What’s Behind the Shrinking Public Equity Market?
One of the most remarkable trends in the financial markets has been the decline of publicly traded U.S. equities. About half as many stocks are listed as there were 25 years ago. What is driving this phenomenon and what are the implications for investors?
A number of articles addressing this trend have noted the sharp drop in initial public offerings (IPOs) since the 1990s, most recently one in The Atlantic magazine by Frank Partnoy, a law professor at UC Berkeley and frequent financial writer. However, many of the articles argue that there is little if anything to be concerned about. But subtly related is another recent trend: rising calls for antitrust action to reduce the monopoly power of market-dominant companies, including Amazon and Facebook.
Judging from the subheading of his article, Partnoy’s worry is that “The number of IPOs is declining, and that could mean that small investors are getting shut out of the most lucrative deals.” He quotes Thomas Farley, the head of the NYSE Group, as saying the drop, “may severely limit [companies’ opportunities] for economic growth, hiring, and wealth creation.” Adena Friedman, NASDAQ’s CEO, warned that if the trend continues, “job creation and economic growth could suffer, and income inequality could worsen as average investors become increasingly shut out of the most attractive offerings.”
Partnoy then observes – with noteworthy understatement – that, of course, “Farley and Friedman have a financial stake in the health of the exchanges.” It is in their business’ interest to promote the listing of public companies in any way that they can. Therefore, there is good reason to discount their statements.
But Partnoy is not alone in his concern. In an article in The Economist’s “Schumpeter” column (which has no byline) last year, the writer opined that, “Continued decline in the number of listed firms would be bad news. It would be a symptom of the oligopolisation of the economy, which will harm growth in the long run.” It adds that “Ordinary Americans without connections are meanwhile unable directly to own shares in new companies that are active in the fastest-growing parts of the economy.”
On the other hand
However, studies by The Harvard Law School Forum on Corporate Governance and Financial Regulation and Vanguard, and articles in Bloomberg and The Wall Street Journal argue that there is little to worry about concerning the drop in the numbers of IPOs and public companies.
Although Partnoy says that, “The pace of decline [of the number of public companies] has been gradual, unaffected by the dot-com bust, the financial crisis, or subsequent recoveries,” the Harvard study notes that 74% of the loss of domestic U.S.-listed companies to date occurred in 1996-2003, and the number of IPOs has fluctuated greatly in years since then. It says, “Since the 2008 financial crisis, the total number of domestic U.S.-listed companies has largely stabilized again.” (According to the National Bureau for Economic Research, the number of U.S. domestic publicly listed companies declined from 8,000 to 4,100 from 1996 to 2012; by contrast, the number increased in the rest of the world from 30,700 to 39,400, and listings of foreign companies on U.S. exchanges increased.)
The Vanguard study points out that microcap companies accounted for most of the decline in listings of public companies since 1996 – both because many of them listed in the 1990s, and many of them delisted shortly thereafter, following the dot-com bust. These microcap companies were so small that, Vanguard says, due to their illiquidity and regulatory constraints on the amount of ownership that may be acquired, active and passive funds would not own most of these securities anyway. As a measure of how extremely microcap-ish these dot-coms and other technology issues of the booming 1990s were, Vanguard says that in spite of the drop in microcap listings, microcaps’ proportion of overall market capitalization since then “has stayed relatively stable, at about 1.5%.”
Hence, it would appear from the Vanguard and Harvard studies that in spite of proclamations by Partnoy and others that the decline in the number of listed companies has been steady, the decline is mostly or almost entirely accounted for by the microcap IPO boom and bust of the 1990s and early 2000s.
The role of private markets
All commentators agree that while the number of listed companies in the U.S. has declined by about half, their total value has not declined at all as a percentage of GDP – in fact it has increased. The total value of public companies has not decreased relative to the economy; what has decreased is the total value of public companies relative to the value of private companies.
The reason is that instead of companies going public by means of an IPO, many have chosen to – in a sense – join the public market through acquisition by a public company, or to join the private market through acquisition by a private equity fund or another private company.
Thus, while the value of publicly-owned companies is stable, the value of privately-owned companies has, by relative terms, increased dramatically. Partnoy says that, “Private assets under management totalled less than $1 trillion in 2000; they surpassed $5 trillion last year. In this climate, many companies no longer need an IPO to raise capital.”
This is partly due to legislation. Both the 1996 National Securities Markets Improvement Act and the 2012 Jumpstart Our Business Startups (JOBS) Act – which increased the allowed number of investors in large private firms from 500 to 2,000 – made it easier for wealthy people and institutions to invest in private equity.
Furthermore, many modern technology firms have much less need for capital than they used to, and founders have other ways of monetizing their ownership besides through public offerings. Going public creates an expense and a nuisance for a firm. Therefore, many companies are choosing to pass on an IPO or to wait much longer to launch one. Instead, they sell to a private equity firm or to a larger company, one that may be either public or private.
Is this trend contributing to a stock market bubble?
The only article I found that addressed this question was The Wall Street Journal’s. If there are fewer public companies available that investors who can only invest in public companies can own, would that mean that money is chasing fewer companies, and that has been driving up their prices?
The WSJ article states the argument this way: “as money pouring into stocks rises as the number of companies and publicly traded shares falls, the remaining listed companies are bound to get a lift.” But it notes that the vast majority of the stocks that have disappeared were small or microcap. “They wouldn’t have had a major influence on the broader blue-chip indexes anyway.” And the article notes that “while common shares in the S&P 500 have shrunk each year since 2010, it has been at a rate of only about 1% a year or less, according to Citigroup.”
Thus, though this argument is initially compelling, it also falls victim to the fact that it is only the number of listed companies that has fallen; in terms of their total value – whether inflated by demand or not – the effect would be negligible.
Does this mean that “small investors are getting shut out of the most lucrative deals”?
Recall that this was the substance of Partnoy’s complaint, according to his article’s subheading. How true is it?
There is little doubt that it is true. In journalist Leigh Gallagher’s book The Airbnb Story, she chronicles how the initial investment of $585,000 in Airbnb by venture capital firm Sequoia was worth “roughly $4.5 billion as of this writing [in 2016]” (and probably much more now) – a rate of return of more than three-quarters of a million percent.
No small investor could have participated in this investment, not directly anyway. But mutual funds can invest in them – and do – and small investors in mutual funds can benefit that way.
However, it must be noted that for every start-up company that offers returns like Airbnb there are many that offer much lower, in fact -100% returns. Small investors who miss out on Airbnb also miss out on those disasters – not to mention that they miss out on the outsized risk of investing in start-ups.
On the whole, as the Bloomberg article makes clear, private-equity returns do not outperform public-equity returns – in fact the opposite. So, are small investors missing out? They may be missing out on the opportunity, but there is no evidence they are missing out, on average, on any rewards.
Partnoy himself makes a mistake on this score. He says:
Unless you are very wealthy or well connected, you probably are not going to be buying into the leading venture-capital funds… We should be wary, however, of accepting a romantic notion of the past in which Wall Street was a level playing field for individual investors. When I was at Morgan Stanley in the 1990s, the bank’s senior employees had special access to a private-equity partnership called Princes Gate, which made early-stage investments in companies like Au Bon Pain and Cannondale and generated 30 percent–plus annual returns. Average investors were not invited. The markets have always been split, in some ways, between haves and have-nots.
Many employees at companies like Morgan Stanley are not only viewed by outsiders as privileged, they feel privileged themselves. And so, Partnoy probably believed that the opportunities opened to him exclusively as a senior employee at Morgan Stanley were making him richer. He quotes the “30 percent-plus annual returns” in the Princes Gate fund as if those were the returns that would continue forever. And maybe they did while he was there. But just like the investments of the Sequoia Fund and other private equity investments, the likelihood is that the dogs would pull down the winners so much that in the long run, its performance would be only average.
The oligopolization of the economy
Let us now come to the central concern of The Economist, as well as that of a recent article, “The Monopolization of America,” by New York Times opinion columnist David Leonhardt.
All of this selling of new companies not to the public through an IPO, but to other large companies is bound to create corporate consolidation. And it is generally acknowledged that antitrust oversight in the United States has been lax of late.
The evidence of this consolidation that is presented by Leonhardt is striking. It shows that the combined market share of the two largest companies in many of the major industries has grown substantially in recent years. And, an article last month in The Economist claims that “Since 1997 market concentration has risen in two-thirds of American industries.”
In view of these claims, it is a little surprising that Vanguard’s study, referred to earlier, argues that “It does not appear that the investable market has become more concentrated.” It bases this statement on two concentration measures applied to the weights of companies in the Russell 3000 Index, the Gini coefficient and the Herfindahl-Hirschman Index.
It is not impossible that the claims by Leonhardt and The Economist could be true and Vanguard’s statement also true. Let us assume that Leonhardt’s and The Economist’s arguments do show that corporate power has become more concentrated.
This would square with the increased tendency of companies to become part of other companies rather than separate public companies through an IPO. It would square with the high number of mergers and lax antitrust enforcement of late. And it would square with the increased profits of large public companies that have been driving increases in stock prices, as well as the stagnating returns to labor that have helped enable those companies to earn such high profits.
So yes, the IPO decline could be part of, or a cause of, the oligopolization of the U.S. economy. And that is something to be concerned about.
Economist and mathematician Michael Edesess is adjunct associate professor and visiting faculty at the Hong Kong University of Science and Technology, chief investment strategist of Compendium Finance, adviser to mobile financial planning software company Plynty, and a research associate of the Edhec-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, was published by Berrett-Koehler in June 2014.