In Private Markets, Red Is the New Black

The luster of the public markets has waned over the last 20 years to the benefit of private capital. Fewer companies are listed on US stock exchanges today than at the turn of the millennium.

Many reasons have been proposed to explain this trend. Hundreds of dot-com start-ups went public in the 1990s and many collapsed in the ensuing crash. The supposed burdens of corporate governance and excessive regulatory oversight of listed companies are among the other potential deterrents to initial public offerings (IPOs).

But one consideration outweighs all others in my experience: Listed firms are under constant pressure to deliver profits. In particular, they are forever in thrall to the tyrannical yardstick of equity analysts: earnings per share (EPS). Predictable quarterly growth is imperative in the public markets. Private capital investors have demonstrated, however, that a positive EPS serves no purpose.

Private equity hones in on cash flows.

Leveraged buyouts (LBOs) aim to maximize capital gains for their shareholders. How is this achieved? By issuing as much debt as is structurally acceptable.

In practice, thanks to innovative covenant-lite packages and lenders’ willingness to grant flexible loan structures to their most regular and preferred clients, debt commitments are maxed out and netted off operating profits. This rarely allows a margin of error. Hence, the long list of bankrupt and zombie buyouts.

Businesses under LBO often squeeze suppliers, cut “excess fat” in the payroll, and skimp on customer service — so long as the short-term repercussions don’t damage the firm’s valuation while under private-equity ownership.

Any extra cash generated from these aggressive reorganizations must then be used exclusively to redeem loans or distribute dividends. To divert operating cash flows to pay taxes, for instance, would be the equivalent of managerial incompetence, maybe even a breach of the fiduciary duty owed to the fund providers. Cash leakage to third parties is inexcusable, pre-tax losses the sign of a job well done.

Venture capital prioritizes top-line growth.

Start-ups are another form of enterprise often held in private hands. And like their LBO brethren, venture capitalists (VCs) believe net earnings are decidedly vulgar.

It is accepted wisdom that the objective of any newly created business is exponential growth. Expanding at all costs and burning cash as quickly as possible is not just normal practice in Silicon Valley, it is the only responsible course if the goal is to dominate or control a market.

Achieving critical mass costs money, and as the recent unicorn stampede demonstrates, start-ups with international ambitions are expected to raise multi-billion-dollar rounds to fuel their expansion. By the time of its stock listing, Uber had raised more than $25 billion.

Up until the dot-com era of the late 1990s, start-ups were supposed to follow a methodical approach. That meant demonstrating the sustainability of their business model and charting a clear path to profitability.

That is no longer the case.

Profits can wait.

The development of global online platforms like Amazon, Google, and Facebook changed the rules of the game. In a digital world, the key to survival is not profitability but market power. Start-ups must quickly establish, if not a monopolistic position, at least an impregnable one.

Theory teaches that monopolies eventually deliver what economists call supernormal profit. Yet, this new genre of entrepreneurial venture takes an awfully long time to become profitable. Years after their VC backers have exited, today’s start-ups are often still heavily loss-making. It took 12 years for Twitter to generate a net income. A decade after launching, Uber incurred an $8.5-billion loss in 2019 — the year of its IPO.

The methods adopted by private capital fund managers have changed the definition of capitalism. The word once referred to the for-profit appropriation of the means of production by private owners. In today’s system, private investors pocket capital gains regardless of the long-term viability of their portfolio companies.

In private markets, losses matter more than profits. Public investors do not share this credo. For now.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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Sebastien Canderle

Sebastien Canderle is a private capital advisor. He has worked as an investment executive for multiple fund managers. He is the author of several books, including The Debt Trap and The Good, the Bad and the Ugly of Private Equity. Canderle also lectures on alternative investments at business schools. He is a fellow of the Institute of Chartered Accountants in England and Wales and holds an MBA from The Wharton School.