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Are private equity blowouts good for investors?

Cracks beginning to show 'on several fronts'

Shares in Uber and Lyft have fallen 27% and 39%, respectively since their IPOs earlier this year
Shares in Uber and Lyft have fallen 27% and 39%, respectively since their IPOs earlier this year
  • James Tierney and Tiffany Hsia
  • 02 December 2019
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There is growing evidence that private equity markets are beginning to overheat after several high-profile IPO flops.

Investors in stocks should pay attention because private funding troubles are also a very public market affair.

In recent months, privately funded companies have discovered that public equity markets will not give them a blank cheque.

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Mundy's Moment: The rise of private equity

WeWork's valuation plummeted from $47bn in early 2019 to $8bn in its bailout by SoftBank this week, after its initial public offering was aborted because of concern about huge losses and its corporate structure.

Shares in Uber and Lyft have fallen 27% and 39%, respectively since their IPOs earlier this year

Day of reckoning

Private equity may be facing its day of reckoning. Historically, companies that relied on private equity funding to get started often chose to go public relatively early in their lifecycle.

To access public market capital for future growth, companies traditionally needed to possess a proven business model that was profitable. The dotcom bubble in the late 1990s was an exception to the rule rather than the norm.

Why are more retail clients turning to private equity investments?

Record private equity fundraising changed the incentives. In recent years, with so much money readily available to private companies, many chose to stay private for longer to avoid some of the scrutiny faced by public companies - including the need to show a profit.

Given the surplus of private capital today - and the scarcity of investment options - valuations and terms in the private markets may be reaching the point of being overheated. 

Gauging the impact of a private equity shakeout

Cracks are beginning to show on several fronts. In addition to the IPO flops, still-private companies such as WeWork and Juul are now worth much less than their most recently priced rounds of equity.

And companies that still have big losses will need to raise more capital just to stay in business.  

James Anderson: Investors need more access to private companies

The implications are complex, but this trend is worth following - whether you are a public equity or private market investor.

A shakeout in private equity could potentially have the following effects:

More rational competition: the flood of private capital has allowed uneconomic businesses to remain funded for a longer-than-normal incubation period, which artificially boosted competition and suppressed inflation.

If Uber subsidises every passenger ride while losing more than $1bn annually, traditional taxi and limo companies get squeezed, while consumers pay below the real cost of the service.

In a private equity crunch, unsustainable business models may no longer be tolerated and rivals with real competitive advantages would benefit from a more rational marketplace.

Larger technology companies could be direct beneficiaries, in our view, as many were not able to compete at all costs against privately held competition because they were more scrutinized by their public shareholders. 

Improvements in governance policies: The WeWork debacle has reinforced the importance of corporate governance. As CEO Adam Neumann and other senior executives faced increasing scrutiny on governance issues, investors lost their appetite for the IPO.

In our view, public equity investors should always ask whether they want to be in business with the people managing an otherwise attractive business.

The private equity shakeout is shining a light on companies that will force them to take a good, hard look in the governance mirror before seeking private or public funding.

Opportunities for public investors in earlier-stage companies: A rationalisation of the private equity market means that growing companies will need to rely more on public equity markets to build their businesses.

We believe this could add significant opportunities for investors in stocks of earlier-stage companies as more so-called unicorns (privately held companies worth at least $1bn) become accessible to public equity funds.

This would make the gains normally associated with the robust growth phase of younger companies available to public market investors.

Bringing order to business

Discipline is coming back into fashion. Over the past decade, private equity investors tolerated a lax attitude toward profitability because in a low-rate environment, financial markets were awash in long-duration, early cycle capital.

Companies were encouraged by venture capital backers to chase growth at all costs, in hopes of getting higher and higher funding marks.

Now, companies will be forced to adapt to tighter scrutiny, and winners will start to emerge from the pack.

Over time, equity investors who have maintained a clear focus on sustainable business models and earnings growth should be rewarded for their discipline in a tighter funding market for early-stage growth companies.

James T. Tierney is chief investment officer, concentrated US growth and Tiffany Hsia is senior research analyst, select US equity portfolios, at AllianceBernstein

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