The role of stock exchanges in supplying capital to corporations is shrinking as private equity bulldozes its way in, attracting more investors with higher returns.
The sector’s growing role in corporate funding contributed to the buzz at a raucous SuperReturn InternationalOpens a new window  last month in Berlin, the annual jamboree of the world’s biggest PE firms.
PE funds have around $2 trillion to investOpens a new window as well as banks lining up to leverage that equity, and their biggest concern is that they may overpayOpens a new window for a deal because of this embarrassment of riches. PE firms raised $432 billion worldwide last year, on top of a record $566 billion in 2017, according to data firm Preqin.
In the meantime, stock market floats are shrinking amid massive buybacks, while start-ups delay initial public offerings ever longer in favor of more rounds of private investment. More public companies are going private – their number has halved since 1996 in the US, while the number of firms backed by PE funds doubled between 2006 and 2017.
US stock buyback announcements totaled a record of more than $1 trillion in 2018. These are authorizations that may take several years to complete, but companies tend to be following through. The soaring volume of buybacks has widened the gap to net issuance – new shares issued minus shares removed from the market – which is now firmly in negative territory.
The relative dearth of IPOs reflects a change in how companies raise capital. Start-ups can now get all the funding they want in private markets, so they no longer go public primarily to raise capital. Rather, it is more often a way for private investors to exit their investment.
Nearly 100 private equity transactions valued at more than $200 billion were completed last year, consultancy Bain & Co. calculates, double the amount two years ago.
Meanwhile, listed companies will see their average return decline to 4.5% a year by 2023, according to one estimate, compared with a 14.2% annual return on private equity investments between 2004 and 2018, 5.30 percentage points higher than the return on listed companies.
Companies acquired through leveraged buyouts and benefiting from the hands-on management of PE firms recorded a 9.6% annual increase in revenues, according to a survey by Cambridge Associates, double that of the Russell 2500, with better improvements also in Ebitda and profit margins.
Not surprisingly, investors are following the higher returns. AÂ recent survey by BlackRockOpens a new window found that 51% of investors surveyed planned to reduce their exposure to listed equities this year, while 47% will increase their allocation to private equity.
Companies with a value of between $500 million and $3 billion are in a blind spot for the public markets, without sufficient analyst following or liquidity to attract investors. This is where private equity investors find their sweet spot.
PE funds may be optimistic about the trend, but the $5 trillion in investments they hold, including cash on hand for future investments, is still a fraction of the $30 trillion capitalization of US public stock markets alone. Price discovery remains an important role for liquid public markets, and is growing in importance with the application of big dataOpens a new window and artificial intelligence.
Some analysts are worried that the LBO market is overheating as the increase in funds available tempts managers to overpay for assets. The average buyout globally is about 11 times Ebitda, Bain says, up from 8.6 times in 2009. The investors flocking to PE funds expect an internal rate of return of 20% or more, but the industry average in the US was just under 10% in 2015, according to Cambridge Associates.
This only adds to the pressure for managers to conclude deals that will meet investor expectations, which often means increasing the equity component of a deal, reducing the leverage – and the return. Banks are becoming more reluctant to provide financing for company purchases at ever higher valuations, especially in high-tech ventures. Another consequence of the investing frenzy is a higher portion of deals that lose money, now estimated at about 30%.
In addition, investors and managers expect the current growth cycle, already long by historical standards, to turn downward in the next year or two, making it harder than ever to achieve the high rate of return that PE firms are currently bragging about.