How the stock market’s fading status could increase social inequality
The public stock market was once the place all companies aspired to be. However, it has been steadily losing its allure for more than two decades now.
Newspaper headlines such as “the incredible shrinking stock market” and “quarterly capitalism’ takes its toll on public markets” attest to the fact that, rather than being associated with “blue chip” status and a badge of honour, the stock market is increasingly being shunned and viewed with disdain.
Companies such as Uber, Lyft and Airbnb are putting off an IPO for much longer than would have been the case in the past. Many others are choosing to stay private indefinitely - the number of Unicorns (private companies worth more than $1 billion) has been increasing at a rapid rate.
Inevitably, most attention has focused on the US, given that it makes up over half of the global stock market by capitalisation. In the US there has been a savage near-50% decline in the number of public companies since the mid-1990s.
However, what is often missed is that this is not exclusive to the US. As our research has found, the UK main market has haemorrhaged an even larger proportion of its companies (-57%) and large parts of Western Europe have also fallen by the wayside this millennium. It is also not solely a developed market problem. Latin America is similarly afflicted.
Why is the stock market losing its appeal to companies?
The increased cost, regulatory burden and perceived hassle of being a public company have all played a part. Just as Usain Bolt would have been unlikely to set world records if he ran wearing a backpack full of rocks, many companies perceive the public market to hold them back. Being a director of a public company also isn’t much fun - just ask Elon Musk.
In addition, with debt cheap and private equity capital plentiful, there has been less need for companies to put themselves through the ringer in order to raise capital.
Prior to its 2004 initial public offering, Google had only raised $25 million in private capital. In contrast, Ant Financial, the Chinese online payments services provider, raised $14 billion privately last year alone. Would public market investors have had the chance to buy into Google at such an early stage of its development today? Unlikely.
Why this matters to retail investors
This gets to the crux of the problem. The public market is a cheap, easily accessible way for ordinary savers to participate in the growth of the corporate sector. Private equity is simply too expensive and inaccessible for most individuals. Sadly, their plight has been forgotten amid much of this debate. Rather than being a mere curiosity or subject for discussion among financial circles (industry navel-gazing?), this really matters.
With companies choosing to stay private for longer, investors who focus solely on public markets will miss out on an increasingly large part of the economy. Moreover, many of these companies are in high-growth disruptive industries. If high quality companies find little reason to go public, then the risk is that over time the quality of the public markets deteriorates. Should this occur, returns from public stock markets could shift lower relative to private markets.
Taken to its extreme, the “haves”(and this includes those in defined benefit pension plans, who often have exposure to private equity) will be able to harvest higher returns from investing across the public and private space but the “have-nots” (and this includes those in defined contribution pension plans) will be left behind. Cost, accessibility, illiquidity and, at least in the US, litigation risk, all play a part. It does not take too much of a leap of the imagination to see that this could contribute to widening inequality.
Three steps that need to be taken
So what is to be done? Three things.
1. Address the regulation disparity.
First, the disparity between public and private company regulation needs to be addressed.
A 2015 study found that the average number of words in a US public company’s filing of its annual results doubled between 1993 and 2014. With the median filing then comprising almost 50,000 words, I doubt that anyone other than the lawyers paid to sign off on them would have read them in their entirety. Regulatory filings have become longer, less readable, less specific, more boilerplate and, arguably, less useful.
Tolstoy-esque length reports are unfortunately a common feature across much of the world. The relative success of lighter-touch regulatory environments shows that moves to lighten this load can support demand for a public listing. Since 2012, 87% of all US IPOs have taken advantage of more relaxed requirements for so-called emerging growth companies, and the fall in UK public companies looks a lot less severe if the junior Alternative Investment Market is taken into account.
However, simply cutting red tape for public companies should only be part of the solution. There may also be a need for movement in the other direction, in how private companies and investors are regulated. One obvious step would be a beefed-up stewardship code for private equity, as exists for public markets. This is something the Financial Reporting Council is already looking at in the UK. Another would be more consistent application of regulations regarding the need to audit and disclose financial results. It is, at a minimum, a curious feature that private companies in the US and Canada essentially face no financial reporting regulation at all. Some of the largest companies in the US are private but do not disclose any financial results. In addition, most medium to large companies do not produce audited statements. This leads to a very uneven playing field compared with public companies and is at odds with the situation in many other markets. Current regulations give US private companies an informational advantage over US public companies and many of their international public and private competitors.
2. Shake-up the IPO process
Second, the IPO process itself is ripe for innovation. The process of investment bankers charging a hefty fee to market companies to prospective investors and underwrite an offering has barely changed in half a century. Average underwriter fees alone are around 7% of the amount raised in the US.
Innovations by Spotify and Slack to circumvent the traditional approach and cut out the underwriter entirely are one reaction to this. Despite doom-mongering, both listings went off without a hitch. Their success could and should spur imitators and innovators. Technology should also be able to cut costs from the process. Matching buyers and sellers in an auction is a “bread and butter” technology challenge. Underwriters are likely to find it increasingly hard to justify their current fees.
3. Democratise private assets
Third, our industry has to find a way to democratise access to private assets. This is not without challenge.
In recent days, Governor of the Bank of England, Mark Carney has been most vocal in arguing that funds that invest in private assets but offer instant liquidity are “built on a lie”. His point is that investors may find they are unable to get their money out, on-demand, as easily as they think. But that should not be used as a reason to prevent ordinary investors from accessing private assets. Semi-liquid funds, which offer periodic liquidity, rather than instant access, offer one potential solution.
If, we fail to crack this nut, we are conceding defeat to the inevitability of rising inequality.