Changing Role of Private and Public Equity
Traditionally, privately held companies went public in the quest for external capital to expand operations which required extensive capital outlays - building manufacturing facilities, investments in R&D or marketing, etc. Although in recent years, private companies have increasingly been able to raise equity capital from large venture capital players via multiple rounds of capital raising before going public. Although today’s unicorns, a term largely used to explain privately held startups valued at more than one billion dollars, have raised more than $136 billion dollars, they are a few months or even years away from going public (and a rising number of startups believe they may never go public). According to the data provided by National Venture Capital Association (NVCA), average time from first VC funding round to exit in the U.S. has increased by more than 40% in the last twelve years. Based on that, there are two broad emerging trends:
Private markets are deep and can be used to fund large businesses till they become profitable and are ready to go public. Latest example of this being $3 billion funding round at WeWork in March 2017 and $1.4 billion funding round at Amazon’s main rival in India – Flipkart in April 2017.
VC firms are holding their investments longer than they used to, and thus providing later-stage funding too, what was traditionally provided by public markets. As a consequence, majority of the IPOs are primarily a capital-returning exercise rather than a capital-raising exercise, along with providing liquidity to founders and employees. Latest example of this being SNAP’s IPO, where third of the proceeds were used to payout founders and early investors.
Larger Funds, Bigger Transactions
Before venture capital funds took hold in the mid 1990’s, private equity capital was primarily provided by leveraged buy-out (LBO) firms focusing on mispriced assets rather than business formation. Although venture capital which has its roots in the 1960’s and successes such as Apple, Cisco and Microsoft in the interim, VC never really took off like PE until the boom starting in 1995 (culminating in the bursting of the internet bubble in 2000!). Over the years since then, and especially after the great financial crisis, VC firms have been able to raise larger funds. According to data provided by Prequin, average VC fund size reached a record high of $166 million in 2016, an increase of 16% from 2015. Given larger fund size, funds have been able to participate in larger transactions and in 2016 VC funds participated in six of the top 10 largest deals in the period 2007-2016. Average deal size has risen nearly 2.5x since 2013 for transactions at Series B and later stages. Capital raising at unicorns such as Uber, Airbnb and Palantir, at 11 digit valuations is primarily the result of this deep VC market, enabling creation of behemoths even before hitting profitability.
Longer Time in Private Hands
While going public via an IPO was considered coming of age for a young company, startups such as Uber and Airbnb which are in the midst of transforming transportation and travel industries, respectively, would want to establish solid businesses before hitting the Wall Street. With listing, comes the pressure to meet quarterly earnings expectations – which may require course correction and focus on profitability before reaching the founder’s ultimate vision. The number of listed companies in the U.S. has nearly halved to 4,300, from the peak of 8,000+ companies in 1996. That is even less than the number of listed stocks in 1975. With large passive flows into main indices and presence of huge fund houses, Wall Street has outgrown small IPOs. Back in 1990s it was commonplace for companies with less than $10 million in annual revenues to go public, given they had a clear growth path. That is something not as common in today’s market. Primary reason for the lower number of listed companies is the large pools of private equity and venture capital that is available today, enabling promoters to remain well-funded even through private offerings. To maximize returns, VC players are holding their investments for longer time periods with average time from 1st VC investment to exit increasing from 4.07 years in 2004 to 5.83 years in 2016.
As pools of private equity capital (PE & VC) increase, it is simply cheaper and easier for companies to raise capital in the private market. Founders are increasingly choosing to remain private so as to enable them to fulfill the company’s potential rather than getting distracted by Wall Street’s quarterly earnings expectations. And when they eventually hit the Wall Street, it will be primarily to provide exits to the VC players, founders and employees.