Among all the talk of globalization and trade tariffs, a seismic shift in capitalism is taking place without, it seems, much public debate. Little by little, the idea that public companies, and wide-spread individual stock ownership, are a necessary and vital part of a capitalist system is dying a slow and quiet death. As a Wall Street Journal recently noted:
The number of U.S.-listed companies has declined by more than 3,000 since peaking at 9,113 in 1997, according to the University of Chicago’s Center for Research in Security Prices. As of June, there were 5,734 such public companies, little more than in 1982, when the economy was less than half its current size. Meanwhile, the average public company’s valuation has ballooned.
In the technology industry, the private fundraising market now dwarfs its public counterpart. There were just 26 U.S.-listed technology IPOs last year, raising $4.3 billion, according to Dealogic. Meanwhile, private U.S. tech companies tapped the late-stage funding market 809 times last year, raising $19 billion, Dow Jones VentureSource’s data show.
As the article notes, there is a massive “de-equitization” taking place around the world, while at the same time the aggregate capital flowing to companies has continued to increase. Anyone paying attention to capital flows in the last decade knows that the job of funding of growing companies (and thus fueling capitalism’s growth) has increasingly been removed from individual investors and transferred to venture capital firms (early stages of growth), private equity firms (later stages) and state-backed funds (sovereign and quasi-sovereign).
There are many reasons for this massive reallocation of capital sourcing, and it’s something that has been coming for many years. Indeed, back in 2012 The Economist noted the shift and outlined some of its drivers:
No doubt the sluggish public equity markets have played a role in this. But these alternative corporate forms have addressed some of the structural weaknesses that once held them back. Access to capital? Private-equity firms, helped by tax breaks, and venture capitalists both have cash to spare, and there are private markets such as SecondMarket (where $1 billion-worth of shares has changed hands since 2008). Limited liability? Partners need no longer be fully liable, and firms can have as many partners as they want. Professional managers? Family firms employ them by the HBS-load and state-owned ones are no longer just sinecures for the well-connected.
In addition to the points above, it should be noted that shareholders themselves bear part of the blame for this shift. As any MBA student knows, there is a long tradition of academic literature bemoaning the bad influence that public shareholders’ “short-term” mentality has on corporate governance and management. Typical of this argument is a 2012 HBR article that labeled public shareholders the “renters” and not “owners” of public companies:
But remember, shareholders aren’t quite the same as owners. A simple illustration: If you own a car, you’re liable for damages in an accident even if they exceed the value of the car. But shareholders are on the hook only for what they’ve invested. And although some shareholders behave much like owners, most of them are effectively renters—often ultra-short-term renters. In real estate, renters are entitled to legal protection but seldom given a formal say in how a property is managed or whether it can be bought or sold. That seems appropriate for short-term shareholders as well.
Because of this so-called renter phenomenon, argued the authors, managers are often well-advised to ignore shareholder concerns for the long-term good of the company:
Employees and customers often know more about and have more of a long-term commitment to a company than shareholders do. Tradition, ethics, and professional standards often do more to constrain behavior than incentives do. The argument here isn’t that managers and boards always know best. It’s simply that widely dispersed short-term shareholders are unlikely to know better—and a governance system that relies on them to keep corporations on the straight and narrow is doomed to fail.
If one buys into the argument that (a) the source of capitalism’s fuel does not matter so much as its successful utilization and that (b) most shareholders are just “hitching a financial ride” on public companies, then it’s natural to ask if the de-equitization of big companies even matters. Maybe it’s irrelevant whether companies grow with big blocks of private money or millions of pieces of public money? In the end, capitalism can thrive with either funding models, right? The answer to these question is “no.” The source of capitalism’s capital matters tremendously, and The Economist noted as much in the same 2012 piece:
First, public companies have been central to innovation and job creation. One reason why entrepreneurs work so hard, and why venture capitalists place so many risky bets, is because they hope to make a fortune by going public. IPOs provide young firms with cash to hire new hands and disrupt established markets. The alternative is to sell themselves to established firms—hardly a recipe for creative destruction. Imagine if the fledgling Apple and Google had been bought by IBM.
Second, public companies let in daylight. They have to publish quarterly reports, hold shareholder meetings (which have grown acrimonious of late), deal with analysts and generally conduct themselves in an open manner. By contrast, private companies and family firms operate in a fog of secrecy.
Third, public companies give ordinary people a chance to invest directly in capitalism’s most important wealth-creating machines. The 20th century saw shareholding broadened, as state firms were privatised and mutual funds proliferated. But today popular capitalism is in retreat. Fewer IPOs mean fewer chances for ordinary people to put their money into a future Google. The rise of private equity and the spread of private markets are returning power to a club of privileged investors.
For me, it’s the last point that is most worth expanding, because the social role of capitalism is not something that should be lost without a debate. A well-running capitalist system is also a social one, for it fulfills a critical public function: the allocation of individual wealth in such a way as to benefit both the individual and society as a whole. I think most people would agree that a capitalist model that allows only rich people to get richer is disfunctional, yet that is precisely what happens if individual investors walk away, or are driven from, capital markets. Indeed, as Simon Caulkin wrote in a 2014 Management Today piece:
Unsurprisingly, alarm bells about this kind of talk are loudest in the US, which is most heavily invested, in all senses, in the culture of the publicly owned corporation. The social costs of its going away are enormous in terms of inequality, immobility and insecurity of all kinds (think Detroit for a foretaste). The decline in public equities, says Voss, ‘should be a grave concern to both investors and policy makers alike’.
At stake is the capacity of the public company to benefit the many, not just a few privileged individuals. Average incomes have barely budged in two decades: now the winner-takes-all economy threatens the entire middle class, potentially undermining capitalism as a whole. The great transforming ideas have emerged from large publicly managed companies with the patience to nurture them to fruition, Stout adds. ‘Of course, many private companies are highly innovative, but what happens after Elon Musk (pictured) or Larry Page or Sergey Brin? Private firms tend to run into problems in the second or third generation – what I call the Paris Hilton syndrome.’ Although Tesla IPO’d in 2010, Musk remains the largest single shareholder.
In addition to the social consequences noted above, there is yet another negative outcome of the great de-equitization, which is the concentration of invested capital in too few firms, as the same WSJ article highlighted:
With fewer places for investors to spread their cash and more companies combining, the average size of a public company in the U.S. has swelled, hitting an all-time high of $4.7 billion in 2014 before dropping slightly through the first half of 2016, according to University of Chicago data. The average public company is more than three times as large as it was in 1997, after adjusting for inflation. The inflation-adjusted total capitalization of the U.S. public market has been hovering near its peak.
Not only are such concentrations-of-necessity inefficient, they are fundamentally antithetical to the capitalist ethos, which is to allocate capital to many entrepreneurs in order to drive innovation and growth. Indeed, we seem to have become dependent on just a small set of companies for so much of our innovation: our phones depend on two companies. Our airplanes depend on two. Our healthcare on about a dozen. Do we really want capital to continue concentrating in, and diminishing the list of, large-scale innovators? I would argue that this outcome is, again, not in the long-term interest of capitalism and our society. Some of those billions sitting in corporate treasury accounts (on and off-shore) could be put to much better use starting new companies and allowing millions of people to become entrepreneurs and business owners.
In response to the analysis above, some people might point to the explosion of mutual fund investments as a compensating mechanism. Isn’t investing $100,000 in a 401k the same as investing $100,000 in equity directly? In theory perhaps, but in reality no. Direct investment of capital makes one an active participant in capitalism itself; outsourcing that job exclusively to money managers (often with high fees and spotty performance) today or investment algorithms tomorrow continues the creation of a capital-deployment elite (real and virtual), which in the long run can undermine a free-market capitalist system much more than any investor short-termism ever could.
In sum, while there are great reasons for the rise of VC and PE firms, and they play a critical and vital role in creating and growing companies, we should pause for a moment and debate whether the death of the small investor may not have some negative long-term social implications. The exit of small investors means decoupling individuals from capitalism itself. Over time, their interest in a successful and efficient capitalist system will naturally decline, making capitalism not a mechanism for wealth creation for all citizens but only for the privileged few with access to VC or PE funds. This is hardly a wining formula for the evolution of Western Democracies. After all, not everyone can become a partner in a VC or PE firm and, I would argue, not everyone should.