Expanding private markets are redefining their public counterparts

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The writer is a former banker and author of ‘A Banquet of Consequences Reloaded’ and ‘Fortune’s Fool’

The rise and rise of private equity and debt is reshaping public markets with consequences we are only beginning to understand.

There is now some $12tn of private equity and debt investments in businesses, real estate and infrastructure. The growth has been driven by multiple factors. On the supply side, there is abundant capital from family offices, wealthy individuals and institutions which are sacrificing liquidity in hopes of higher returns and exclusive early access to profitable deals.

On the demand side, private capital is attractive due to the high cost of public issues such as initial listing expenses and ongoing regulatory compliance. Other factors include fewer onerous reporting obligations and less rigour around related-party transactions and expenses. Some founders also avoid public markets because of concerns about loss of business and operational control. For ventures that have low funding requirements, founders and original investors can maximise their profits and retain control longer by delaying raising public equity.

Asset managers have facilitated the process by broadening their remit to increase assets managed and collect higher fees than on conventional investments. Favourable regulations, such as a US expansion of the number of permitted shareholders allowed in a private company, have helped. But there are several collateral effects of private investing.

First, public markets are becoming more a mechanism for allowing private investors to monetise gains, exit holdings and obtain tradeable stock as acquisition currency rather than raising new growth capital.

Second, as private investors capture a greater share of returns prior to going public, public investors may suffer over the long run, as evidenced by the poor post-IPO performance of many private investor-owned companies after adjustment for market movements.

Third, divergent valuations of comparable businesses make ranking of investment choices difficult. In recent times, values of privately held businesses have not fallen by as much as corresponding public ones. The difference is the valuation models used and the ability to defer adjustments in values. Notably, private valuations derived from successive funding rounds often prove optimistic. Private companies have lower reporting requirements, making informed discussions more difficult.

Fourth, the interactions between the two market segments also can become a source of potential financial instability transmitting shocks across markets. With fund managers holding a higher level of illiquid private investments, they have to sell down more tradeable public market holdings to generate cash when needed, sometimes irrespective of value considerations. This can hit public markets disproportionately in moments of turmoil.

Fifth, with many businesses choosing to stay private for longer, public markets risk becoming narrower, limiting diversification opportunities.

Sixth, small investors and some pension funds have limited access to private investments due to size or mandate issues. Obtaining exposure, where possible, necessitates the use of multiple intermediaries, incurring additional fees and costs. This raises the risk of groups of investors becoming confined to disadvantaged public investments with select insiders enjoying more lucrative opportunities.

Finally, private-market groups increasingly resemble closely held Japanese, Korean and Indian conglomerates. Heavy on financial engineering, these new groups lack transparency and often do not have the compensating longer-investment horizons, greater research and development funding and close government relations of their Asian counterparts.

Private markets risk evolving into a self-contained shadow economy in which asset managers can bypass many regulatory requirements and the greater scrutiny of listed assets. With large amounts of capital under control, such a scenario would represent an unwelcome return to the late 19th-century era of robber barons and privileged investing.

In his 1958 book The Affluent Society, John Kenneth Galbraith highlighted growing private wealth and public squalor. The rise of private markets is an unanticipated postscript to that process. If benefits from business activity accrue primarily to a few wealthy parties, then it may undermine the legitimacy of the system which allowed it in the first place.