Behind the Campaign to Open Private Equity to the Public
+ Big Tech's Antitrust Deflections + Deadspin's Comeback Story + Deal Radar + Weekly Tweets
“Who gets to invest in what?” That question underlies the debate about whether ordinary Americans should be allowed to invest in privately issued securities.
For background, the private equity (PE) asset class is currently limited to accredited investors, which consists of institutions such as endowments, pension plans, insurance companies, and wealthy individuals. The rationale behind this restriction is straightforward: private companies are not legally obligated to publish their financials and many private companies go bust; therefore investing in these companies involves too much risk for mom-and-pop investors.
The Trump administration, however, has been engaged in a long-running campaign to lower the barriers to entry for PE investing:
In August 2018, SEC chairman Jay Clayton advocated publicly for allowing more retail investors into private equity and the SEC released a paper analyzing the growth of unregistered securities offerings.
In December 2019, the SEC proposed broadening the definition of “accredited investor” to consider an investor’s “professional knowledge, experience, or certifications” in addition to wealth and income.
In June 2020, the Department of Labor (DOL) issued guidance on allowing workers in participant-directed 401k plans to gain indirect exposure to private equity investments through diversified funds.
The DOL’s recent guidance stops short of allowing people to invest directly in PE fund, but it would nonetheless trigger tectonic economic changes. The US 401k market encompasses about $5.6 trillion in assets. If just 10% of those assets ($560 billion) made their way into private equity coffers, it would represent a 38% increase to the $1.46 trillion of “dry powder” (uninvested capital) sitting in PE funds today.
There’s no question that private equity firms stand to benefit from a large injection of 401k cash. The real question is whether everyone else would reap similar rewards.
The core argument for relaxing requirements around PE investing is that private markets generate higher returns than public markets, and that ordinary workers deserve a share of those returns. This, however, is a debated point. “PE funds have returned about the same as public equity indices since at least 2006,” says Ludovic Phalippou, a well-known academic and PE critic in his most recent paper. Mr. Phalippou’s main point is that private equity’s preferred metric for calculating returns, internal rate of return (IRR), is flawed and misleading.
There is also the practical question of how 401k funds would invest in private equity. Benjamin Bain and Sabrina Wilmer write in Bloomberg that one possibility is, “…making PE part of a target-date fund, a popular option that mixes investments in stocks and bonds and gradually reduces exposure to risky assets as investors reach their retirement date.”
Target-date funds sound like a sensible solution for private equity exposure, but when considering how this would look in practice, there are more questions than answers. For example, how many PE funds would a 401k saver be invested in? Do those funds have different strategies and time horizons? Does the investor get to decide which types of PE funds they’re invested in – and how many – depending on their risk tolerance? How will the valuations of private companies be reflected in their 401k balance? And what about liquidity, the investor’s ability to exit a private equity position?
Illiquidity is a particularly thorny hurdle. Private equity firms typically buy and hold large stakes in companies for between three to 10 years. Plan participants and administrators are accustomed to instantaneous portfolio realignments; adding PE may force investors to lock capital in place for years at a time and plan administrators to alter the structure of accounts.
Then there is the broader consideration of whether funneling more dollars into private equity is a good thing for investors and businesses. In a recent op-ed advocating for the DOL’s June guidance, the DOL’s deputy chair Patrick Pizzella points out that more companies today are private and fewer are public: “Main Street investors could once choose from about 7,400 different exchange-listed operating companies. Today, that number is 4,300,” he says. Mr. Pizzella is correct, but he doesn’t address the fact that more PE funds will lead to more privatization across industries and fewer public companies. His proposed solution for widespread privatization is to embrace that trend rather than reverse it.
That worldview is problematic because the US business landscape has been consolidating for decades, driven in large part by private equity sponsors that often merge a business with another PE-backed portfolio company or sell it to a larger publicly traded firm. Revenues of Fortune 500 companies jumped from 58 percent of GDP in 1994 to 73 percent in 2013, while the 100 largest U.S. companies are growing faster than their Fortune 500 peers, according to a recent FiveThirtyEight study. Increased privatization is likely to accelerate this trend.
There is also the question of business transparency. Publicly traded companies are required to disclose on a quarterly and annual basis all relevant financial information, from operating results to management compensation. In addition, public companies must disclose analysis of their own strengths and weaknesses, while also subjecting themselves to the questions of institutional shareholders and analysts on earnings calls. The more private companies replace public companies, the less U.S. investors understand the businesses they’re invested in.
This brings us back to that opening question, which informs the entire spectrum of debate: Who gets to invest in what?
It is helpful to frame that question in political terms: a Republican might suggest that everyone, regardless of income or education, should be allowed to invest in private securities, on the basis of free market principles. A Democrat might retort that privately placed securities are inherently risky and that protecting ordinary investors from private securities is a public good, even if that means sacrificing their potential upside. The Republican will probably call the Democrat paternalistic and the Democrat will probably call the Republican reckless, and they’ll agree to disagree.
But in a way, neither is talking about the investment landscape as it currently exists: The Republican’s insistence on “financial choice” in this context is misguided because the vast majority of 401k participants (myself included) are not hand-selecting stocks or analyzing the balance sheets of the dozens or even hundreds of companies their 401ks are invested in. The Democrat’s insistence on protecting investors may be overly cautious, as long as there is a sufficient regulatory framework in place.
In that case, one might ask, what difference does it really make if some 401ks have opt-in private equity placements? Some 401k accounts may get lucky and receive higher PE returns than others, but that’s also true of mutual funds and individual stocks. If PE exposure is implemented in a way that provides sufficient diversification, investor protection, flexibility, and choice, then maybe the DOL’s guidance is actionable after all.
The most important question isn’t whether the DOL guidance would affect retirees, PE funds, and the 401k industry (it would, obviously). Rather, it’s how such guidance will affect businesses, workers, consumers, the financial system, and the economy.
In other words, if we’re going to have a conversation about opening private equity to the public, it needs to focus on the public.
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“We made this place together, we own it together, we run it together. Without access, without favor, without discretion, without influence”
Thus spoke Defector, a new sports media company pioneered by the journalists formerly of Deadspin, an irreverent sports blog.
Why it matters: Defector’s founding team of 18 journalists are the same who quit Deadspin in protest in 2019 after clashing with the management of Great Hill Partners, the private equity firm that acquired the blog’s parent company.
The Defectors (can we call them that?) are riding the wave of subscriber-only blogs and paid newsletters as they seek to create an independent newsroom and business:
Defector’s founders said the company had no outside investors, and each employee has taken a stake of roughly 5 percent in the venture. Unlike Deadspin, a free site that relies on ads, Defector will offer subscriptions at $8 a month, with an annual subscription available at a discount. The 19 staff members will be paid as the money comes in, and they can vote out the editor in chief with a two-thirds majority. They will also own their own intellectual property, meaning they will get the money if Hollywood shows an interest in their work for Defector.
Reminder: The Defectors’ bad brush with PE ownership is hardly unique in the news industry. As I wrote earlier this year, many media companies have had troubled relationship with PE investors and VC backers.
In sum, the media industry continues to be a tough business, where margins are thin and fundamentals are bad. As a result, journalists and media entrepreneurs are getting creative in building new revenue models.
“Still, with all our faults and problems, the rest of the world would love even the tiniest sip of the elixir we have here in the U.S.”
That’s what Jeff Bezos said in his opening statement to the House Judiciary Antitrust Subcommittee during this week’s hearings. Bezos’s fellow masters of the universe similarly appealed to congressional patriotism during their opening remarks. Sundar Pichai of Google waxed nostalgic about arriving in the U.S. for graduate school. Tim Cook labeled Apple as a “uniquely American company.” Mark Zuckerberg of Facebook warned about the rise of Chinese companies.
The tech CEOs would have us believe their own market dominance and America’s greatness are bound up together, but there is something richly ironic about drumming up “everyone loves America” sentiment during an antitrust hearing. Remember, European regulatory authorities have fined Google billions of dollars and opened investigations into Amazon, Google, and Facebook.
By the way, Mr. Bezos, if we’re judging countries on their ability to handle the Covid-19 pandemic, then not a single country wants anything to do with whatever elixir the U.S. is brewing.
Private Equity
Berkshire Partners Acquires CrossFit: The deal follows the ouster of CrossFit’s former CEO, Greg Glassman, over his comments George Floyd’s murder. (Axios)
PE Cash Flows to 2020 Campaign: PE executives at PE have donated nearly $92 million on presidential campaigns and congressional races to date. (WSJ)
PE Firms Binge On Debt: PE firms are once again saddling their portfolio companies with debt to fund dividends, despite the continued economic threat and uncertainty around Covid-19. (Bloomberg)
BC Partners Goes Shopping in Italy: The global PE firm is taking private IMA, a machinery make, in a $3.4 billion deal. (Bloomberg)
California Pizza Kitchen Goes Bust: The PE-backed restaurant chain filed for Chapter 11 bankruptcy, citing restaurant closures during the pandemic. (Eater)
Massachusetts Pensioners Suffer PE Blow: So much for those outsized returns: the Massachusetts state pension fund saw an 8.3% decline in the value of its private-equity investments over Q2. (WSJ Pro PE)
Venture Capital
Digital Health Startup Ro Raises $200M: The company, which seeks to become “the Shopify of healthcare”, is now valued at $1.5 billion. General Catalyst led the round. (CNBC)
Student Fund To Invest In Students: Meet “Stanford 2020”, a new venture fund created by Stanford classmates to invest exclusively in their fellow students’ startups. (TechCrunch)
AUTO1 Raises $300 Million: The European digital used-car trading platform raised the funds in the form of convertible notes; Softbank Group, an existing shareholder, participated in the round. (Reuters)
M&A
SAP To Spin Off Qualtrics: The German software giant SAP acquired experience management platform Qualtrics for $8 billion less than two years ago, but is now spinning out the company in an IPO. (TechCrunch)
Reliance Industries Evaluating Retail Acquisition: The Indian conglomerate, fresh off financing rounds from private equity and Facebook, is looking at a +$3 billion acquisition of Future Group’s Indian retain chains. (Live Mint)
IPOs
Sports-SPAC Files For $500M IPO: PE firm RedBird Capital Partners and former Oakland Athletics executive Billy Beane are sponsoring a new sports-focused SPAC. (WSJ)
John Hyatt, author of What’s the Deal, is a financial blogger and writer. Follow him on Twitter, connect with him on LinkedIn, email him your feedback at johngilberthyatt@gmail.com – and don’t forget to subscribe!