Podcast Summary
The shift from public to private markets: The number of public companies has been shrinking due to private markets, with factors including IPOs, venture capital, buyouts, and mergers and acquisitions driving this trend. Understanding this shift provides valuable insights for investors.
The shift from public to private markets over the last several decades is a significant trend in the world of investing. Michael Mauboussin, the head of Consilient Research at Counterpoint Global, explores this topic in his latest paper. The motivation behind the paper comes from the observation that the number of public companies has been shrinking, and this trend is largely driven by the private market. IPOs, venture capital, buyouts, and mergers and acquisitions all play a role in this transition. Additionally, Mauboussin wanted to gain a clearer understanding of the current landscape and the factors that led to this shift. Overall, the paper provides valuable insights into the reasons for this trend and what it means for investors. If you're interested in learning more, I encourage you to read Mauboussin's paper, which will be linked in the show notes.
The Importance of Understanding Private Markets: The private markets, specifically buyouts and venture capital, have grown significantly in size and importance, with $1.85 trillion in assets combined. Fewer IPOs and a shift towards sales as exit strategy have made understanding these markets crucial for investors.
While public markets remain the largest asset class in the financial industry, with a market cap of $38 trillion, the private markets, specifically buyouts and venture capital, have grown significantly in size and importance. The US buyout industry manages $1.4 trillion in assets, and the US venture capital industry manages $450 billion. However, even the largest venture capital funds, like Benchmark, are not large enough to move the needle for large institutions. The history of the industry shows that there have been fewer IPOs since the dotcom bubble, with an average of 115 per year from 2001 to 2019 compared to the 280 per year from the mid-1970s to 2000. Additionally, the exit strategy for venture capital-backed companies has shifted from IPOs to sales of the business. In the case of buyouts, the industry has seen a trend of companies staying private for longer, leading to larger market caps at IPO or direct listing. For instance, the market cap of the five largest tech companies (Facebook, Amazon, Apple, Microsoft, and Google) went up by 1.8 trillion dollars between January and July 2021, which is larger than the aggregate buyout industry. These statistics highlight the importance of understanding the private markets and their role in the overall financial ecosystem. As the trend of companies staying private for longer continues, it is crucial for investors to adapt and consider the opportunities and challenges presented by the private markets.
Factors contributing to decrease in public companies: The number of public companies has decreased significantly due to older IPOs, secondary transactions, mergers and acquisitions, and record-breaking private investment. Despite assets remaining stable, the focus on private markets for exits has grown.
The number of public companies has decreased significantly since the late 1960s, despite the assets remaining relatively stable. This trend can be attributed to several factors, including the increasing age of companies at IPO, the rise of secondary transactions in the buyout industry, and an active market for mergers and acquisitions. Additionally, the committed capital to private buyouts and venture capital has reached record highs, but the returns in these categories, specifically for buyouts using Public Market Equivalents, have been a topic of interest. The discussion also touched upon the limitations of using the number of companies as a metric and the importance of considering assets instead. Overall, the conversation highlighted the evolving landscape of public and private markets and the impact on company exits.
Evaluating Private Equity Performance: Beyond IRR: Consider alternative metrics like Modified IRR or Public Market Equivalent (PME) for more accurate insights into private equity returns. Private equity has high dispersion in returns, so access to top-performing funds is crucial for maximizing potential returns.
When evaluating the performance of private equity investments, it's important to consider the limitations of commonly used metrics like Internal Rate of Return (IRR) and consider alternative approaches like Modified IRR or Public Market Equivalent (PME). These methods can provide more accurate and meaningful insights into the returns of private equity investments. Furthermore, it's crucial to understand that private equity, particularly in the form of buyouts and venture capital, comes with high dispersion in returns. This means that while the historical averages have been promising, the top-performing funds have significantly outperformed the bottom ones. As private equity becomes more accessible to individuals through 401k programs, it's essential to ensure that investors have access to the top-performing funds to maximize their potential returns.
Persistence in Performance: A Key Factor in Buyout and VC Industries: The best performing funds and firms in both buyout and venture capital industries tend to continue excelling, creating a positive feedback loop. Price paid and EBITDA adjustments significantly impact deal outcomes in both industries, with a record number of buyout deals including such adjustments.
Persistence, or the tendency of past performance to predict future results, remains a significant factor in both the buyout and venture capital industries. The best performing funds and firms tend to continue to excel, creating a positive feedback loop where the best companies want to work with the same venture capitalists, leading to further success. However, this phenomenon is more pronounced in venture capital than buyouts. In buyouts, the successful firms are able to raise more funds and compete with one another, while less successful firms struggle to raise capital and eventually drop out of the competition. Additionally, in both industries, price paid and EBITDA adjustments play crucial roles in determining the outcome of deals. In recent years, a record number of buyout deals have included EBITDA adjustments, reflecting the increasing complexity of these transactions.
Higher EBITDA multiples in buyouts despite missed forecasts: Companies securing financing for buyouts use higher EBITDA multiples, but historically have missed EBITDA forecasts significantly. Record-high multiples of 11.5 times in 2019 indicate potential challenges in generating excess returns. Factors like software-based businesses, interest rates, and financing sources have influenced this trend.
Companies seeking to secure financing for buyouts are using higher EBITDA multiples, giving themselves the benefit of the doubt for future cost savings. However, historically, these companies have often missed their EBITDA forecasts by a significant margin. The record-high EV to EBITDA multiple of 11.5 times in 2019 is a warning sign of difficulty in generating excess returns. The shift towards software-based businesses in buyouts and the coevolution of the high yield bond and leveraged loan markets have contributed to this trend. Interest rates and the increasing prevalence of software businesses in buyouts are factors influencing the increase in multiples. It's important to note that these multiples have historically been a warning sign of difficulty in generating excess returns. The financing landscape for buyouts has evolved significantly, with buyout firms sourcing debt from various sources, including banks and private debt funds, and dealing with changing interest rates and the rise of stock-based compensation. These developments have significant implications for how companies finance their growth.
The landscape of corporate finance has evolved with the rise of leveraged loans and decline of traditional IPOs: Leveraged loans have grown to match the size of the high yield market, are often packaged into CLOs, and have historically low interest rates for even high yield issuers. The use of leverage in buyout deals has not significantly increased, but equity financing and the blurring lines between financing and compensation have.
The landscape of corporate finance has shifted significantly over the past few decades, with the emergence of the leveraged loan market and the decline of traditional IPOs. Leveraged loans, which are more senior, collateralized, and floating rate, have grown to match the size of the high yield market. These loans are often packaged into Collateralized Loan Obligations (CLOs) and sold to investors. The use of leverage in buyout deals has not significantly increased, but rather, there has been an increase in equity financing. Additionally, the rise of intangible companies and the prevalence of stock-based compensation have blurred the lines between financing and compensation. Notably, even high yield issuers are able to borrow at historically low interest rates. This coevolution of the buyout and leverage loan markets, along with the changing nature of corporate financing, has important implications for investors and businesses alike.
Understanding the Shift Towards Intangible Assets: Intangible assets like human capital, software, and R&D impact cash flow, financials, and valuation, but measuring them accurately is a challenge. The shift towards intangibles is a long-term trend, requiring a nuanced approach to financial analysis.
The way companies create and manage value has significantly shifted over the past few decades, with a larger focus on intangible assets such as human capital, software, and research and development. This shift is important for financial analysts to understand as it can impact a company's cash flow, financial statements, and valuation. Measuring intangible investments accurately is a challenge, but it's crucial for getting an accurate picture of a company's investment activities. The transition towards intangible investments is a significant one, and it's important to note that this trend is not a recent development but has been happening for several generations. The first challenge is measuring intangible investments, which is difficult to do accurately for individual companies. The second challenge is understanding the economic characteristics of intangible assets versus tangible assets, as they behave differently in terms of depreciation, amortization, and other financial metrics. Overall, the increasing importance of intangible assets in driving business growth requires a more nuanced approach to financial analysis.
Understanding intangible assets' unique characteristics: Properly accounting for intangible assets is crucial for investors to make informed decisions and maximize returns. Intangible assets, like intellectual property, are non-rival and partially excludable, allowing for significant excess rents and impacting earnings, invested capital, and accounting metrics.
Understanding the unique characteristics of intangible assets and their impact on economics is crucial for investors. Intangible assets, such as intellectual property, have different properties than traditional physical goods. They can be non-rival, meaning multiple people can use them at once, and partially excludable, allowing companies to generate significant excess rents. This understanding is valuable for measuring value and evaluating investments, as it can impact earnings, invested capital, and accounting metrics like price to earnings and price to book. These adjustments can lead to more efficient investing and a clearer view of future profitability. Additionally, successful investors over the last decade may have embraced the idea of increasing returns from intangible assets, leading to the rise of superstar firms with high returns on capital. Overall, properly accounting for intangible assets is essential for all investors, not just systematic ones, to make informed decisions and maximize returns.
The Widening Gap Between Large and Small Companies: Large firms with network effects capture disproportionate market share, fewer small companies go public, and small companies are more likely to be acquired, leading to market concentration
The gap between the returns of large, "superstar" firms and smaller companies has widened significantly over the past few decades. This phenomenon, known as the increasing returns to scale or network effects, allows these large firms to capture a disproportionate share of the market. Additionally, fewer small companies are going public due to increased costs and the difficulty of transitioning to larger sizes. As a result, these small companies are more likely to be acquired by larger firms, leading to a concentration of market share in the hands of a few dominant players. This trend, which has been observed since the mid-1990s, is particularly relevant in industries with strong network effects, where the value of a product or service increases as more people use it. The applicability of this concept has become more material in today's economy as we move towards more intangible goods and services.
Economies of scale and demand-side economics in platform businesses: Platform businesses benefit from decreasing costs per unit due to economies of scale and increasing consumer demand, leading to profitable growth and market dominance.
The combination of economies of scale leading to decreasing costs per unit and increasing demand-side economics resulting in higher willingness to pay creates a powerful mechanism for value creation in platform businesses. This two-sided benefit is a significant factor contributing to the success and profitability of leading technology companies. The increase in concentration due to mergers and acquisitions has also played a role in this equation. However, the lack of regulation of these companies as natural monopolies raises concerns about potential unjust profits and the extension of their power. As an investor, it's crucial to stay attuned to regulatory developments, even if the impact on shareholders from breaking up these companies is not clear-cut. The historical example of AT&T and its regulation provides some context for understanding the current situation.
Pension funds and endowments shifting investments to private markets: Institutions allocate more to alternatives for higher returns, but assessing long-term performance can be challenging, creating an agency issue for CIOs.
The growing trend of pension funds and endowments shifting their investments from public markets to private markets, such as venture capital and buyouts, is a complex issue with significant implications for both shareholders and allocators. While there have been cases where breaking up monopolies has been beneficial for shareholders, the growing liabilities of pension funds and their need to meet spending requirements make it a challenging situation. The risk premium for equities has shifted significantly over the past few decades, making it increasingly difficult for pension funds to meet their return targets through traditional public equity investments. As a result, many institutions have allocated more to alternatives, with nearly 90% of surveyed institutional investors expecting 8% or higher returns from these investments. However, the long-term performance of these investments can be difficult to assess, creating an agency issue where the CIO may be under pressure to meet return targets but may not be held accountable for the long-term performance of the alternative investments. Overall, the topic of pension fund investments and the shift towards private markets is an important one that requires continued monitoring as we move into the future.
The Role of Active Management in Public Markets: Despite challenges, active management remains valuable for price discovery and liquidity in public markets. Focus on intangible investments and corporate valuation for insights, and stay updated on industry trends for young investors.
Despite the growing number of investors and the challenges in meeting high expectations, there will always be a role for active management in public markets due to its contributions to price discovery and liquidity. The debate should focus on the optimal percentage of assets allocated to active versus passive management, but active management is not going away anytime soon. Intangible investments and customer-based corporate valuation are valuable tools that can provide insights for investors. For young investors starting their careers, it's essential to focus on intangible investments and stay updated on the latest research and trends in the industry. Additionally, developing a deep understanding of companies and their intangible assets can lead to valuable investment opportunities.
Finding a unique angle in investing: To succeed in investing, focus on unique niches or team decision making for better outcomes. Explore less trafficked markets or geographies, prioritize cognitive diversity, and consider the exploration vs exploitation dilemma.
To succeed in the investing business, especially for young people, it's essential to find a niche or unique angle that sets you apart from the competition. This could mean focusing on less trafficked markets or geographies, even if they have smaller asset classes. Another area of interest is the concept of team decision making and cognitive diversity, which can lead to better investment outcomes. Additionally, there's ongoing research on the exploration versus exploitation dilemma, which is crucial for businesses to consider when allocating resources. These concepts have connections to the work being done at the Santa Fe Institute, particularly in the areas of collective intelligence and understanding intangible factors.
Impact of Santa Fe Institute on Speaker's Investment Approach: SFI's research on complex systems, emergence, and expectations influenced the speaker's investment perspective. He recommends following Dennis Lynch for open-mindedness and rigorous thinking, adapting to market conditions, and reading 'The Shortest History of Wall Street'.
The Santa Fe Institute (SFI) had a significant impact on the speaker's thought process and investment approach, particularly in the areas of complex systems, emergence, and expectations. The speaker's interaction with SFI's president, David Krakauer, and the institute's research on intangibles, bundling, and open-mindedness, have influenced his investment perspective. The speaker recommends following Dennis Lynch, the head of Counterpoint Global, for his open-mindedness and rigorous thinking. He also emphasizes the importance of adapting to the current market conditions and not lamenting the state of the world. The speaker highly recommends reading "The Shortest History of Wall Street" for its context and insights into the asset management industry. Overall, the speaker's conversation with Patrick O'Shaughnessy highlights the importance of a multidisciplinary approach to investing and the value of being open-minded and adaptable.
