So how can investors gain access to private companies? Investment trusts are one answer. Scottish Mortgage Investment Trust says: “It’s important that all our shareholders, from the smallest holders to the very largest, have access to such innovative enterprises and the enduring real value they create.” By the looks of what SMT has been saying, there will be more opportunity to invest, indirectly, in unquoted companies.

But as the Neil Woodford and SoftBank debacles highlight, there are real risks from investing in companies that are not subject to the same amount of scrutiny or are very illiquid. Mr Woodford’s demise was the result of loading up on too many unquoted, illiquid stocks – as well as making some errant bets on the performance of domestically focused stocks that were a play on UK growth. 

WeWork’s failed attempt to go public is a case study in how private markets got it wrong. It shows how private markets can ascribe absurdly unrealistic valuations to large entities that by all rights should have listed years ago. SoftBank boss Masayoshi Son admitted to turning a “blind eye” to WeWork’s problems, ignoring high debts, a complete lack of capital discipline and a byzantine corporate structure. SoftBank recently disclosed a $4.6bn write-down on its holding. This was all made possible by the shadows of private markets. 

And speed to market is a problem even if they do list. Instead of young businesses hitting the stock market, increasingly we see companies remaining in private hands for a lot longer than they used to. This distorts price discovery, which means that when the company does eventually list, there is often a lot less upside left for ordinary investors. Increasingly, IPOs are becoming nothing more than an exit strategy for early-stage investors and founders. This is particularly true of the super-hyped Silicon Valley start-ups, some of which are now opting for direct listings that do not raise any new capital, but enable founders to realise their paper holdings. It’s also true in the UK, where private equity realisations such as AA (AA.) and Foxtons (FOXT) have performed very poorly after going public.

Scottish Mortgage is aware of the problem, but is keen to point out that the disasters are the exception, not the rule. “It is common knowledge that there are high-profile examples of unquoted or recently listed companies that have suffered serious problems, but it seems to us that generalising from these distinctly colourful sagas is misguided. The flaws of their business models were not impossible to identify. Although we are wary of treating our unquoted assets as a separate portfolio our experience remains encouraging.” Of course, that is not how investors in Woodford funds would assess the situation. 

And while we bemoan the decline of public companies, the world’s largest private company is about to list. Saudi Aramco’s IPO has been years in the making and been beset by problems, delays and troublesome valuations. Nevertheless, the Saudi government has stuck to its guns and the company will start trading on the Tadawul before the year is out. This, too, however, looks more like an exit strategy for the Saudi regime. Rather than being viewed as a stock market debut, it should instead be billed as an unquoted finale.

Private equity investment trusts

Source: Winterflood as at 25/11/19