How private equity has devoured public markets and is now devouring itself
One of the key causes of the Woodford implosion was the number of illiquid, unquoted holdings in his portfolio. The lack of a liquid market means that both valuing and transferring such holdings isn’t straightforward. Why then, should anyone invest in a fund that invests in private companies?
Earlier this month, Scottish Mortgage Trust (SMT), one of the largest UK investment trusts, issued its half yearly report. Given the recent tribulations at Woodford, they felt compelled to comment on a number of their unquoted holdings:
We are convinced that the long term risk taking, essential to economic and social progress, is continuing to migrate to private markets and at an accelerating pace. 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 which they create.
The phrase “long term risk taking…is continuing to migrate to private markets” is key. In simple terms, it means that the biggest growth phase of companies increasingly takes place outside of stock markets. Or, from our perspective, the opportunity to make the biggest gains are increasingly unavailable to private investors.
This reflected a comment I heard at a conference on private equity I attended earlier this year. The manager of Pantheon International (PIN) made the argument that private equity was the only way to access true high growth opportunities. She illustrated the point memorably by comparing Amazon to a slew of more recent stock market issuances.
When Amazon had its IPO (which used to stand for Initial Public Offering, though is now interchangeable with “It’s Probably Overpriced”), it raised $54m by issuing shares at $18 each. Due to stock splits, if you had invested $100 in Amazon at IPO, that stake would have been worth more than $120,000 by the time the shares peaked in 2018. And yes, those figures are correct.
Amazon’s IPO was seeking additional capital to accelerate a phase of explosive growth. It’s best days clearly lay ahead of it. Those who were willing to risk capital were richly rewarded. This is how the stock market is supposed to work.
Compare this to Facebook, which in 2012 raised $16 billion with its IPO at $38 a share. Shares currently trade around $195, so it would still be a 5 bagger over 7 years, which sounds good, but is very similar to the performance of Apple or Microsoft over the same period. It was effectively a mature company. Yes, it still had growth opportunities, but no more so than its peers in the wider tech sector.
Fast forward to Uber, which IPO’d with a value of $85bn in spring 2019 and has since seen its shares slump by 40%, We Work, which ended up pulling its IPO, Lyft and Slack, which have underwhelmed and you have to conclude that investing in an IPO is fraught with danger. In fact, data quoted by Gervais Williams at the recent Mello event showed that 83% of US IPO’s were unprofitable. Or pre-profit, as the Americans say.
That stock markets are no longer the preferred environment for young, fast-growing companies is reflected in the number of companies listed on major markets. Getting these figures isn’t easy, but the number of listings on the LSE dropped by 15% between 2015 and 2019. In the US, astonishingly, the number of listed companies is half the amount there were in 1996, when the peak of 8,000 was passed. Companies merge, go bust, and get taken private at a far quicker rate than new ones come to market.
The secondary implications are equally worrying: that growth is increasingly captured by private equity, which, with the exception of a small number of listed funds, is the preserve of ultra high net worth individuals. So the rich get richer while us private investors are left waiting for the crumbs, which often come in the form of multi-billion IPOs of companies which may never be profitable.
But the story actually gets even stranger than this. In a recent LinkedIn post, Ray Dalio, one of the world’s greatest investors, commented on how the private equity sector had become so swollen with investment that it could no longer find sensible opportunities:
Because investors have so much money to invest and because of past success stories of stocks of revolutionary technology companies doing so well, more companies than at any time since the dot-com bubble don’t have to make profits or even have clear paths to making profits to sell their stock because they can instead sell their dreams to those investors who are flush with money and borrowing power.
There is now so much money wanting to buy these dreams that in some cases venture capital investors are pushing money onto startups that don’t want more money because they already have more than enough; but the investors are threatening to harm these companies by providing enormous support to their startup competitors if they don’t take the money.
So, we’ve found ourselves in a bizarre situation where returns are increasingly captured by private equity, but these returns are not derived from profits, or even the possibility of profits, but instead from the hope that the sheer weight of money seeking a home will drive up the value of every asset. Having devoured much of the stock market, PE is now eating itself!
There is no easy solution to this. But one of the biggest factors that will determine returns is the range of opportunities open to us as investors. We assume we are spoiled for choice: the reality is that we have less than ever.
Meanwhile, Woodford may just be a taste of what is to come, for while managers are right to try to capture some of the explosive growth phase for the benefit of private investors, valuation remains a contentious issue. The collapse of the WeWork IPO led Softbank to write down its investment in the company from $10.3bn to $1.1bn: a $9.2bn loss of 90%. Ouch! The truth is, public markets remain the best ways of valuing a company.
It seems that, having got away with listing Slack, Lyft, Uber and others at optimistic prices, We Work marks the moment when the market wises up to the PE approach. And it may be that PE learns a lesson that us private investors learned some time ago: that the most predictable returns come from profitable companies with manageable debt.
But that 90% write down on We Work should make everyone pause and wonder. Perhaps listing companies earlier in their life cycle and allowing the market to find a fair valuation is better than PE seeking to capture all the gains, only to find out, when they come to market, that what they think is a thoroughbred is, in fact, a donkey.
Paul de Gruchy, Director, ShareSoc