Listed equity is shrinking, reducing opportunities for investors
Since early 1998, more equity has been withdrawn than added to the US stockmarket each year, while there has been a vast rise in corporate debt.
US companies have shrunk their equity through large-scale buy-backs (about to be given another boost by the Trump administration’s favourable tax rules on repatriation of foreign profits) and mergers and acquisitions financed by bond issues.
Such buy-backs have been driven by perverse management incentives, poorly designed tax policies and short-sighted investment managers. The net result is that, while GDP has grown, the volume of quoted equity has shrunk.
Data for the UK, while less extreme, is similar. You can see why anti-capitalists conclude that stockmarkets today serve not to raise capital but to enable managers and investors to cash in their gains.
Now even mainstream media such as the Financial Times have started to question whether there is a private equity bubble. The promoters of private equity funds, which have bought many listed businesses in recent years, have had to turn away institutional investors seeking to put tens of billions into their latest capital raisings.
As a business manager, why would you not prefer a private life under private equity ownership, with perhaps tighter performance targets, but far greater financial rewards that will never be disclosed to the media? And as a private equity investor, why would you not want the latest fund to be financed on a 5-1 debt-equity ratio, given easy availability of low-cost bank and bond finance?
Private equity looks like hedge funds all over again. It took years for academics to get enough reliable data to prove hedge funds added no value for investors. The profs will probably conclude the same is true of private equity funds once you account for the effects, costs and risks of gearing and the fees. But the lucrative private equity bandwagon will keep on rolling for some time.
There may be some inevitability about shrinking equity. In an economy where the proportion of GDP accounted for by services rises, you would expect the proportion of GDP handled by publicly listed businesses to decline, since many services are hard to scale up.
Meanwhile, what the stockmarket did for enterprise in the 19th century is being done by crowdfunding platforms. The early-stage and start-up businesses they finance will account for more than all private sector net employment growth over the next decade, since large companies will shed more workers than they hire, and add more robots.
It will not be long before funds offering diversified investment into crowdfunded businesses become mainstream. That and EISs offering investors the best chance of capital growth over the next decade.
They will carry the appropriate risk-reward ratio; a ratio fund managers will fail to match with over-engineered multi-asset solutions.
Investment management’s worst enemy – a simple investment policy based on one pile of cash and a smaller one of risky assets – could yet prove its nemesis.
While listed equity shrinkage remains the trend, though, investors will be encouraged to follow a universally successful marketing strategy: buy now while stocks last.
Chris Gilchrist is director of Fiveways Financial Planning