Last Tuesday, Spotify, a superstar in the music-streaming sector, went public employing a very unusual initial public offering. Spotify listed existing shares directly on the New York Stock Exchange without relying on investment bankers to underwrite its offering or to raise new capital. At its price Monday of $150, Spotify has a market capitalization of $26 billion.
The question that we need to ask is where did Spotify get the money it needed since it was founded in 2006? The answer is from the private capital markets. In 2016, Spotify raised $1 billion via a convertible debt financing that allowed it to remain private until this year. To prod Spotify to go public, the lenders’ terms got better over time, causing Spotify’s cost of capital to rise if it delayed going public. When it finally offered stock to the public, it was not to raise money but to allow its private backers to sell shares and recoup some of their funds.
And Spotify is not unique. It is only a notable representative of a broader trend. The private markets have become the most popular source of money for companies. At least $2.4 trillion was raised privately in the U.S. last year, compared with the public market, where $2.1 trillion was raised, according to the Wall Street Journal.
The growth of the private market has shrunk the public market. The number of public companies has fallen by more than half since 1996.
We need to focus on why there are fewer public companies and why the private markets have such strong appeal.
Michael Mauboussin, who works for Credit Suisse and teaches at Columbia Business School, gave his explanations in an investment report entitled “The Incredible Shrinking Universe of Stocks.”
1. Complying with public companies’ regulatory requirements is time-consuming and expensive. Companies issuing stock and debt publicly must register with the Securities and Exchange Commission and provide intimate financial details. Regulators require little — in some cases no — disclosure of companies raising funds privately.
2. Many founders of startups believe that the private markets provide a better environment in which they can implement their long-term strategies. Private capital can encourage innovation by enabling companies to take risks without reporting the immediate impact on profits.
3. Tech companies’ hunger for capital is less than that of firms in other industries because they require fewer expenditures for manufacturing plants and equipment.
4. In recent years, investors and private companies have employed creative financing strategies that might run afoul of the regulatory restrictions imposed on public companies.
5. Because they have sufficient assets to hold private investments for years, many big, mainstream fund managers, such as Fidelity, T. Rowe Price, hedge funds and university endowments, are investing in unicorns — private firms worth over $1 billion.
6. The number of public companies has shrunk because of financial problems. About one-third of departures are involuntary as companies become too small to qualify for the public markets or go bankrupt.
7. The proliferation of takeovers. Decades of lax antitrust enforcement mean that most industries have grown more concentrated. The number of mergers and acquisitions annually dwarfs the number of IPOs. This “de-equitization” of the U.S. concerns some regulators. SEC Chairman Jay Clayton noted in comments before a congressional panel last year that “there are fewer investment opportunities for Main Street investors.”
To address the reduced investment opportunities for individual investors, the Blackstone Group announced in October that it is pushing aggressively into products for them. Blackstone predicted that, over time, retail investors will represent half of its assets under management. Other private equity firms, including KKR and The Carlyle Group, are establishing funds aimed at individual investors, though ones with a net worth of at least $1 million.
We should applaud the evolution of the private capital market because these innovations permit companies to grow larger and make appropriate investments without fear of investor backlash. At the same time, the average investor should not be cut out of the benefits of the equity market.
Originally published in the Sarasota Herald-Tribune
