A public reckoning for the private markets
Much has changed in the decade since the 2008 financial crash.
Investors have been forced to recalibrate their expectations as potential returns in mainstream public markets have ebbed. Consequently, those hungry for yield have sought returns from a variety of new sources. The popularity of alternative finance, encompassing the likes of crowdfunding and P2P lending, has boomed, whilst digital assets have offered an outlet for investors willing to stomach more risk in exchange for high returns.
Private markets – a coverall term that encompasses rarely or never-traded investments in real estate, infrastructure, venture capital, direct lending and private equity – have also benefited. These assets have hoovered up investor cash, with private capital funds raising $5tn since 2012. In fact, many funds are struggling to find investments, with uninvested cash in private funds topping $2tn. War chests are bursting.
The love affair with private markets is based on something deeper than a hunt for yield. Their popularity is built on a now widely held thesis that private markets are simply better than public markets since public markets are too focused on short term financials and don’t let companies build and invest over the long term.
Speaking with my entrepreneurial hat on, this seems a fair criticism, especially given the fact that it’s rare for investors today to follow the principles of value investing. Further, a large portion of stocks are traded by algorithms, which are entirely uninterested in qualitative measures that are essential for measuring a business’ success, especially in its early years.
But of late we’ve seen the perils of swinging too far in favour of private markets, which are failing to instil discipline, good governance, and financial prudence on companies. The thesis that private markets are somehow better than public markets is not strictly true, as recent headline-making funding flops have shown.
Despite providing investors and companies with the chance to access opportunities and capital, private markets have much fewer actors, and almost no active secondary market. Investors can’t short assets. Thus, the valuation metrics that arise are based upon a lot fewer data points than the valuations that arise from the public markets.
Further, there’s little independent analysis being done on the space, the market is self-policed by the players involved. There’s nothing wrong with that per se, as private markets can self-govern as they please, but a market’s reputation can be sullied if companies with faultless funding credentials reveal ropey business models at later rounds.
The problem is more acute as the entire private market community, without a means of exit, is stuck in a giant conflict of interest as it seeks positive returns for portfolio companies, rather than scolding them into better behaviour. This enables profligacy, as investors seek to find buyers willing to stomach a higher valuation.
Unlike in public markets, where investors who lose faith can sell, private investors know that the only way to get out without losing their shirt is by painting a positive picture of their investments. As they attempt to ‘pass the bag’, they pass the buck, which engulfs the entire market in a fog of hyperbole and false optimism. It’s “pump and dump” among “big-boy” investors. Maybe not off too much concern to regulators who need to protect the mom-and-pops. But it can lead to a huge misallocation of capital that’s not necessarily good for society.
Of course, this problem is more acute come the later stages of the funding spectrum, especially amongst companies upon whose future a VC firm may be betting the house. This is one reason why we get the Ubers and WeWorks, as there are always one or two companies that have to “return the fund”. According to the power-law dynamics of VC investing, a fund’s entire return will be thanks to 1 or 2 superstar unicorns. That’s fine in and of itself. But if that superstar has been identified, and it starts to engage in questionable behavior, will investors hold management to account? Or will they quietly hope to get out and and make it someone else’s problem?
Private markets are home to many honest actors and many great companies. But, like anything private, it has always had an air of mystery surrounding it, especially as the sums of investment capital have grown larger and larger, with the likes of Softbank pouring petrol on the fire.
The last decade has seen some fine companies climb the private funding ladder before finding receptive public investors. But 2019 will be remembered as the year when lots of unicorns tried to leap from private to public and their business models were found wanting. All was well whilst Softbank was still writing the cheques, but their appetite (and ability) to do so is waning.
As we’ve mentioned on the blog before, regardless of whether companies are public or private, only those with sustainable business models and robust balance sheets will survive to see the next cycle. 2019 feels like the beginning of the end of the post-2008 cycle, and, as we’ve seen, the reckoning will not be forgiving for any company that falls short.