The number of listed companies in the U.S. has decreased substantially over the last 20+ years. Given our vantage point in the world of venture capital, our team sought to determine how the changing financial market is impacting our industry, and what it may mean for venture-backed companies, fund managers and their investors.
What is going on in the Public Equity Market?
According to Credit Suisse, in 1996 there were 7,322 listed companies. By 2016, that number had dropped to nearly half of the 1996 level, to 3,671 listed companies, and the phenomenon continues. Typically, one or more of the following scenarios could drive this change: 1) a declining number of initial public offerings (“IPOs”) (e.g., companies foregoing an IPO to remain private and/or pursuing liquidity via merger or acquisition (“M&A”) instead), 2) companies delisting voluntarily (e.g., going private or merging with another company), or 3) companies delisting involuntarily (e.g., removed for cause or closing down all together). Interestingly in this case, the correct answer is all of the above.
Figure 1: New Listings vs. Delisting Firms from 1976 to 2016.
Digging a bit deeper here, we can see a few factors at play, as outlined in Figure 1 above: new listings are outpaced by delists, primarily consisting of smaller firms, both voluntarily via M&A or involuntarily following the dotcom bubble of the early 2000s. Further, per Figure 2 below, since 2003, there have been more large-firm IPOs than smaller ones in all but one year, but even the number of larger IPOs is decreasing in recent years.
Figure 2: New IPOs by Size
So why is this happening? We believe the data suggests that eligible companies do not see a net benefit in listing via an IPO when compared to the other options available to them.
First and foremost, there is a growing amount of private capital available. From 1996 to 2016, venture capital assets under management rose from $4B to $333B. In 2017 we saw another spike with the establishment of the SoftBank Vision Fund, a new $100B vehicle. Today, one can observe traditional, growth stage venture managers raising larger funds to remain competitive in this environment. Hedge funds and mutual funds have been for several years looking for deal flow upstream as well. All in, private assets under management totaled less than $1 trillion in 2000, but surpassed $5 trillion in 2017. Clearly, an IPO is no longer the only method to raise capital.
Consequently, the increase in private capital has led to the rise of the “mega round,” effectively a “private IPO,” defined as a capital raise of $100M or more. Figure 3 highlights the increasing frequency with which these larger financings are occurring.
Source: Nasdaq Private Markets, ThomsonOne, and Pitchbook NVCA Venture Monitor.
Figure 3: The Rise of “Mega Rounds”
Amplifying the situation are the growing benefits to companies from remaining private. First, the cost of going public continues to rise despite initiatives to simplify the process, making it also increasingly less attractive for small- to medium-sized companies to list. Leading accounting firm PwC stated:
Based on the public registration statements of 315 companies, on average, companies incur an underwriter fee equal to 4-7% of gross proceeds, plus an additional $4.2 million of offering costs directly attributable to the IPO. Legal and Accounting fees also add up and can increase significantly for larger companies that may face additional complexities in preparing for an IPO…In addition to the costs associated with going public—the offering and incremental organizational costs— there are significant expenses related to the process of being public…Two thirds of CFOs surveyed [by PWC] estimated spending between $1M and $1.9M annually on the costs of being public.
Second, once listed, companies must succumb to the short-term focus of the public markets, often influencing management teams to sacrifice long-term growth opportunities to meet quarterly performance targets. For example, a recent McKinsey survey of over 1,000 executives found that 61% percent of respondents polled would cut discretionary spending to avoid risking an earnings miss. This short-termism can lead to underperformance as well, as McKinsey also found that companies that invested heavily into research and development (“R&D”) and focused on long-term growth initiatives meaningfully outperformed their peers, generating 47% more revenue and 59% higher earnings. Remaining private enables a company to focus on the long-term success of the business.
Third, regulatory issues may also factor into companies’ desire to remain private. A Vanguard report on the subject touches on some of them:
Loosening regulation on the private market has allowed private companies to garner benefits usually enjoyed by public companies. For example, Rule 504 of Regulation D adopted by the [Securities and Exchange Commission (“SEC”)] in 1982 provided an exemption for certain types of investors to invest in the private market. Since then, however, the exemption has allowed a growing number of individual investors to participate in the private market. Liquidity in private securities has increased in part because the adoption of SEC Rule 144A facilitated the resale of private securities, and the emergence of exchanges catering to private company investors allows investors to trade their shares. Also, the JOBS Act increased the cap—from 500 to 2,000—on the number of shareholders that requires companies to go public, thus allowing private companies to broaden their investor base.
Two additional potential regulatory deterrents to going public are Regulation Full Disclosure (“Reg FD”), enacted in 2000, and the 2003 Global Analyst Research Settlement. Reg FD “provides that when an issuer, or person acting on its behalf, discloses material nonpublic information to certain enumerated persons…it must make public disclosure of that information.” While the intended effect of the rule was to provide all investors equal access to any material information about a public company, the disclosure requirements created challenges for smaller companies that may be faced with high costs to meet the mandated compliance procedures, and as a result exposed them to potential liabilities if those requirements were not met. Separately, the Global Analyst Research Settlement, which addressed “alleged conflicts of interest between investment banking and securities research at brokerage firms,” unintentionally furthered the challenges for smaller public companies, increasing “the compliance burden on investment banks providing sell-side coverage of stocks, making research a less attractive business, and likely exacerbated low levels of coverage on small-cap stocks.” Together, the increased cost to comply with these regulations as well as the diminished economics of sell-side research coverage combine to create additional areas of concern for small to medium sized business. If you’re a more modestly-sized company looking at your options, perhaps you’ll bypass the public markets all together until you’re a larger company that can better navigate these challenges and command more attention from analysts.
Not surprisingly, as a consequence of all of the above, not only has the average age of a company seeking to go public increased, but the proportion of venture-backed company exits via IPOs has decreased. Specifically, from 1976 to 1996, the median age of a company seeking a new listing was 7.8 years, whereas from 1997 to 2016 it was 10.7 years. Further, as of 2017, just 15% of venture-backed exits were IPOs, down dramatically from 89% in 1985 and even 39% in 2000. This is illustrated in Figure 4 below. We’ve observed this market shift firsthand, from Greenspring Associates’ founding in 2000 to today, nearly two decades later.
Figure 4: Venture-Backed Company Exit Activity 1985-2017
What are the Consequences for Venture Capital?
In the short term, we believe some of these dynamics are good for the venture capital industry. First, for larger, likely more mature, venture-backed companies, IPOs will remain a viable option. The number of venture-backed companies going public has actually increased in recent years: in 2018, 87 venture-backed companies went public in the U.S., up from 61 companies in 2017 and 42 companies in 2016. But fewer public companies overall means more investor concentration in the public market, which can be good news for those venture-backed companies that do pursue an IPO; traditional public market investors are clamoring for new, good ideas that launch with a decent market cap, and the growth opportunities presented by venture-backed companies are attractive. We observe this even when valuations are “high;” the public market investors appear willing to let companies grow into their valuations as a tradeoff to be able to invest in them at all. The 10-year bull market impacts this dynamic as well, of course.
Secondly, the growth of the private markets, including those public market investors that are dipping into private equity, provides an immense amount of capital available for those venture-backed companies that remain private. Mature venture-backed companies can raise the aforementioned “mega rounds,” allowing them to avoid the additional cost and regulation that they may otherwise encounter if they pursued an IPO. Additionally, the growth of the private market overall also means more private equity dollars are available for potential acquisitions.
This situation isn’t without challenges in the near term, however. With more public investors such as mutual funds and hedge funds playing upstream in the private markets for deal flow, the world of late-stage investing, specifically for those entities financing the “mega rounds” and “private IPOs,” will become more competitive. For example, “26 mutual funds had $11.5B invested in late-stage venture companies as of mid-year 2016, and the bulk of that investment, $8.1B of the $11.5B, came from Fidelity, T. Rowe Price and Wellington…The head of global capital markets at Fidelity has suggested that the pre-IPO market has become the IPO market of the past.”
It does not end there – one must consider the longer-term perspective as well. We feel the financial markets must evolve to provide for a more attractive mechanism for small- to medium-sized venture-backed (and otherwise) companies to list; for all of the reasons discussed above, the current construct is unfavorable for those companies. While it is true that the vast majority of venture capital outcomes are acquisitions, it is still helpful for businesses to have an IPO as a viable option, even when that business is of a more modest size.
Fortunately, we have seen recent advancements on this front. First, in July, 2018, “lawmakers in the House of Representatives introduced a proposal to study the problem of high IPO fees for companies with less than $1 billion in revenue” [3,12] - which we hope will result in more reasonable fees for small- to medium-sized companies that generally have less negotiating power when pursuing a listing. Secondly, just this month we saw the SEC approve the Long Term Stock Exchange (“LTSE”), a new exchange option for companies to consider when contemplating listing. While the exchange is not yet live and the construct is still under SEC review, “the broad goals of the new exchange are to shift incentives away from the quarterly grind and more towards long-term value creation.” While these developments are encouraging, they are by no means a comprehensive solution.
In the near term, we believe that the IPO market will remain a useful tool for venture-backed companies, but for increasingly more mature companies, both in terms of age and market cap, than in the past. The greater amount of private downstream capital available will allow venture-backed companies to remain private longer, generating more value outside of the public markets.
Venture capital remains an outliers business, with a very large difference between the best performing funds and the worst. For the venture managers that we support and for our own expansion stage direct investment strategy, the task remains the same – identify the outliers and invest in them in a meaningful way to impact fund-level returns. It’s the power law distribution of returns in venture capital: you not only need to win, but win the most from the winners.
Given the above dynamics, as companies are staying private longer, the unprecedented value creation by the top performing private companies is being captured by venture funds and other private investors, bringing incredible returns to their limited partners. Investors who do not have access to venture capital are missing this opportunity. Therefore, while top quartile venture has historically outperformed other asset classes, we believe venture exposure is more important than ever today, as venture funds will capture more value in their companies at the expense of public equity managers.
That being said, we cannot ignore the long-term implications of the changing financial markets. “The decline in IPOs has continued through several economic cycles and has also disproportionately affected smaller startups that might want—or need—to sell shares in the public markets…[A] variety of different factors have played roles, from fundamental shifts in the structure of capital markets and investing, to successive waves of re-regulation that have washed over public companies.” There is value in independence, and it is critical that we identify a better mechanism for small- to medium-sized companies to go public to provide greater optionality for them – critical not only to the integrity of the U.S. public equity market, but also to support the virtuous cycle of the venture capital industry: the flow of capital from Limited Partner to General Partner to venture-backed company, and back again in the form of returns.