As investors seek to diversify their portfolios, they’re finding opportunities to invest in the growth potential of private companies. With fewer public companies to invest in, the private sector is filling the gap.
An estimated $2.9 trillion of capital was raised in private markets in 2018 — the pace of this trend hasn’t slowed in 2019 — compared to roughly $1.4 trillion on public stock exchanges. This is partly due to a decreased number of public companies; since 1996, the number of publicly held U.S. companies has fallen more than 50% to about 3,600 companies, albeit their valuations are higher. Meanwhile, the issuance of new public companies in both North America and South America is also down, decreasing approximately 14% from June 2018 to June 2019 and continuing the stagnant pace of IPOs since the 1990s.
Equity returns on public stocks in the S&P 500 are up 20% year-to-date, continuing to offer higher returns than global bond yields. Nevertheless, low inflation and historically weak small-cap performance are offsetting the equity premium, making private companies “very interesting,” according to Christopher J. Wolfe, Chief Investment Officer at First Republic Private Wealth Management, who spoke on Bloomberg Radio in September 2019. “There are some structural changes going on in the markets that represent meaningful opportunities for clients.”
These structural changes include an uptick in M&A activity and the low cost of financing, which are assisting the growth ambitions of private companies. Additionally, many private companies are staying private longer, further limiting the number of publicly traded companies. Another influential shift is the growing usage of secondary markets for investors to get needed liquidity, trading their shares in private companies much like they do with traditional securities.
Structural change is evident in the public markets as well. Chief among them is the influence of machine trading and lightning-fast trading algorithms on stock market price movements. These changes are compelling a narrowing in the valuation multiples between an investment in a private company and a publicly traded one.
“Private companies are now more highly rated than they have been in the past, but that makes sense — the cost of money, the cost of financing these companies, is now so low,” Wolfe said. “A private company might trade at a similar valuation multiple [as a publicly traded one].”
Given that investors can obtain liquidity through the secondary trading markets and diversify their portfolios with businesses providing added flexibility, depth and sophistication, Wolfe maintained that investments in private companies are a trend that will continue for the foreseeable future.
“As long as the real cost of capital is close to zero and you don’t have a lot of public market opportunity, [investors are] going to keep funding the private markets,” he said. “The ‘liquification’ of the private markets is well underway.”
Choosing private investments carefully
Like anything that seems too good to be true, investors must be careful in selecting which private companies to invest in and how much. “Although the benefits are clear, investing in private markets is not without its challenges,” Wolfe said.
A case in point is “zombification” — investments in private companies fueled by cheap funding that are essentially on life support.
Another concern is private equity deal multiples, which are at historic highs. “The sheer volume of capital flooding into the private equity industry has created enormous pressure to complete deals — arming private equity managers with the capital to match higher offer prices,” Wolfe said.
While private equity over the past five years has generated record deal values, the challenge is maintaining pace with the high investor demand, he added. In turn, this is compelling many investors to look elsewhere for returns, impelling the growing investor interest in private company investments.
As with any investment, proper due diligence and discipline are required. In this regard, investors should work with advisors to ascertain and measure a private company’s past performance, market challenges, key competitors and current working capital, in addition to determining the purpose of the financing and how it will be deployed.
“Smoothing the bumps”
Wolfe pegged a recession at low probability in 2019. “Looking forward, investors will need to moderate their expectations,” he said. “Productivity growth looks like it’s stagnant a bit, and demographic changes like the aging population in the United States and elsewhere have major implications for investment risks and returns.”
“We’re in a place where we think the ‘low and slow’ story is still the central one,” he added. “It’s just going to feel a bit bumpy.”
Smoothing the bumps is an approach that measures the risks and rewards of different investment classes. The good news for the foreseeable future is that private market investments enhance the opportunity to strike this delicate balance.