CPD: The growing trend of private companies

From

What are the differences between private companies and listed public companies, the growing trend from public to private and the factors driving it.

Listed equities are the cornerstone of most diversified investment portfolios. Whether held directly, via an exchange traded fund or an unlisted managed investment, even those investors with a lower tolerance to risk tend to have some exposure to equities.

What most diversified portfolios don’t have is an exposure to private companies, or more specifically, private equity (PE) investments; this has traditionally been the domain of institutional investors. However, the advent of listed private equity (LPE) – entities listed on international stock exchanges whose main activity is investing in private companies, private equity funds or the investment managers of private equity funds – makes this asset class more accessible to all investors.

Listed public companies and private companies each has strengths and weaknesses, and both can add value to a diversified portfolio. PE has typically provided better returns than those offered by listed equities, with lower levels of volatility.

Listed public companies

Shares in companies such as Nvidia, CBA or Apple are purchased on major stock exchanges. If a company wishes to ‘go public’ it will typically go through an ‘initial public offering’ (IPO) process, with the primary objective to raise capital for the business, which can then be used for a range of purposes. These may include implementing expansion plans, product research and development, or simply so the company’s founders can cash out. Daily trading in the market typically determines the valuation of the company. As outlined in figure one, there are advantages and disadvantages to taking a company public.

 Trends for listed public companies

Over recent decades the number of listed public companies has decreased. Although predominantly a US phenomenon (figure two), this trend is also occurring more broadly across global equity markets. While bankruptcies and mergers and acquisitions are in part responsible for the disappearance of some companies, there are also other forces at play.

At a peak 1996, there were over 8,000 publicly traded companies in the US…today there are approximately 4,300. It’s not that the US has 40 percent fewer companies than it did 30 years ago, its that companies are increasingly choosing to stay private[2]

The increasing drawbacks and distractions in going public, has coincided with tremendous growth in private capital allowing private businesses to remain private, and listed public companies to be delisted and become private once again.

With one of the main advantages of being a listed public company – i.e. a forum to raise capital – becoming more difficult to access for some market segments, many participants quite simply see fewer benefit of being public and choose to delist and become a private company once again[3]

Private companies

A private company can be a corporation, a limited liability company, a partnership, or a sole proprietorship, as long as the shares are privately held and not traded publicly. A private company may issue stock and have shareholders, however their shares do not trade on public exchanges and are not issued through an IPO.

While private companies tend to be synonymous with smaller to medium size businesses, there are some well-known big businesses that are private companies. Examples include: Mars, known for manufacturing confectionary and Visy, an Australian company established in Melbourne in 1948 that’s since grown to become one of the world’s largest paper, packaging and recycling companies. Private companies are commonly owned by founders, families or private equity firms.

Private companies owned and run by a family tend to prefer staying private and therefore maintain majority or sole ownership of the business. Figure three outlines some of the advantages and disadvantage to keeping a company private.

One of the major reasons a company stays private is that there are less onerous reporting requirements. While private companies must practice accurate and current accounting, they may not need to meet the stringent and complex accounting rules and standards applied to listed public companies, which can be a significant expense.

Companies don’t always need to go public to access capital. Private companies can access growth capital and growth debt/finance through private equity and venture channels, as well as bank financing and non-bank debt providers such as Business Development Companies (BDCs).

From the perspective of a private company business owner, they are able to access capital via a sophisticated capital partner (PE company), on terms which are directly negotiated, without necessarily having to be in the public spotlight and having to report to public shareholders every quarter. Having PE backing allows private companies to access capital as required, not just when public markets are doing well or have an appetite for capital raisings.

How many private companies are there?

World Bank data estimates that in 2018 there were close to 43,300 listed public companies globally, with India, USA, Japan, China and Canada having the most public companies on their respective stock exchanges[5].

While there is no aggregate data that accurately captures all private companies around the world, private companies vastly outnumber public companies globally. This has implications for investors; there are many great businesses not easily accessible to most investors, who are limited to investing via public exchanges or fund managers with access only to public companies.

The trend from public to private – and its implications for investors

The trend from public to private companies “is important because it changes the nature of an investor’s opportunity set. The companies that are listed on exchanges are bigger, older, and in more concentrated sectors than two decades ago. This likely contributes to [a view that] public markets are more informationally efficient than ever before”[6].

This trend is occurring across broader public markets; public companies continue to decrease relative to private companies (figure five). There is an argument and evidence to suggest this concentration of bigger companies in public markets, coupled with the trend toward passive investing, are greatly increasing the efficiencies of public markets.

“In 2017, new capital raised from private markets exceeded capital raised in public markets for the first time in US history. It was a development that went largely unnoticed, yet the implications are significant, wide ranging and ongoing. Indeed, it is becoming increasingly apparent that we are in the middle of one of the most profound shifts in the capital markets since the 19th century”[7]

Investors need to be aware that the public market pool they have traditionally invested within has changed over time and that they are potentially overlooking diversification options beyond publicly listed companies. Today, that means considering investing in a broader universe of quality companies, particularly private companies and private equity.

An additional consideration is the ‘growth’ opportunity investors may miss out on by not investing in private companies. Traditionally, a company would appear to have “made it” when the founders were able to ring the bell when listing in the public market via an IPO. Fast forward to today, and there has been a significant change in the investment landscape with companies staying private for much longer.

Companies that have remained private can focus on the growth of their business; this can have huge rewards for early-stage investors who can capitalise on growth valuations once the company lists on an exchange.

Today there are more institutions that want to invest in private companies, and changes in regulations have both made it more convenient to stay private and less convenient to go public. The reality is that the structure of the market has changed, and companies can afford to wait a lot longer to go public.

How companies raise capital

One of the major differences between private and public companies is the way they raise capital. The need for capital is not limited to establishing a business, most will need to raise or access capital as the company evolves, grows or transitions into new market segments.

Equity financing vs. debt financing: what’s the difference?

Once a company has decided it needs to source capital, it usually has two choices: debt or equity financing. The choice made will often depend upon which funding source is most easily accessible to the company. This is impacted by its cash flow, stage in its lifecycle, and the importance of maintaining control to its principal owners.

Most companies use a combination of debt and equity financing, as there are distinct advantages and disadvantages with each. Principal among them is that equity financing carries no repayment obligation and provides extra working capital that can be used to grow a business, however it does dilute existing equity ownership, which is often held by the founders.

Whereas with debt financing, the lender has no control over your business, but the business has to commit to regular repayment obligations; these may prove testing during times of economic stress or business specific headwinds where a company’s cashflow is adversely impacted.

Company lifecycle and funding

All companies start as an idea and, along the way, there will come points in the company’s lifecycle where access to capital is required. There are specific types of investors that can help companies each step of the way.

When a business first gets up and running, often it is the founders who will contribute their own capital to get things started. As time progresses and the company begins to grow and increase sales, it often needs to raise external capital funding to expand the businesses into new markets or locations, to invest in research and development, or to fend off the competition.

While companies do aim to use the profits from ongoing business operations to fund such projects, it is often more favourable to seek external lenders or investors. Despite all the differences among the thousands of companies in the world across various industry sectors, there’s only a few types of funding available to all firms (figure seven).

Funding a Start-up [FFF]: Friends and family members may want to support the business venture by lending or gifting funds to the business. In some cases, friends or family may want to invest or purchase an ownership interest in the business venture. This is the most basic form of crowdsource funding and is commonly called “friends, family and fools” rather than founders, friends and family [FFF].

Fools are grouped into this category because of the risk associated with lending or investing in a seed venture. Generally, these individuals are not sophisticated investors and there’s typically less due diligence involved in committing capital to the venture.[8]

Venture Capital: This is a form of private equity financing provided by venture capital firms or funds to start-up companies deemed to have high growth potential, or that have demonstrated high growth. Venture capital firms or funds, typically backed by high net wealth investors and institutions, invest in these early-stage companies in exchange for equity or an ownership stake. Venture capitalists take on the risk of financing start-ups in anticipation that some of the firms they support will become successful.

Venture capital may be attractive for new companies with limited operating history that are too small to raise capital in the public markets and have not reached the point where they are able to secure a bank loan or complete a debt offering[9].

Private Equity: PE typically refers to investment funds that buy and restructure companies that are not publicly traded. PE is an asset class comprised of equity securities and debt in operating companies that are not publicly traded on a stock exchange. However, the term has come to be used to describe the business of taking a company into private ownership to restructure it before selling it again at a hoped-for profit.

A private equity investment is generally made by a private equity or venture capital firm, each of which has its goals, preferences and investment strategies; however, all provide working capital to a target company to nurture expansion, new-product development, or a restructure of the company’s operations, management, or ownership[10].

IPO: An IPO refers to the process of offering shares of a private company to the public; this share issuance allows a company to raise capital from public investors. The transition from a private to a public company can be an important time for private investors to fully realise gains from their investment – investors in private companies are typically unable to easily ‘cash out’. Meanwhile, it also allows public investors to participate in future growth of the business.

A company planning an IPO will typically select an underwriter or underwriters. They will also choose an exchange in which the shares will be issued and subsequently traded publicly[11].

Why might a company benefit from having a private equity partner?

Whether a company is private or public, it’s possible that any business can come to a junction in its journey where current management might simply not have the specific skills or knowledge to successfully pilot the company going forward or to tackle the next phase of growth. A private equity partner does not simply provide funding; it can provide a range of experience and expertise.

PE managers have become more specialised, with firms often focused on specific industries, sectors or aspects of the businesses lifecycle. Often PE firms will have capability and knowledge of specific industries, operational experience, financial modelling and analytical skill, insight into how businesses are performing and understand how management interventions could help the business grow.

PE firms also bring the ability to research markets, competition and customers, all of which benefits the strategic direction of the company they are backing. For the company, it means a better business model and improved revenues and profits. For the PE manager, it means generating a meaningful return on invested capital when they choose to realise their stake in the business.

The role of private equity in investor portfolios

When used as part of a diversified portfolio, PE provides diversification benefits by providing investors with exposure to an investment universe that sits outside of the types of businesses that underlay the traditional asset class options. For example, companies in the earlier stages of their growth lifecycle that are private companies not listed on public stock exchanges. Noting that an increased number of companies are staying private for longer, advisers should consider how their clients can access that growth opportunity.

There are also sectors and regions where PE is able to provide better access to investment opportunities relative to listed equity markets – for example, industries such as consumer facing businesses, healthcare and information technology.

As well diversification benefits and growth opportunities, there is the attractive return profile that PE has demonstrated over many years relative to public equity returns. The PE model typically provides a superior governance and ownership model, which allows the PE managers to take a genuine and strategic long-term view to execute on value creation and maximise returns on capital for PE fund investors.

Access to PE investing has evolved over many years, particularly as an increased number of investors develop interest in this asset class. Many investors don’t have the capacity to own illiquid, long term PE investments, or the capital required to meet the minimum investment levels for PE opportunities. This has resulted in the notable growth in the LPE universe. Publicly traded entities that invest in privately held businesses and PE backed listed companies are an attractive gateway for a broader range of investors to access the diversification and risk/reward characteristics of PE. LPE securities are liquid, regulated, diversified, and easily investable[12].

 

Take the FAAA accredited quiz to earn 0.5 CPD hour:

CPD Quiz

The following CPD quiz is accredited by the FAAA at 0.5 hour.

Legislated CPD Area: Technical Competence (0.5 hrs)

ASIC Knowledge Requirements: Securities (0.5 hrs)

 

———-
Notes:
[1] Investopedia, Initial Public Offering (IPO), 2019
[2] https://edition.cnn.com/2024/04/09/investing/premarket-stocks-trading/index.html
[3] Investopedia, Why Companies Stay Private, 2019
[4] Crystal Vogt on Chron, The Advantages of Being a Private Company, 2019
[5] The Global Economy, Listed Companies – Country Rankings
[6] Mauboussain, Callahan & Majd, The Incredible Shrinking Universe of Stocks, 2017
[7] EY, A New Equilibrium, 2019
[8] The Business Professor, Funding from friends family and fools, 2015
[9] Investopedia, Venture Capital, 2020
[10] truCrowd, Private Equity Financing, 2016
[11] Investopedia, Initial Public Offering (IPO), 2019
[12]  JANA Investment Advisers Pty Ltd, MyConsultant, 2016
Important information: While every care has been taken in the preparation of this document, neither Barwon Investment Partners Pty Limited ABN 19 116 012 009 AFSL 298445 nor PAN-Tribal Asset Management Pty Limited ABN 35 600 756 41 AFSL 462065 make any representation as to the accuracy or completeness of any statement in it, including without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document has been prepared for use by sophisticated investors and investment professionals only and is solely for the use of the party to whom it is provided.

You must be logged in to post or view comments.