Today’s public markets, which were first designed to fill the capital-raising needs of the 19th century, are out of step with capital formation in the 21st century.
It’s essential to move the markets forward to provide adequate access to investment opportunity for all, and not just a few, investors. Right now, the average investor has little or no access to where the real action is.
Why is this happening? Because the public capital markets continue to shrink in the Western world.
In the last 20 years, the U.S. stock market has undergone an alarming change. Between 1996 and 2016, the number of listed companies fell by half, to 3,600, down from 7,300, according to a Credit Suisse research study.
Additionally, the number of listed companies and initial public offerings in the U.S., the U.K. and the Eurozone has been on a steady decline since the heady days of the dotcom boom. To that point, activity peaked in the U.S. in 1996, with nearly 700 IPOs. By 2017, that number was barely 100, according to CFA Institute research.
With the number of IPOs declining, small investors are getting shut out of the most lucrative deals.
Private companies have not suffered, however. The private capital markets now provide more than enough capital to fund business models, particularly those in this capital-light era where companies do not require massive amounts of financing to grow and mature.
Investment bankers, lawyers and exchanges, such as the New York Stock Exchange and the London Stock Exchange, bemoan this trend, of course. A once-rich source of revenue has dissipated. Business models evolve, though, and these businesses can pivot to find other lucrative revenue streams.
For average investors, this decline brings profound long-term consequences. Main Street investors generally are not able to invest in private markets; they lack access to companies when they might be expanding at their fastest pace.
Average savers are disadvantaged because only sophisticated funds can invest in venture capital, private equity or infrastructure funds. Therefore, non-public market funding of new businesses basically excludes retail investors from participating in the early-stage growth and the related returns.
Today, in the U.S. and across Europe, the big game-changing ideas are often funded privately. Many new ventures aspire to an IPO not as a start, but as the end point of their fortunes. And some never make it to the public markets, choosing to be acquired.
When so much growth occurs in the private sphere, it changes the very nature of returns that can be expected from public markets. But those public markets remain the sole channel for most retail investors. And those markets continue to shrink.
Due to this trend, existing listed markets have become more exposed to older industries, slower-growing companies and short-termism driven by the steady beat of quarterly earnings expectations.
Private markets have become the bastion of more long-term thinking due to their structural characteristics.
So what can be done?
In the recent CFA Institute report “Capital Formation: The Evolving Role of Public and Private Markets,” the following suggestions are made:
- Avoid a race to the bottom: Regulators should avoid lowering disclosure standards and investors protections in a bid to encourage IPOs. We do not see public disclosure requirements as an impediment to going public, and we certainly would not encourage lowering investor protections by “innovations” such as dual-class shares that disempower investors. In short, we see no obvious regulatory solution to make the public markets more attractive without damaging investor protections and market integrity.
- Improve Defined Contribution plans access to private markets: With retirement systems continuing to shift from Defined Benefit to Defined Contribution plans, individuals are being forced to take more responsibility over their investments. DC plans could become a professional intermediary for access to private markets. Having increasingly large parts of the capital markets off limits for retirement savers clearly disadvantages them; this must be addressed. A framework does need to be built, however, to protect investors in private markets, where disclosure standards remain low. This should be the topic of conversation between regulators and the industry: How do we build a regulated pathway for retail clients into private deals?
- Look out for systemic implications: Regulators should take precautionary steps to examine the systemic implications of growing private markets. Private markets, by their nature, lack the transparency of public markets and are certainly not liquid. This brings profound challenges and unseen risks.
Don’t be deceived by the recent S-1 filings by Lyft and Uber, declaring their intention to go public in 2019. Should those firms go the IPO route, the listings will dominate the headlines and lull people into marking the return of public listings. Additionally, other firms may find it easier to get adequate private financing — which Main Street investors don’t have access to.
Unless the inequitable lack of access to private markets is addressed, retirement savers will continue to be deprived of the ability to participate in high-growth business models and further promote the sense that markets are being operated for the benefit of well-connected “insiders.”
That surely will not be a resoundingly positive message in these populist times. And those many Main Street investors will be driven away just when they need investment returns the most.
— By Paul Smith, president/CEO of CFA Institute