If you set out to design a public capital market that holds little appeal for business leaders, you would be hard pressed to do better than — or, I should say, worse than — the U.S. stock market.
Public markets have become the domain of activist investors, high-frequency traders, quants and hedge funds that measure success in 12-week increments or less. The focus on short-term returns among such investors pushes public companies to also prioritize short-term tactics, such as buying back stock or managing earnings to meet analysts’ quarterly expectations.
This mindset may reward shareholders quickly, but it often does so at the expense of investments in things like innovation, human capital and sustainability that pay off over years.
Not surprisingly, most companies would prefer to invest in things that create long-term value, and so many are choosing to remain private longer. Roughly 4,300 companies were listed on U.S. stock exchanges at the end of 2017, nearly half as many as 20 years earlier.
And the companies that do go public tend to wait until later in their life cycles, which means that Main Street investors who do not have access to private equity or venture capital miss out on much of the value creation that happens while companies are still privately held. The same goes for companies’ employees, who in many cases are waiting for their firms to go public to realize the value of stock that provided the bulk of their compensation.
With companies remaining private longer, the big long-term investors, such as pensions and endowments, have been shifting their portfolios toward alternative and illiquid asset classes. Between 2005 and 2015, the share of public pension portfolios allocated to alternative assets such as private equity, venture capital and real estate more than doubled (to 24% from 9%). That leaves private markets flush with capital, which reinforces their appeal for founders and business leaders.
Understanding the trade-off
The opportunity (and refuge) that private markets offer companies actually creates new and serious problems for long-term investors and, indeed, for capitalism. Compared with public markets, the rise of private markets brings with it the cost of greater inefficiencies and opacities.
As Eduard van Gelderen and I argue in a newly published paper, the rise of private-market investing can disadvantage pensions and endowments that were organized to invest in public capital markets and may find themselves at a disadvantage in terms of insights, skills and access to deals compared with providers to whom they entrust their private-market portfolios.
The illiquidity of private assets also threatens to exacerbate plunges in the prices of public stocks and bonds if a financial crisis forces pension funds to sell assets quickly and draw those assets primarily from public assets, Mark Machin, the president and CEO of the Canada Pension Plan Investment Board, warned recently.
Among the biggest beneficiaries of the migration to private markets is Wall Street. Pension funds like the California Public Employees Retirement System and the California State Teachers Retirement System that used to be able to build portfolios of public companies at low cost now pay upward of “2 and 20” for a similar portfolio in the private market.
This shift also increases their reliance on financial intermediaries. You are twice as likely to become a billionaire today by setting up an asset management firm that manages pension money than you are if you create a technology company.
Of course, pension fund managers are starting to realize just how much this shift costs them and, by extension, the millions of workers who count on them for income in retirement.
A number of large public plans are engineering approaches to private markets that aim to lower fees and increase alignment. For example, a year ago the United Kingdom’s Railpen, the Public Institution for Social Security of Kuwait, Wafra, and the Alaska Permanent Fund launched a joint venture called Constellation Capital to seed new private equity managers and align the interests of long-term investors and private-market managers.
These are important and necessary steps for private market investors, but these and efforts like them are ultimately Band-Aids on a bigger problem, which is the dysfunction of public markets. If public markets became less of a burden, companies would want to list earlier and grow. Public pension funds could pursue the returns they need in more cost-effective ways without enriching financial intermediaries.
That’s why I’ve signed on to work at LTSE, which is working to transform the public company experience by aligning the world of large institutional investors — my area of expertise — with companies that aim to build their businesses over years and decades.
LTSE is designed to connect the institutions that have long-term oriented capital with the visionary companies that need it, in a public capital market that works for the benefit of all participants.