Author: Nicholas Rilley, CFA, CAIA
Public markets were designed to give investors access to the world’s best companies, but increasingly, they don’t.
For most of modern market history, the most successful companies progressed through a familiar lifecycle. This would include: seed funding, venture capital, public listing, then a gradual climb from small-cap, to mid-cap, then eventually entering the S&P 500 or Dow Jones Industrial Average.
That model has now changed and this has significant consequences for markets, investors and fiduciaries.
Three structural shifts are reshaping the relationship between public and private equity. Firstly, companies are staying private for longer. Secondly, technology businesses can now scale at unprecedented speed. Lastly, firms can enter public markets at enormous valuations and move directly into major indices shortly after listing.
The result is a blurring of the traditional boundary between private and public markets. Investors are being forced to rethink assumptions that have defined equity investing for decades and portfolio construction needs to evolve to reflect these shifts.
The theme of companies staying private for longer is not new. In 1980, the median age of a company at its IPO was 6 years, whereas in 2021 it was 11. Two main factors have driven this. The rise of the venture capital & private equity industries has significantly expanded the pool of available private capital. At the same time, regulatory requirements such as Sarbanes-Oxley have made public company life more onerous and expensive.
OpenAI CFO Sarah Friar recently noted that “private markets have been incredibly generous to us, much bigger to tap than I think most people ever thought possible... but there is something attractive about the public markets over time too because it is not just about equity… we want to be able to raise money across the whole spectrum”.
Academic research supports the idea of a historic small cap premium, but analysis by BCA shows that this outperformance has come from a few extremely successful companies. They note that migration across size buckets has decreased to almost half of what it was at the turn of the century. Fewer IPOs deprive small cap indices of these high-flying winners and this helps explain why small cap stocks have struggled. Essentially, the best returns may be gone by the time a company reaches your portfolio.
Technological revolutions are again not new, but the speed at which modern day firms can scale is remarkable. Leading AI companies OpenAI (ChatGPT) and Anthropic (Claude) were only founded in 2015 and 2021 respectively. ChatGPT reached 100 million users in just two months, while Anthropic has already reached an annual run rate of $30bn revenue. Technology platforms and smart phones have made technology more scalable than ever before.
Aerospace and AI company SpaceX is gearing up for IPO this summer, and there is an expectation that both OpenAI and Anthropic will IPO in the next year or so.. These companies may list with huge market capitalisations of perhaps $1tn, which would give them a chance of being in the top 10 largest companies in the S&P 500.
Passive investing has grown immensely in recent decades. But this raises a question: what index are you passively tracking? Nasdaq has recently changed their rules to allow new large companies (ranked in the top 40) to join the Nasdaq-100 index just 15 trading days after IPO, removing prior 3-month and 10% float requirement. Furthermore, S&P Dow Jones is considering speeding up the entry of mega cap companies into its indexes by easing time, profitability and liquidity requirements.
When a $1 trillion company can enter a widely-followed index, passive investors may be forced to effectively make an active decision on a meaningful investment with just 15 days’ notice. For investors, this raises a governance question.
Another theme has been Mega Cap Technology companies either acquiring smaller competitors, or buying stakes in private businesses. Amazon has a stake in Anthropic, while Alphabet (Google) has a stake in SpaceX. Both have recently seen a boost to profits from these investments.
This is not the only reason that investors in public equities have had to pay closer attention to private markets. Services launched by Anthropic have led to significant falls in the share prices of professional services and software companies. Equity investors have had to spend time understanding these new threats, which is made harder as these private companies move quickly and there is less information about them in the public domain.
Three of the four leading AI platforms are private, so it is difficult for investors to get exposure. The other is Gemini, which is owned by Google and developed by DeepMind, which they acquired in 2014.
Although it is difficult for investors to get access to companies like OpenAI, Anthropic, SpaceX, and Revolut before they IPO, there are a few ways it can be done. Private Markets funds, Hedge Funds and even US based ETFs can own private markets securities.
Investors once viewed public and private markets as two distinct asset classes, but the lines are now blurring. This convergence is not a future trend, it is already reshaping portfolios, indices and valuations. For fiduciaries, the more pressing question is whether existing frameworks are adequate to reflect these shifts.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Channel Islands) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.