Both institutional investors and the issuers of securities have been migrating to private markets in the last two decades. The average ultra-high-net-worth individual now has 54% of his or her assets invested in private equity, and public pension funds have been allocating an ever-greater portion of their portfolios to VC and other illiquid investments.
Fundraising by private equity and venture capital firms has been strong, and initial public offerings (IPOs) have lagged. The average size of an IPO has declined, as has the number of companies going public each year. As reported in a Harvard analysis, the average annual number of IPOs fell by over 61% between the 1990s and the 2000s.
This is particularly true in today’s volatile market conditions, which have seen an 82.5% year-over-year decline in the number of IPOs completed in the second quarter of 2022, according to FactSet data. This isn’t a new trend, either. In 2017, companies raised $3 trillion in private markets, compared to just $1.5 trillion in public markets, according to Milken Institute.
Increasing regulation of public markets
An IPO requires a cost-benefit analysis for any company, and the costs have risen since the 1990s. One of the most significant regulatory changes that have increased costs and discouraged IPOs is the Sarbanes-Oxley Act (SOX), passed in 2002 in response to corporate scandals such as Enron and WorldCom.
SOX requires companies to disclose significant amounts of financial information and establish more robust internal controls. The compliance costs for SOX are substantial, particularly for small and mid-sized companies. A 2006 analysis showed that Section 404 prices averaged $8.5 million for larger firms and $1.2 million for smaller companies with a market capitalization of under $700 million.
In addition, the Department of Justice (DOJ) and Federal Trade Commission (FTC), which review mergers, have been accommodating to acquirers in recent decades. This has led to increased consolidation in many industries, as companies can realize significant synergies by combining operations.
The result of all these factors is that companies are increasingly choosing to remain private for extended periods. In the tech sector, for instance, the average age of a newly public company grew from 4.5 years in 1999 to over 12 in 2020. High-growth companies, in particular, are choosing to stay private. There are just 2,800 public companies with annual revenues over $100 million, compared to 18,000 private firms of that size.
Increasingly accommodating regulation of private markets
At the same time that public markets have become more difficult and expensive to access, private markets have become increasingly accommodating. There’s a nearly century-long history of legislators creating a favorable environment for companies to raise private capital.
One key development has been the increasing use of Regulation D of the Securities Act of 1933, which exempts companies from registering their securities with the SEC. This exemption has been used more and more by companies looking to raise capital in private placements.
Further, the Small Business Investment Act of 1958 made venture capital increasingly accessible to small businesses, while the Economic Recovery Tax Act of 1981 lowered the capital gains tax rate, making it more attractive for investors to put money into riskier ventures. Rule 144A of the Securities Act, enacted in 1990, also made it easier for companies to raise capital in the private markets.
The JOBS Act of 2012 was perhaps the most significant legislation for private markets in recent years. The act increased the amount of money that could be raised in a Regulation D offering from $5 million to $50 million and also created a new category of “emerging growth companies” that are exempt from specific Sarbanes-Oxley requirements.
In 2017, the Amendment to Rule 504 of Regulation D provided an exemption from securities registration requirements for specific offerings, making it easier for companies to raise capital from investors. And in 2020, the Information Letter under ERISA allowed defined contribution plans to offer private equity as an investment option, which opens up a whole new pool of potential investors.
These regulations are just a tiny sampling of the many that have created a more favorable environment for private markets. As a result of these and other changes, companies are increasingly choosing to remain private for more extended periods and going public when they’re ready.
Growing private markets; waning public markets
The result of these regulatory changes is that private markets have been growing at the expense of public needs. Of course, legislation isn’t the only reason for this shift or the primary.
Other factors include rising investor demand for higher-return investments, particularly in light of high inflation and low bond yields; the emergence of large, sophisticated private equity firms that can provide the capital companies need to stay private; and the increasing use of technology, which has made it easier for companies to remain secret for more extended periods.
Whatever the reasons, the trend is clear. At the beginning of the century, there were 7,810 publicly listed companies, compared to just 4,814 by the end of 2020. Thousands of firms, and trillions of dollars, are leaving public markets in favor of private ones.
The drivers underlying this trend are likely to continue, meaning we can expect the shift from public to private markets to accelerate in the years ahead. As economists forecast a prolonged economic downturn, IPOs will likely decline. In addition, sophisticated private equity firms will be well-positioned to take advantage of opportunities in the distressed market.
The result is that investors sticking to the traditional 60-40 portfolio split between stocks and bonds are likely to find that their portfolios are increasingly lagging behind the performance of those with a greater allocation to alternative investments. For many investors, the question isn’t whether to invest in private markets but how.
Private equity funds often come with $25 million minimum investment requirements, which can be prohibitive for smaller investors. These access-constricted investments have been the primary drivers of private market returns over the past several years. Still, most investors are priced out without the network, knowledge, and deep pockets.
Gridline is one solution that provides access to a curated selection of professionally managed alternative investment funds. Historically, these opportunities have been available only to sophisticated family offices and endowments. Gridline enables individual investors to gain diversified exposure to non-public assets with lower capital minimums, lower fees, and greater liquidity.