Jamal Mecklai: The decline of public markets?

MARKET MANIAC

The two largest stock exchanges in the world""the New York Stock Exchange and the London Stock Exchange""lost capital during 2006. On both exchanges the amount of capital taken out of the market by companies delisting (going private) was more than the amount of capital raised by fresh issues, although the number of listed companies on the LSE did increase. Closer home, the number of companies reporting quarterly results""a must for a listed company""fell from 3,577 in December 2005 to 3,397 in September 2006, a drop of over 5%.

Clearly, managements of many companies are finding public ownership not as attractive as they used to. Much of this has to do with the post-Enron increase in the cost of listing/staying listed (Sarbanes-Oxley, Clause 49, and other governance initiatives), although, to be sure, there is already some evidence that the hoo-hah over corporate governance may already be starting to quieten down.

For instance, US Treasury Secretary Hank Paulson is actively jawboning about the need to dilute SOX implementation. The SEC has "proposed several measures meant to respond to business pleas for regulatory relief. One would let companies and auditors scale back their reviews of corporate internal financial controls. Another would allow foreign companies to more easily escape SEC oversight." And there is at least one academic study reportedly showing that SOX actually reduces, rather than adds, value to small shareholders, because the constraints on decision-making (in most) companies imposed by the controls cost more than the gains from more accurate reporting (in the few).

On the other hand, the "options backdating" scandal is just coming into the public domain, with several major US companies""notably Apple Computer""under federal investigation. And, the current media outrage over the severance package of $210 million to Bob Nardelli of Home Depot and the outsize bonuses on Wall Street this year could play quite well in the new Democratic Congress in the US. Thus, it seems likely that the "pain from governance regulations" trigger that has pushed companies to go private will continue to carry some sting into 2007.

In parallel, of course, is the high-on-the-hog private equity industry, which concluded an amazing $700 bn of deals in 2006 (for scale, the total IPOs on the NYSE were around $50 bn). Flush with funds, particularly as more and more US institutional investors have realised that public market returns cannot consistently exceed nominal economic growth (of around 5%), these firms are aiming higher and higher""size wise. Deal sizes of $50-60 bn are in the pipeline, more than dwarfing the all-time record $21.9 bn that ICBC raised in its IPO this year. Clearly, the advantage of scale that public markets once enjoyed is no longer an issue.

For the past few years, there has been a steady exodus of top-level managers from publicly listed companies scurrying out of the glare of the public spotlight to the extraordinarily high-strung reward/risk equations available in companies run by private monies. There is now an increasing flow of Wall Streeters making their way to the private equity giants, or, indeed, starting private equity funds themselves""it is hard to swing a cat anywhere these days""certainly not at trendy bars like Indigo""without bumping into a group of bright young private equity upstarts. Business school graduates, too, are beginning to seek out careers in private equity""careers being the operative word. Perhaps the final piece is provided by entrepreneurs, many of whom seem to prefer a strategic sale to the rigours of an IPO""just last week, a bright young Indian entrepreneur told me that for him an IPO would be like punishment; he's building his business for a strategic sale.

There is no doubt that the pendulum has swung dramatically towards greater private ownership of financial assets. The question is whether it has further to go.

With Indian, Chinese, Russian and other emerging market companies growing strongly, the global demand for capital from public markets is still rising, as is market liquidity. But, if the trend to going private continues, we could get to a point when global market liquidity begins to shrink, stock exchanges would come under pressure""which, may, in part explain, the hysterical scurrying around we are seeing in the sector right now.

Perhaps the turning point would be seen when the price of risk starts to rise, since lower market liquidity would lead to weaker price discovery, which in turn would make risk assessment that much more difficult.

Currently""and this has been one of the conundrums facing market analysts for a few years now""the market price of risk has been falling, rather than rising. And this could well be because the share of risks that remain out of sight (in private equity investments) is unknown. With the scale of these holdings rising, any problems in a large private equity portfolio could tip the balance. Granted that most private equity investments are backed by strong management capabilities, but then let's not forget that LTCM was backed by the best minds in the financial risk management business.

The good news is that taxi drivers aren't talking private equity""yet.