Over the past few weeks, the primary story in the financial media, from Barron’s to CNBC, FT and Fortune, has been the IPO market, or the lack thereof. Fortune referenced our research in their cover story “So Long, Wall Street” – specifically, the fact that recently within the tech sector, the value of P2P (public to private) transactions exceeds the value of IPOs. This has been true since 2010 if we remove outliers such as Facebook and Alibaba, and the trend is strengthening. But why? What is driving this historic shift from public to private equity?
Behind the Public to Private Shift
As you might expect, the answer is complicated and everyone has a theory, most of them valid. Barron’s contends the retail investor has fled the scene, partly due to being burned in the recent past by speculative investing, not just in the stock market but also the housing market. Historically, this was the easy money and contributed to irrational valuations for new issues. See China for a present day example.
Others point to the burdens of being a public company. Depending on the size of the company, expenses associated with operating a public company can be several million dollars annually. This comes in the form of significantly greater financial and legal infrastructure, and hefty fees from third-party advisors. We know, however, the more significant burden is in managing a business to meet Wall Street’s expectations on a quarterly basis, which forces companies to think quarter to quarter rather than investing for the long-term growth and health of the business. This is partly where the disconnect lies between public and private equity, and where investment horizons are short-term and longer-term, respectively.
Meanwhile, there continues to be an extraordinary amount of private capital available for tech companies, for both minority growth investment and full buyouts. Tech companies are staying private longer and longer, because they can, and those who have chosen to go public are quickly realizing that path is not as attractive as it once was. Just this year seven tech companies have been acquired or gone private after five or fewer years in the public markets. Examples include Cvent, Demandware, and Marketo.
Liquidity as a Major Factor
The points above about the burdens of being public are all valid, but we also believe there is another factor at play that is keeping companies out of the public markets, and drawing those that are public into M&A or P2P transactions, and that is that the public markets don’t always provide the liquidity benefits that private investors seek.
The dream scenario in a public offering is pricing at an already rich valuation, strong aftermarket appreciation, a secondary offering in which private investors realize significant liquidity (at an irrational valuation), and finally a public float and daily trading volumes that enable private investors to sell off their remaining stake in the open market. This does happen, and it has happened recently in the cases of Hubspot, Marketo, Twitter, and certainly Facebook (and Twilio is off to a good start). But there is also, unfortunately, the more likely scenario in which a company goes public and for whatever reason, the stock stalls, or worse, declines. In this scenario, the private investors are lucky to get any liquidity.
Figure 1. Percentage Liquidity Realized Since IPO
Evidenced in Figure 1, we can see how difficult it has been for investors in stocks of those companies to get liquidity. Perhaps this dynamic, exacerbated by overall weak receptivity to new issues, persuaded Bain Capital, investors in Blue Coat, to sell the business to Symantec versus pursuing an IPO. There is something to be said for guaranteed liquidity at a favorable price versus rolling the dice for more value over a longer-term period of liquidity. We believe this is the primary factor driving the historical shift from public to private transactions.
So long as PE supplies of dry powder remain at all-time highs, credit markets remain open, and quality businesses remain available, we contend that the volume and value of P2P and M&A transactions in the tech sector will continue to be robust, possibly even accelerating in the second half of 2016. Stay tuned for our updates as new trends emerge or existing ones entrench.
[This article was contributed by Douglas Melsheimer, Managing Director.]