Public vs. Private Equity

December 27, 2019

At The Fiduciary Group, our investment universe primarily consists of publicly-traded equities (stocks) and fixed income securities (bonds).  From time to time, we receive questions from clients about making investments in non-publicly traded companies.  We typically refer to these types of investments as private equity, which consists of capital not listed or traded on a public exchange.

To finance business operations, many companies turn to capital markets for equity and / or debt financing from investors. This can happen in either private or public markets, and the decision to access one or the other is an important one. As investors, we have the ability to participate in either arena. There are several reasons why we generally favor public markets over private equity investing.

First, publicly owned companies must submit regular financial statements to the Securities & Exchange Commission (SEC) in compliance with GAAP accounting standards, which can provide shareholders with confidence that they have received a full and fair representation of the company’s results. These reporting standards do not apply to privately owned firms. In addition, the leaders of public companies are subject to a heightened level of scrutiny by various stakeholders and can generally be replaced at the discretion of the board of directors.  Conversely, for private companies, it can be difficult to terminate and replace someone with a material equity ownership interest in the business (especially if they are a founder and hold a class of common stock with outsized voting power).

As it relates to the scrutiny of regulators and public market investors, consider the recent experience of WeWork. The commercial real estate firm, which raised money at higher and higher valuations in private markets over the past few years, filed for an initial public offering (IPO) in August 2019. Shortly thereafter, the company’s financials and corporate governance came under fire. In the weeks that followed, under the scrutiny of public markets, WeWork was all but forced to make changes that were amenable to those investors’ interests (including the departure of the founder / CEO). This process eventually led WeWork to abandon its aspirations of an IPO. To us, this suggests participants in liquid, public markets may be in a healthier position to appropriately ascertain asset values than a small group of PE managers operating amongst each other behind closed doors.

Second, we also believe the liquidity of public markets helps clients make an informed appraisal of the value of assets within their portfolio.  With publicly traded securities, investors are able to buy and sell every business day at a given price. On the other hand, private equity may have a limited secondary market, making it difficult to easily ascertain fair value. That can be exacerbated when you look to monetize a position and can only negotiate with a limited number of potential buyers. Recently, we were working with an estate that had a significant private equity holding that could only be priced using book value, which had little to no relationship to the underlying value of the business.  In that case, an inability to effectively realize the underlying value of the asset was burdensome and costly.

Finally, since publicly traded companies are typically more mature, they often have the advantage of established lines of businesses and diversified revenue streams.  Private companies are often trying to break into new markets or take business from larger, established competitors. It’s possible these companies ultimately attain their business objectives, but it can be more challenging to do so when competing against fortified and scaled incumbents who often have ready access to cost-effective capital.

For clients, there is also a question surrounding the suitability of an investment in a private company within their portfolio. For example, we recently received an inquiry about investing in private equity in a trust account.  Trustees are held to a “prudent investor rule”, meaning Trustees should manage portfolios using sound discretion and should avoid overly risky investments (this is a standard of care that we apply to all portfolios).  My response to the request was that I did not believe this particular investment would meet the prudent investor rule, and so we refrained from doing so.

Moreover, private equity funds can only be held by “accredited investors”, which is typically defined as someone with at least $1 million in net worth or annual income of at least $200,000.  In the example above regarding the estate holding private equity interests, some of the beneficiaries did not qualify as accredited investors and were unable to take ownership of those private equity interests.

Our skepticism with private equity is brought to light by the tremendous growth of the asset class in recent decades. Global private equity deal volume has consistently exceeded $1 trillion annually in recent years, compared to roughly $200 billion a year in the early 2000’s. While the growth in this asset class speaks to the lure of private equity, we believe most investors will be best served by accessing value-generative businesses through public equity markets.

If you would like to start a conversation with us about how we might help you build and manage you wealth over time, please reach out to us.

AUTHOR:

MALCOLM BUTLER, JD