Commentary: The decreasing number of public companies – an elephant in the markets?

A robust pipeline of high-profile initial public offerings will offset the steady decline in the number of public companies, yet some institutional investors remain concerned. These fears may be overblown.

There is no disputing that the number of publicly held companies has declined in recent years. Whether this is cause for concern, however, may depend on the perspective.

Detractors, for instance, are quick to note that the decrease reflects the challenges of the public markets, ranging from "short-termism," emphasizing quarterly performance above all else, to imposing regulatory demands and the high costs of compliance. It's the same message that has been articulated for years by leveraged buyout firms, which would argue today that the private capital landscape now has the breadth and scale to support growing companies without ever requiring an IPO.

At face value, these developments might spook public market investors concerned that these trends represent a fundamental change in either the composition of the public market or the concentration of stocks within it. At the very least, investors are asking: At what point does the decline become material enough to warrant revisiting their investment policies or how they allocate to public equities and alternatives altogether?

The short answer is that the public markets have not fundamentally changed for institutional investors. Yes, there are fewer listed companies, but the catalysts behind the decrease are less sinister than the conventional wisdom might assume. The longer answer, though, offers institutional investors a deeper understanding around what is actually triggering the decline and how it will affect performance in the years ahead.

To invoke the old chestnut about lies and statistics made popular by Mark Twain, much of the anxiety among institutional investors stems from an inflated view around the extent of the decrease. Most of the commentary on this topic, for instance, will quantify that since 1996, the number of public issuers in the U.S. has fallen by 46%. What is often unsaid is that 1996 represented a peak number of public companies in the U.S.

When observers zoom out to expand the window of time analyzed, the decline seems far less dramatic. Recall that in the early 1990s, the public market absorbed an abnormally high level of IPO activity, often characterized by very small companies generating little or no profits. In hindsight, we now recognize that this surge of new offerings culminated in the tech bubble of the early aughts, which sparked an equally swift and dramatic shakeout. This simply highlights the impact of "starting point" bias. And when looking at the same sample since 1980, for instance, the decrease over the longer time frame narrows to just 16%.

The numbers themselves also provide very little context around catalysts behind the decline, even if it's smaller than most had assumed. Consider, for instance, that in 1996, the Nasdaq increased its asset-size requirements for issuers, making it harder to access the public markets for certain smaller companies unable to meet the adjusted threshold. Six years later, in 2002, the Sarbanes-Oxley regulations ushered in further alterations to public company listing standards, adopted across all domestic exchanges, and also introduced corporate governance rules that served to increase the costs of being public.

Another, more material element that helps explain the decrease can be traced back to merger and acquisition activity. Again, starting in 1996, M&A accounted for nearly 60% of all delistings. A small percentage of this activity reflects "taking private" deals in which private equity firms or unlisted acquirers subsume a publicly held company. Overwhelmingly, though, the bulk of the M&A activity has consisted of deals between publicly held enterprises.

The point, at least for public market investors, is that while M&A may accelerate delistings, it does not necessarily limit asset owners' access to the growth of the U.S. economy.

Beyond the nature of delistings, analysis into the decline would be incomplete without considering IPOs. The tech bubble and the accompanying surge of IPOs in the 1990s has been addressed, but again, context matters. For instance, the number of new listings for companies with a market cap below $100 million has decreased considerably, while IPOs for companies valued above that demarcation has remained stable.

Through the lens of an institutional investor, whose investment policies often have little to no allocation to microcap and nanocap stocks due to liquidity constraints or ownership limits, the shortfall in IPOs in recent years has had little impact as it relates to the breadth of their available investment universe.

Certain contributing factors have made the private markets more appealing to companies, at least compared to previous eras. The expanding scale of the private capital market, for one, has created an ecosystem in which sponsors and entrepreneurs can monetize their investments without necessarily having to go public. McKinsey & Co. quantified that the assets under management in private markets now exceeds $5 trillion. Moreover, the Jumpstart Our Business Startup Act legislation, passed in 2016, further supported this growth by raising the investor limit for private companies to as many as 2,000 investors from 500 previously.

There are certain advantages to the companies and their "private" investors in eschewing an IPO. A sale, they would note, often provides more certainty and a "cleaner" exit, without enduring extended lockup periods that follow a public listing. Another factor, particularly for smaller companies, is the costs. For Sarbanes-Oxley compliance alone, management consulting firm Protiviti estimates the internal expenses can range from $600,000 to $1.6 million annually. And this doesn't include external audit-related fees.

For these reasons and others, there is likely some truth to the idea that some companies are content to remain private for longer. This is particularly the case 10 years into an upcycle in which private equity investors have been paying ever-increasing prices for assets. This has obviated the need for companies to even test the public markets, whereas in the past an IPO would have provided the most rewarding realization.

Still, based on the data, the decline in the number of public companies has had little if any impact as it relates to the market concentration of public equities. In fact, the Herfindahl-Hirschman index, a widely used measure of market concentration, suggests that public markets remain competitive. Additionally, the cumulative weights of the 10, 50 and 100 largest stocks have been relatively stable over the past decade and have actually decreased from highs witnessed during the tech bubble.

Not to be overlooked, several high-profile IPOs early in 2019 and the slate expected to follow later in the year suggests that just as the economy runs in cycles, so, too, does the pull of the public markets. Already Lyft, Uber, and Pinterest have generated headlines through their respective offerings, while market watchers now anticipate Airbnb, Palantir and WeWork, among others, will soon be joining them among the high-profile unicorns to go public.

So, while regulatory changes and the growth of private asset classes will likely facilitate the trend in which private companies stay private for longer, adding downward pressure to the number of publicly traded companies, none of the developments are significant enough to warrant institutional investors making material changes to their investment philosophy.

Frank Benham is a managing principal and director of research at Meketa Investment Group. Roberto Obregon is a vice president at the firm. Both are based in Boston. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.