A Smaller Public Market Creates More Opportunity For Private Investment
In the past, going public was the sign of a successful company. Completing an initial public offering (IPO) signaled stability and growth potential. Today, this conventional wisdom seems out of date….
In the past, going public was the sign of a successful company. Completing an initial public offering (IPO) signaled stability and growth potential. Today, this conventional wisdom seems out of date. The number of IPOs during the past 16 years (2001-2016) amounts to just 75% of the public offerings during only four years prior (1996-2000). Not surprisingly, the number of public companies on U.S. exchanges has shrunk by 37% since 2000. While this trend may limit opportunities for stock investors, it creates more prospects for private capital.
The Shrinking Public Market
Despite market capitalization tripling between 1996 and 2016, the number of companies issuing stock on U.S. exchanges shrank during the same period. Chart 1 shows that the number of listed companies shrank significantly to 4,331 in 2016 from 8,090 in 1996. This decline is partly due to fewer companies going public each year. 2014 saw 244 IPOs, the highest annual amount in the last decade. This figure compares to 445 IPOs in 2000 and over 800 in 1996 [Chart 2].
Chart 1: Number of Public Companies in the U.S. (1996-2016)
Source: The World Bank, World Federation of Exchanges database
Chart 2: Number of IPOs on U.S. Exchanges (1996-2016)
Source: WilmerHale, 2017 IPO Report, 2017
The drop in annual IPOs coincided with the end of the 1990s tech boom. Many analysts blame this sustained decline on increased regulation after the implementation of the Sarbanes-Oxley Act (2002), which increased public companies’ cost of compliance. In addition, many companies believe that they need significant scope to be successful after going public. Research shows that smaller companies that have gone public on average become less profitable after an IPO.
PE’s Growing Interest in Tech
Pursuing innovation as a public company can also be more difficult than as a private company. Stanford professor, Shai Bernstein, argues that innovation quality declines after companies go public. Private companies are free from stock market pressures, which may hamper risk-taking and restrict the patience required to develop new technologies.
Chart 3: Private Equity Investment in Technology Companies (2006-2017)
Source: Pitchbook
Technology companies’ preference to stay private provides an opportunity for private equity firms. Between 2006 and 2016, annual PE investment in IT-related companies increased from $48 billion to $149 billion [Chart 3]. Large tech deals are driving investment volumes. Examples include Michael Dell and Silver Lake’s acquisition of Dell Technologies in 2013 for $24.9B in public-to-private MBO and Apollo’s take private acquisition of Rackspace in 2016 for $4 billion.
Private equity has shown a particular interest in software companies. From 2006 to August 2017, software investments received almost half of private equity investments. In 2016, three of the top five software deals were take-private transactions: EMC (by Dell and Silver Lake), Qlik Technologies (by Thoma Bravo), and Marketo (by Vista).
Chart 4: Private Equity IT Investments by Sector, $billion (2006- 2017)
Source: PitchBook
Venture Capital: Competing or Complementary?
Not only are larger tech firms looking at the benefits of becoming private companies, but smaller venture-backed companies are seeking private equity funding to extend the runway to exit. With currently 267 “unicorns”, i.e., VC-backed companies valued at $1 billion or more, either the company must grow organically to become IPO-ready, or look to larger investors for additional infusions of capital. Whereas ten years ago, Series C and D, i.e., the third and fourth round of venture capital, was described as late stage, today Series F and G rounds are quite common.
Chart 5: Private Equity Investments in Venture-Backed Companies, ($B)
Examples of private equity-backed companies that were originally venture-backed include Chewy, Active Network, and Calabrio.
- Chewy, an online retail platform for pet products, was purchased by PetSmart via its private investment sponsors to integrate the e-commerce expertise of Chewy into PetSmart operations. This $3.35 billion leveraged buyout comes less than a year after the company received $75 million in venture funding.
- Active Network, a company that provides activity and management services data technology and software, recently announced a sale by its private equity backers, Apollo Investment and Vista Equity Partners, to Global Payments. Apollo Investment and Vista Equity Partners took Active Network private in 2013 in a $1 billion leveraged buyout. In 2008 the company raised $80 million in a Series F round of venture funding and went public in 2011.
- Calabrio, a software provider for customer interaction and workforce optimization, was acquired by KKR in 2016 for $200 million. This transaction served as an exit for the venture funds that invested in 2007 and 2008.
Connecting the dots on these trends illustrates the growing opportunity for investment in a more diverse set of private companies than even ten years ago. Private and public companies alike are seeking private equity investment for both the injection of capital and fund managers’ expertise that drives innovation. Private equity firms are raising more capital than ever before, which is the biggest indication that their is industry optimism that this trend will continue.
