A growing number of prominent business leaders have been pushing regulators to address what they believe to be one of the most significant detriments to U.S. economic growth — “short-termism,” or the heightened importance that public companies and their shareholders place on near-term profits.
Warren Buffett and Jamie Dimon co-authored an op-ed piece last June in The Wall Street Journal, arguing that far too many public companies are holding back on investing for the future because they feel pressure to increase the bottom line to meet the next quarter’s forecasts.
At the same time, a movement has gained ground to make it easier for individual investors to access the private company market, where many businesses take a longer-term approach to creating value.
Last month, SEC Chairman Jay Clayton announced that the SEC would weigh the possibility of a major regulatory overhaul that would broaden the definition of “accredited” investor. This would allow more retail clients to take part in private placements, giving them greater opportunity to tap into a rapidly growing segment of the economy.
The fact that these two developing stories are unfolding at the same time is no coincidence.
Rise of Short-Termism
McKinsey & Co. has spent years analyzing the extent to which public companies have shifted their focus away from long-term strategic planning and toward maximizing short-term profits.
Using a data set of 615 domestic large- and mid-cap companies that were publicly listed from 2001-2015, McKinsey developed the Corporate Horizon Index (CHI), which measures the aggregate amount of short-termism in the market.
Their findings show that the median CHI score has become increasingly short-term over the last 20 years. McKinsey also conducted a series of surveys that showed that 87% of public company executives reported feeling the most pressure to generate strong financial results in under two years.
The rise in short-termism could have a meaningful impact on your clients who hold a significant percentage of their wealth in public companies, including via 401(k) plans and IRAs.
There are two primary reasons that stock market returns are expected to decline. First is the logical assumption that public businesses focused on short-term profits are less likely to deliver sustainable growth over the long-term.
To this point, McKinsey’s research shows that from 2007 to 2014, companies classified as having a long-term focus invested more in R&D and showed revenue 47% higher and earnings growth 36% higher than that experienced by short-term oriented businesses. Additionally, the long-term focused firms were 50% more likely to rank in the top decile for total shareholder returns within their given industry.
In contrast, experienced private equity managers are almost obsessively focused on creating value in their portfolio companies over a three- to six-year period, which is the typical length of PE ownership.
These managers spend a tremendous amount of time with the senior executives running their portfolio companies, focusing on long-term value creation plans such as expanding into new markets, making add-on acquisitions and/or improving operations by streamlining costs and selling noncore assets.
Shrinking Universe of Public Companies
The second potential cause of declining equity returns is the shrinking universe of publicly traded companies. All too aware of the constant pressure applied by public market investors and analysts to meet quarterly earnings, many leading private companies are avoiding listings altogether.
With the number of IPOs running at half the levels of the 1990s and 1980s, the number of U.S. public companies has nearly halved over the past 20 years to under 4,000, leaving a pool of generally more mature, lower growth companies.
There also is mounting research suggesting that much of the equity value in some of the world’s most successful and often disruptive businesses is being created prior to an IPO, leaving retail investors unable to participate in most of the upside.
This trend can be seen below. If your retail clients had purchased stock in Amazon’s IPO in 1997 and held it until today, they would have achieved a return of over 900 times.
By comparison, if your clients had bought into the IPOs of Alibaba, Facebook and Google (all of which stayed private much longer than Amazon did), they would have experienced much smaller returns, as private investors had already reaped the hyper growth that occurred during the private phase.
Some public companies are even delisting from exchanges to focus on long-term goals.
One high profile example is Dell, the technology giant that was taken private in 2013 after spending 25 years as a publicly traded company. Dell believed that it was unable to execute upon its long-term plans while operating under the microscope of public markets, with the company’s founder, Michael Dell, highlighting that as a private company it was “able to be bold, make investments and focus 100% on customers.”
After spending five years turning the business around and pursuing a key acquisition, Dell is now apparently worth nearly triple its valuation at the time of its buyout.
The Private Equity Solution
With continued short-termism posing a threat to the long-term return profile of public markets, it is increasingly important for your clients to find ways to gain exposure to private businesses that buck this trend.
This is where the SEC announcement about potentially loosening of the definition of “accredited” investor comes into play and is an area to watch closely.
Perhaps the biggest issue for investors looking to allocate to private equity is liquidity, as these funds typically require long lock-up periods. However, for investors truly intending to maintain long-term exposure to equities, reallocating 5%-10% of a total portfolio to private equity should have a negligible impact on overall liquidity while enhancing diversification.
In addition, one of the inherent benefits of the illiquid nature of private equity is that the investor is placing the decision of when to sell in the hands of experienced fund managers, thereby preventing individuals from selling investments at the wrong time under adverse market conditions. In other words, the private equity model forces individual investors to adopt a “buy and hold” discipline.
Fortunately, technological advancements have made private equity more accessible to qualified investors than ever before, while also streamlining the reporting and administration for their wealth advisors.
Nick Veronis is co-founder and managing partner of iCapital Network, and Dan Fletcher is director of iCapital Network.
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