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Call it the 18th Century Version 2.0. Prior to the Buttonwood Agreement of 1792, which launched the New York Stock & Exchange Board (which later became the NYSE) to organize the trading of a handful of government bonds and bank shares, essentially all businesses were privately owned. Yet the appeal of readily tradable ownership, which offered the ability to raise vast sums of capital while limiting investors’ liability, launched an era of public companies that culminated in their near-complete domination of all kinds of equities by the 1960s.
The public and private company worlds would occasionally cross paths with initial public offerings, and the public markets would provide a valuation reference point for private company transactions. But these worlds essentially operated completely separately, each with their own rules. Private companies focused on cash flows and were run for the benefit of their owners, whereas public companies focused on growing earnings per share and often were run for the benefit of their senior leadership.
The 1979 acquisition of Houdaille by KKR for $355 million, the first leveraged buyout (LBO) of a public company, set in motion forces that brought these worlds colliding back together. Nearly 40 years of growing shareholder influence, initially from LBOs and corporate raiders and more recently from sophisticated activist investors, has increasingly tightened the linkage. Another critical driver: the vast financial firepower of private equity. Once insignificant, private equity firms currently manage $4.6 trillion in assets (compared to $4.3 trillion in all ETF assets), with $600 billion in additional buyout funding ready to invest, according to Preqin, who gathers data on the industry.
Even hedge funds and mutual funds, which previously operated almost exclusively in the public equity realm, are increasingly taking stakes in private companies. Mutual fund giant Fidelity recently disclosed positions in Uber, Airbnb and SpaceX. Ironically, the expansion of private equity’s influence is bolstered by the rapid adoption of passive equity investing. As investors direct more money into ETFs, the ETF fund companies (which get to vote their shares) are consolidating the ownership of public companies, almost like private equity owners.
Public equity markets are headed back to a version, call it 2.0, of the 18th Century world where private equity ruled the investing landscape. Public companies aren’t going away anytime soon, but they are increasingly having to play by the rules of private equity – with different valuation metrics and governance practices (oversight).
What does this mean for public equity investors?
- First, private equity valuation measures will increasingly drive public company valuations. Private firms care little about accounting earnings (unlike public companies), focusing instead on operating cash flow. As a result, the price/earnings multiple is falling out of favor, and is being replaced by the EV/Ebitda multiple1. This might change one’s perception of valuation. Post Holdings, a breakfast cereal and protein company, trades at a remarkable 32x price/earnings multiple, twice that of peers Kellogg and General Mills and more appropriate for a rapidly growing tech company. Yet, on an EV/Ebitda basis, its 9.9x multiple is at a discount to the 11.7x multiple of its two peers. (This discrepancy alone identifies Post as a stock worth examining).
- Second, underperforming companies, especially those with weak governance, will come under shareholder pressure more quickly. Investors now have the tools, through activism or outright acquisition, to apply the higher accountability of private ownership in the hopes of boosting performance. We need to look no further for an example than this week’s sweeping activist-led changes to the board at natural foods maker Hain Celestial Group.
- We will also likely see more quasi-public companies, like Kraft Heinz which is 51% owned by 3G Capital and Berkshire Hathaway (itself a quasi-private company). Similarly, Advance Auto Parts is led by chairman Jeff Smith, head of activist firm Starboard Value who owns a 4% stake in Advance. Google and Amazon act a lot like private companies with their many large internally-funded ventures.
- It could eventually be bad news for currently in-favor tech companies. Rapid share price gains for Facebook (up 340% since its 2012 IPO at $38) have kept investors smiling, but once the stock eventually stalls out, governance issues will come to bear. Even now, investors shot down its ever-powerful chairman Mark Zuckerberg’s plan to perpetuate his voting control after he gives away his shares.
One might ask the same question of Amazon. While the market yields to the remarkable execution of chairman Jeff Bezos, will a downturn prompt demands for a spin-off of its Amazon Web Services cloud business or a more accountable leadership?
How far will the privatization of the public equity market eventually go? We believe the answer is “further.” Investors’ appetite for better accountability, the ever-advancing demands for more disclosure (often unflattering), and the endless search for better returns won’t relent. Once the high tides of the enduring if tepid economic recovery and very friendly interest rate environment flow back out, investors will look carefully at what companies are operating successfully under the new 18th Century Version 2.0 rules and who is still living in the 1960s.
 EV is enterprise value, generally the market value plus debt less cash. Ebitda is Earnings before interest, taxes, depreciation and amortization, which generally is cash operating earnings.