Somewhere in Southeast Asia or Brazil or Silicon Valley, the world’s next great entrepreneur is hatching a plan. Two decades ago, the dream would have been to take that invention to the public markets, to an IPO. And investors large and small would have been able to bet on the next big thing.
But that scenario is less likely today than ever before. The number of US companies trading on the market has dropped by more than half since the late 1990s. Deaths are rising: More companies are being acquired once they’re listed. Births are declining: Fewer companies are raising money in the public capital markets, aka “going public.” The average annual number of new listings from 2009 to 2016 is 179, according to data from the Center for Research in Security Prices, compared with an annual average of 683.5 from 1995 to 2000.
The public markets are an increasingly unfriendly space, especially for small companies. Financiers have a name for the phenomenon: “Go big or go home.” One theory is that the shift in the public markets toward passive investing—accelerated over the past decade by ETFs—favors giants and excludes small innovative companies. If the easiest, safest way to make a decent return is to bet on the S&P 500, an investment that ETFs has made even easier and cheaper, why bother to invest in S&P 501?
One consequence of this decline in the public markets is that innovation is now being funded in the private markets. Private equity and venture capital investors still pride themselves on being able to judge and made smart bets on the value of individual companies. Since 2002, private equity’s net asset value has grown more than sevenfold to $5.8 trillion in 2018, twice as fast as global public equities. The number of US private equity-backed companies rose to 8,000 from 4,000 in 2006, according to McKinsey. And private equity investors have reaped the rewards: Private equity funds returned more than 13% a year over the 25 years ended in March, compared with just under 10% a year for an equivalent investment in the S&P 500, according to Cambridge Associates.
But private equity, of course, is only accessible to the wealthy. Average investors are locked out of the gains that come from innovative companies if they’re funded in private markets rather than public markets.
“We are at risk of creating a two-tiered capital markets structure in the US: one in which the majority of the appreciation accrues to those institutions and wealthy individuals who can invest in the private markets and a second for the vast majority of individual Americans who comprise the retail investor base,” said Scott Kupor, managing partner of VC firm Andreessen Horowitz, and former chairman of the board of the National Venture Capital Association, in testimony before Congress.
The schism between public and private markets has been exacerbated by Wall Street firms’ increasing focus on financial engineering rather than investing for the long-term or for value. Passive investing creates the mindset: Why not follow the market, rather than try to beat it? ETFs are both a great passive investing tool and, because they are modular and trade quickly, a great tool to help Wall Street with increasingly sophisticated trading strategies that generate profits. They are myriad, but here’s one example: You can place a calculated bet on a group of stocks to rise, and then a bet for the corresponding ETF that holds the same stocks to fall. This is called “double alpha” trading, says Tim McCarthy, former president of San Francisco-based Charles Schwab and Japan’s Nikko Asset Management.
In the 1990s, four small investment banks, nicknamed “the four horsemen,” helped bring small company and venture-backed IPOs to market. The lack of a similar set in the market today points to Wall Street’s changing interests and incentives. A few decades ago, Wall Street firms and investors had more of an incentive to help companies go and stay public.
“The engaged participants are less attuned toward trying to understand the intrinsic value of a company,” says Andrew Karolyi, finance professor and Harold Bierman Jr. Distinguished Professor of Management at Cornell University’s S.C. Johnson College of Business.
Ironically, Karolyi believes that intrinsic value—things like inventions or processes—have become an increasingly important part of US companies, more so than the rest of the world. Just as investors’ interest and appetite for value investing was declining, the importance of a careful approach to evaluating companies, especially small companies, was rising.
Private equity investors have been only too happy to step into the breach, funding such companies as Facebook and Cloudera for a longer time before they went public, and some companies, such as Instagram, never hit the public markets at all as independent entities. (Instagram had 13 employees and $60 million in private equity funding when Facebook acquired it.) These are companies where the value is built on an idea, or technology that stems directly from the idea.
“What’s unusual about the United States is there’s been a significant increase in the intangibility ratio,” Karolyi says. “There is more private equity money available that understands the intrinsic value of these types of intangible assets.”
(America’s dominance in intellectual property may be waning, by the way: In 2016, Chinese scientists filed for more than 1.2 million patents, compared with more than 600,000 in the US.)
The decline of public companies in the US has other consequences. Companies that go public increase employment by 45% relative to private companies, said Kupor. And public company headquarters are strong stakeholders in communities—supporters of local charities and civic life, and centers of pride.
The US public markets do still have a limited appetite for small cap companies, but it’s being filled by emerging markets companies that have the concrete growth story of the middle class. Take Arco in Brazil, a technology platform that raised $220 million in a NASDAQ IPO in 2018. It sells its technology to schools in Brazil, where parents kept spending even through the recent recession.
Last May, demolition crews took down the 21-story Martin Tower, former world headquarters of Bethlehem Steel, a one-time US industrial giant that employed nearly 300,000 at its peak, and which closed in 2003. Arco, meanwhile, spent the summer working on the acquisition of a K-12 content provider, Sistema Positivo de Ensino, and it says it’s now serving 4,800 schools and 1.2 million students.