What is the point of the equity market?
The number of listed companies has collapsed in many parts of the world as companies increasingly reject public markets. This has serious implications.
Equity markets are part of our financial plumbing. We take them for granted. But rarely do we step back and ask what they’re really there for. Principally to allow companies to raise money to finance future growth? While that once was true, it no longer is. The number of US listed companies has shrunk by around half over the past 20 years, and our analysis find a similar collapse in the UK and parts of Western Europe. Declining appetite for IPOs and consistently higher numbers of companies delisting (mainly due to mergers and acquisitions) are to blame.
However, it is not all bad news. This is not a sign of a lack of entrepreneurialism. New companies continue to be created in reassuring numbers. It is, however, evidence that companies are choosing to finance themselves differently. Cheap debt and more accessible and scalable private equity markets have both taken market share. Public markets now need private equity as a source of IPOs far more than private equity needs the public market for an exit.
Companies have also been put off by the cost and hassle of public listing. These have grown considerably relative to private markets. Regulation and short termism both weigh down heavily.
Put simply, financing needs can be met more cheaply and easily by other sources, without much of the baggage that comes with a public listing. Those companies that do list are tending to be more mature businesses, meaning investors miss out on the higher growth that occurs earlier.
But, not all public markets have struggled to attract companies. Some have thrived. Emerging markets have fared far better than developed, driven by buoyant growth in emerging Asia and Europe. China comes out on top by some way. Stockmarkets in developed Asia have also expanded. In these markets, the benefits appear still to outweigh the costs.
Furthermore, although equity markets may no longer be fulfilling their initial purpose on a widespread basis, they continue to serve a number of highly important functions.
Existing listed companies are active users of their ability to raise new equity. Since 2001, there have been, on average, four times as many secondary fundraisings as IPOs in the US. Similar patterns are seen elsewhere, even in in hot IPO markets like China.
Existing listed companies also commonly use equity to incentivise employees at all levels of an organisation. If structured appropriately, this can have long term benefits.
Around 30% of global mergers and acquisitions were also at least partly financed with equity in 2017, although this is a far cry from the 70% of the second half of the 1990s. Equity markets also provide liquidity and exit opportunities for investors.
A question that lingers is whether the decline in appetite for a listing in some regions matters? We feel strongly that the answer is yes. The listing requirements for public companies, arduous as they may be, raise standards of corporate governance. This has wider social and economic benefits.
Public equity markets, via active investors, also contribute to efficient allocation of capital. Struggling companies are marked down in a transparent and orderly manner. This process of creative destruction is essential for a healthily functioning economy. Debt markets play a contrasting role. The temptation to amend and extend debt terms to avoid recognition of losses is strong. While equity markets can contribute to efficient capital allocation, debt markets have a history of doing the opposite.
However, in a world where companies place less value on a stock market listing to raise growth finance, their economic benefit is clearly diminished. The responsibility of maintaining the economic value of the public market now falls squarely on asset owners and managers. Effective stewardship has never been more important.
A further reason why we believe that the decline in appetite for a stock market listing matters is because of the impact on savers. Public equity markets represent the cheapest and most accessible way that savers can participate in the growth of the corporate sector. However, 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. If high-quality companies find little reason to go public, then the risk is that over time the quality of the public markets deteriorates. Returns from public equity markets in aggregate could move structurally lower relative to private markets. Savers would be the biggest losers. It is our responsibility, as active investors, to do all we can to help our investors achieve their goals and navigate any such changes in the market environment.
Where able, investors will need to broaden their scope and embrace private assets to avoid missing out. A more holistic approach, where public and private market exposures sit alongside each other, is likely to be more appropriate.
However, this does not mean that investors, managers, companies, regulators and politicians are relieved from their responsibility of ensuring that public markets retain their crucial role in the proper functioning of capitalist economies.
Our full research paper can be found below.